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Unformatted text preview: wiL79549_ch01_0002-0045 07/25/2008 7:00 pm Page 2 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: A Look at This Chapter 1 A Look Ahead Accounting is crucial in our information age. In this chapter, we discuss the importance of accounting to different types of organizations and describe its many users and uses. We explain that ethics are essential to accounting. We also explain business transactions and how they are reflected in financial statements. Chapter 2 describes and analyzes business transactions. We explain the analysis and recording of transactions, the ledger and trial balance, and the double-entry system. More generally, Chapters 2 through 4 show (via the accounting cycle) how financial statements reflect business activities. Accounting in Business Chapter Learning Objectives Learning Objectives are classified as conceptual, analytical, or procedural. CAP Conceptual Analytical Procedural purpose and importance C1 Explain the in the information age. (p.of accounting 4) C2 Identify users and uses of accounting. (p. 5) C3 Identify opportunities6)in accounting and related fields. (p. ethics C4 Explain why(p. 8) are crucial to accounting. accounting C5 Explain generally acceptedapply several principles and define and A1 Define and interpret the accounting equation and each of its prepare basic financial P1 Identify andand explain how they statements components. (p. 12) A2 Analyze business transactions using the accounting equation. (p. 13) and A3 Compute 20) interpret return on assets. (p. 1A—Explain the relation A4 Appendix return and risk. (p. 23) between accounting principles. (p. 9) describe C6 Appendix 1B—Identify and of the three major activities organizations. (p. 24) LP1 interrelate. (p. 17) wiL79549_ch01_0002-0045 07/25/2008 7:00 pm Page 3 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Decision Feature A Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur. An Entrepreneurial Decision problem at the end of the assignments returns to this feature with a mini-case. Life Is Good “People are drawn to Jake usually with a grin or a big laugh . . . Jake rules!” — Bert Jacobs BOSTON—Bert and John Jacobs launched their T-shirt walls. “We take our inspiration from Dr. Seuss,” insists Bert. “We like company, Life is good ® (Lifeisgood.com), with to feel that in our own way we’re having a positive impact . . . and “nothing in our bank account and $78 in cash,” ex- having a lot of fun along the way.” The brothers have successfully plains Bert. Sales activities involved peddling T-shirts on college cam- organized their business, set up accounting systems, learned to puses and at street fairs. Although they lived and slept in their van and prepare and read financial reports, and apply financial analysis. Adds made only enough to pay for food and gas, they stayed the course. John, “Consistent performance is what has enhanced and strengthened Then, Bert says, “We created Jake, and he showed us the way!” [our products].” Jake is the smiling stick figure that now adorns their products. Bert The brothers’ accounting system tracks all transactions, and they and John first drew Jake on their apartment wall and then printed him on regularly prepare financial reports when making business decisions. a batch of T-shirts that sold within an hour at a Cambridge street fair. “It Those accounting realities have been creatively merged with their scared the hell out of us,” says Bert. “We looked at each other and said, fun-loving approach. In recent years, Life is good has held a factory talent ‘Oh my God, what do we have here?’ ” What they had was a Hollywood show, bowling tournament, and watermelon seed–spitting contest. The story in the making.Within a few years, Jake was adorning T-shirts, brothers exude positive thinking. “The foundation of our brand is opti- sweatshirts, and headwear and was producing millions in sales. mism,” explains Bert, “and optimism is timeless.” Bert and John have integrated their fun and quirky style into their business. A walk through the Life is good factory reveals blaring music, popcorn machines, free-roaming dogs, and giant murals on bright-colored [Sources: Life is good Website, January 2009; SGB, January 2006; Boston Common, Winter 2006; Worthwhile Magazine, 2005; American Executive, August 2005; Inc., October 2006; Entrepreneur, May 2007] wiL79549_ch01_0002-0045 08/18/2008 9:07 am Page 4 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter Preview A Preview opens each chapter with a summary of topics covered. Today’s world is one of information—its preparation, communication, analysis, and use. Accounting is at the core of this information age. Knowledge of accounting gives us career opportunities and the insight to take advantage of them. This book introduces concepts, procedures, and analyses that help us make better decisions, including career choices. In this chapter we describe accounting, the users and uses of accounting information, the forms and activities of organizations, and several accounting principles. We also introduce transaction analysis and financial statements. Accounting in Business Importance of Accounting • Accounting • information users Opportunities in accounting Fundamentals of Accounting • Ethics—key • concept Generally accepted accounting principles Transaction Analysis • Accounting • equation Transaction analysis— illustrated Financial Statements • Income statement • Statement of owner’s equity • Balance sheet • Statement of cash flows Importance of Accounting C1 Explain the purpose and importance of accounting in the information age. Video1.1 Real company names are printed in bold magenta. Why is accounting so popular on campuses? Why are there so many accounting jobs for graduates? Why is accounting so important to companies? Why do politicians and business leaders focus on accounting regulations? The answer is that we live in an information age, where that information, and its reliability, impacts the financial well-being of us all. Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires selecting transactions and events relevant to an organization. Examples are the sale of iPods by Apple and the receipt of ticket money by TicketMaster. Recording business activities requires keeping a chronological log of transactions and events measured in dollars and classified and summarized in a useful format. Communicating business activities requires preparing accounting reports such as financial statements. It also requires analyzing and interpreting such reports. (The financial statements and notes of Best Buy are shown in Appendix A of this book. This appendix also shows the financial statements of Circuit City, RadioShack, and Apple.) Exhibit 1.1 summarizes accounting activities. We must guard against a narrow view of accounting. The most common contact with accounting is through credit approvals, checking accounts, tax forms, and payroll. These experiences are limited and tend to focus on the recordkeeping parts of accounting. Recordkeeping, or bookkeeping, is the recording of transactions and events, either manually or electronically. This EXHIBIT 1.1 Accounting Activities Identifying Recording Communicating Select transactions and events Input, measure, and classify Prepare, analyze, and interpret wiL79549_ch01_0002-0045 08/18/2008 9:07 am Page 5 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business is just one part of accounting. Accounting also identifies and communicates information on transactions and events, and it includes the crucial processes of analysis and interpretation. Technology is a key part of modern business and plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving clerical accuracy. Some small organizations continue to perform various accounting tasks manually, but even they are impacted by technology. As technology has changed the way we store, process, and summarize masses of data, accounting has been freed to expand. Consulting, planning, and other financial services are now closely linked to accounting. These services require sorting through data, interpreting their meaning, identifying key factors, and analyzing their implications. 5 Margin notes further enhance the textual material. Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting. The best software and recordkeeping cannot make up for lack of accounting knowledge. Users of Accounting Information Accounting is often called the language of business because all organizations set up an accounting information system to communicate data to help people make better decisions. Exhibit 1.2 shows that the accounting information system serves many kinds of users (this is a partial listing) who can be divided into two groups: external users and internal users. EXHIBIT 1.2 Users of Accounting Information A A A A A A A A A A A A A 000027 000028 000029 000030 000031 000032 000033 000034 000035 000036 000037 000038 000039 • Lenders • Shareholders • Governments 521 789 506 505 567 152 726 ----359 657 254 658 236 –012 003 –006 –009 –013 003 –001 -----–003 008 –003 –003 –003 521 789 506 505 567 152 726 ----359 657 254 658 236 521 789 506 505 567 152 726 ----359 657 254 658 236 521 789 506 505 567 152 726 0 359 657 254 658 236 521 789 506 505 567 152 726 ----359 657 254 658 236 • Consumer groups • External auditors • Customers • Officers • Managers • Internal auditors • Sales staff • Budget officers • Controllers External Information Users External users of accounting information are not directly involved in running the organization. They include shareholders (investors), lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. External users have limited access to an organization’s information. Yet their business decisions depend on information that is reliable, relevant, and comparable. Financial accounting is the area of accounting aimed at serving external users by providing them with general-purpose financial statements. The term general-purpose refers to the broad range of purposes for which external users rely on these statements. Each external user has special information needs depending on the types of decisions to be made. Lenders (creditors) loan money or other resources to an organization. Banks, savings and loans, co-ops, and mortgage and finance companies are lenders. Lenders look for information to help them assess whether an organization is likely to repay its loans with interest. Shareholders (investors) are the owners of a corporation. They use accounting reports in deciding whether to buy, hold, or sell stock. Shareholders typically elect a board of directors to oversee their interests in an organization. Since directors are responsible to shareholders, their information needs are similar. External (independent) auditors examine financial statements to verify that they are prepared according to generally accepted accounting principles. Employees and labor unions use financial statements to judge the fairness of wages, assess job prospects, and bargain for better wages. Regulators often have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) and other tax authorities require organizations to file accounting reports in computing taxes. Other regulators include utility boards that use accounting information to set utility rates and securities regulators that require reports for companies that sell their stock to the public. Accounting serves the needs of many other external users. Voters, legislators, and government officials use accounting information to monitor and evaluate government receipts and Infographics reinforce key concepts through visual learning. C2 Identify users and uses of accounting. wiL79549_ch01_0002-0045 08/18/2008 9:07 am Page 6 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 6 expenses. Contributors to nonprofit organizations use accounting information to evaluate the use and impact of their donations. Suppliers use accounting information to judge the soundness of a customer before making sales on credit, and customers use financial reports to assess the staying power of potential suppliers. Internal Information Users Internal users of accounting information are those directly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Managerial accounting is the area of accounting that serves the decision-making needs of internal users. Internal reports are not subject to the same rules as external reports and instead are designed with the special needs of internal users in mind. There are several types of internal users, and many are managers of key operating activities. Research and development managers need information about projected costs and revenues of any proposed changes in products and services. Purchasing managers need to know what, when, and how much to purchase. Human resource managers need information about employees’ payroll, benefits, performance, and compensation. Production managers depend on information to monitor costs and ensure quality. Distribution managers need reports for timely, accurate, and efficient delivery of products and services. Marketing managers use reports about sales and costs to target consumers, set prices, and monitor consumer needs, tastes, and price concerns. Service managers require information on the costs and benefits of looking after products and services. Decisions of these and other internal users depend on accounting reports. Both internal and external users rely on internal controls to monitor and control company activities. Internal controls are procedures set up to protect company property and equipment, ensure reliable accounting reports, promote efficiency, and encourage adherence to company policies. Examples are good records, physical controls (locks, passwords, guards), and independent reviews. Decision Insight boxes highlight relevant items from practice. Decision Insight They Fought the Law Our economic and social welfare depends on reliable accounting information. A few managers forgot that and are now paying their dues. They include L. Dennis Kozlowski (in photo) of Tyco, convicted of falsifying accounting records; Bernard Ebbers of WorldCom, convicted of an $11 billion accounting scandal, Andrew Fastow of Enron, guilty of hiding debt and inflating income, and Joe Nacchio of Qwest, accused of falsely reporting sales. Opportunities in Accounting C3 Identify opportunities in accounting and related fields. Accounting information affects many aspects of our lives. When we earn money, pay taxes, invest savings, budget earnings, and plan for the future, we are influenced by accounting. Accounting has four broad areas of opportunities: financial, managerial, taxation, and accounting-related. Exhibit 1.3 lists selected opportunities in each area. EXHIBIT 1.3 Opportunities in accounting Accounting Opportunities Financial • Preparation • Analysis • Auditing • Regulatory • Consulting • Planning • Criminal investigation Managerial • General accounting • Cost accounting • Budgeting • Internal auditing • Consulting • Controller • Treasurer • Strategy Taxation • Preparation • Planning • Regulatory • Investigations • Consulting • Enforcement • Legal services • Estate plans Accounting-related • Lenders • Consultants • Analysts • Traders • Directors • Underwriters • Planners • Appraisers • FBI investigators • Market researchers • Systems designers • Merger services • Business valuation • Forensic accounting • Litigation support • Entrepreneurs wiL79549_ch01_0002-0045 08/18/2008 9:07 am Page 7 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business The majority of accounting opportunities are in private accounting, as shown in Exhibit 1.4. Public Government, accounting offers the next largest number of not-for-profit and Private opportunities. Still other opportunities exist in education 15% government (and not-for-profit) agencies, includ- accounting 60% Public ing business regulation and investigation of law accounting violations. 25% Accounting specialists are highly regarded. Their professional standing often is denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements, pass an examination, and exhibit ethical character. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), personal financial specialist (PFS), certified fraud examiner (CFE), and certified forensic accountant (CrFA). Individuals with accounting knowledge are always in demand as they can help with financial analysis, strategic planning, e-commerce, product feasibility analysis, information technology, and financial management. Benefit packages can include flexible work schedules, telecommuting options, career path alternatives, casual work environments, extended vacation time, and child and elder care. Demand for accounting specialists is booming. Exhibit 1.5 reports average annual salaries for several accounting positions. Salary variation depends on location, company size, professional designation, experience, and other factors. For example, salaries for chief financial officers (CFO) range from under $75,000 to more than $1 million per year. Likewise, salaries for bookkeepers range from under $30,000 to more than $80,000. Field Title (experience) Public Accounting Partner . . . . . . . . . . . . . . . . . Manager (6–8 years) . . . . . . . Senior (3–5 years). . . . . . . . . Junior (0–2 years) . . . . . . . . CFO. . . . . . . . . . . . . . . . . . . Controller/Treasurer . . . . . . Manager (6–8 years) . . . . . . . Senior (3–5 years). . . . . . . . . Junior (0–2 years) . . . . . . . . Full-charge bookkeeper . . . . . Accounts manager . . . . . . . . . Payroll manager . . . . . . . . . . . Accounting clerk (0–2 years) Private Accounting Recordkeeping 2007 Salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 Estimate* $190,000 94,500 72,000 51,500 232,000 147,500 87,500 72,500 49,000 57,500 51,000 54,500 37,500 $242,500 120,500 92,000 65,500 296,000 188,000 111,500 92,500 62,500 73,500 65,000 69,500 48,000 7 EXHIBIT 1.4 Accounting Jobs by Area Point: The largest accounting firms are Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers, and KPMG. Point: Census Bureau (2007) reports that for workers 18 and over, higher education yields higher average pay: Advanced degree . . . . . . . . $79,946 Bachelor’s degree . . . . . . . . 54,689 High school degree . . . . . . . 29,448 No high school degree . . . . 19,915 EXHIBIT 1.5 Accounting Salaries for Selected Fields Point: For updated salary information: www.AICPA.org Abbott-Langer.com Kforce.com * Estimates assume a 5% compounded annual increase over current levels. Quick Check Answers—p. 26 1. What is the purpose of accounting? 2. What is the relation between accounting and recordkeeping? 3. Identify some advantages of technology for accounting. 4. Who are the internal and external users of accounting information? 5. Identify at least five types of managers who are internal users of accounting information. 6. What are internal controls and why are they important? Quick Check is a chance to stop and reflect on key points. wiL79549_ch01_0002-0045 08/18/2008 9:07 am Page 8 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 8 Fundamentals of Accounting Accounting is guided by principles, standards, concepts, and assumptions. This section describes several of these key fundamentals of accounting. Ethics—A Key Concept C4 Explain why ethics are crucial to accounting. Point: Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior financial officers and the contents of that code. The goal of accounting is to provide useful information for decisions. For information to be useful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. For example, accounting users are less likely to trust an auditor’s report if the auditor’s pay depends on the success of the client’s business. To avoid such concerns, ethics rules are often set. For example, auditors are banned from direct investment in their client and cannot accept pay that depends on figures in the client’s reports. Exhibit 1.6 gives guidelines for making ethical decisions. EXHIBIT 1.6 Point: The American Institute of Certified Public Accountants’ Code of Professional Conduct is available at www.AICPA.org. Identify ethical concerns Analyze options Make ethical decision Use personal ethics to recognize an ethical concern. Guidelines for Ethical Decision Making Consider all good and bad consequences. Choose best option after weighing all consequences. Providers of accounting information often face ethical choices as they prepare financial reports. These choices can affect the price a buyer pays and the wages paid to workers. They can even affect the success of products and services. Misleading information can lead to a wrongful closing of a division that harms workers, customers, and suppliers. There is an old saying: Good ethics are good business. Some people extend ethics to social responsibility, which refers to a concern for the impact of actions on society. An organization’s social responsibility can include donations to hospitals, colleges, community programs, and law enforcement. It also can include programs to reduce pollution, increase product safety, improve worker conditions, and support continuing education. These programs are not limited to large companies. For example, many small businesses offer discounts to students and senior citizens. Still others help sponsor events such as the Special Olympics and summer reading programs. Decision Insight Copyright © 2007 by KLD Research & Analytics, Inc. The “Domini 400 Social Index.” Graphical displays are often used to illustrate key points. 8.0 DSI S&P 500 7.0 6.0 Value of $1 Invested Virtuous Returns Virtue is not always its own reward. Compare the S&P 500 with the Domini Social Index (DSI), which covers 400 companies that have especially good records of social responsibility. We see that returns for companies with socially responsible behavior are at least as high as those of the S&P 500. 5.0 4.0 3.0 2.0 1.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Generally Accepted Accounting Principles Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP). To use and interpret financial statements effectively, we need to wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 9 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business understand these principles, which can change over time in response to the demands of users. GAAP aims to make information in financial statements relevant, reliable, and comparable. Relevant information affects the decisions of its users. Reliable information is trusted by users. Comparable information is helpful in contrasting organizations. Two main groups establish generally accepted accounting principles in the United States. The Financial Accounting Standards Board (FASB) is the private group that sets both broad and specific principles. The Securities and Exchange Commission (SEC) is the government group that establishes reporting requirements for companies that issue stock to the public. In today’s global economy, there is increased demand by external users for comparability in accounting reports. This often arises when companies wish to raise money from lenders and investors in different countries. To that end, the International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. The IASB hopes to create more harmony among accounting practices of different countries. If standards are harmonized, one company can potentially use a single set of financial statements in all financial markets. Many countries’ standard setters support the IASB, and differences between U.S. GAAP and IASB’s practices are fading. Yet, the IASB does not have authority to impose its standards on companies. 9 C5 Explain generally accepted accounting principles and define and apply several accounting principles. Setting Accounting Principles Point: State ethics codes require CPAs who audit financial statements to disclose areas where those statements fail to comply with GAAP. If CPAs fail to report noncompliance, they can lose their licenses and be subject to criminal and civil actions and fines. Decision Insight Principles and Scruples Auditors, directors, and lawyers are using principles to improve accounting reports. Examples include accounting restatements at Navistar, financial restatements at Nortel, accounting reviews at Echostar, and expense adjustments at Electronic Data Systems. Principles-based accounting has led accounting firms to drop clients deemed too risky. Examples include Grant Thornton’s resignation as auditor of Fremont General due to alleged failures in providing information when promised, and Ernst and Young’s resignation as auditor of Catalina Marketing due to alleged accounting errors. Principles and Assumptions of Accounting Accounting principles (and assumptions) are of two types. General principles are the basic assumptions, concepts, and guidelines for preparing financial statements. Specific principles are detailed rules used in reporting business transactions and events. General principles stem from long-used accounting practices. Specific principles arise more EXHIBIT 1.7 often from the rulings of authoritative groups. Building Blocks for GAAP G AA P We need to understand both general and specific principles to effectively use accounting information. Several general principles are described in this secMatching Cost tion that are relied on in later Principles Full chapters. General principles (in Revenue disclosure recognition red font) and assumptions (in yellow font) are portrayed as Going Monetary Time Business Assumptions building blocks of GAAP in concern unit period entity Exhibit 1.7. The specific principles are described as we encounter them in the book. General principles consist of at least four basic principles, four assumptions, and certain constraints. The cost principle means that accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured as the amount of cash paid. If something besides cash is exchanged Accounting Principles Point: The cost principle is also called the historical cost principle. wiL79549_ch01_0002-0045 07/29/2008 7:04 pm Page 10 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 10 Example: When a bookstore sells a textbook on credit is its earnings process complete? Answer: A bookstore can record sales for these books minus an amount expected for returns. Chapter 1 Accounting in Business (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. The cost principle emphasizes reliability and verifiability, and information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence; it demands more than a person’s opinion. To illustrate, suppose a company pays $5,000 for equipment. The cost principle requires that this purchase be recorded at a cost of $5,000. It makes no difference if the owner thinks this equipment is worth $7,000. Revenue (sales) is the amount received from selling products and services. The revenue recognition principle provides guidance on when a company must recognize revenue. To recognize means to record it. If revenue is recognized too early, a company would look more profitable than it is. If revenue is recognized too late, a company would look less profitable than it is. Three concepts are important to revenue recognition. (1) Revenue is recognized when earned. The earnings process is normally complete when services are performed or a seller transfers ownership of products to the buyer. (2) Proceeds from selling products and services need not be in cash. A common noncash proceed received by a seller is a customer’s promise to pay at a future date, called credit sales. (3) Revenue is measured by the cash received plus the cash value of any other items received. The matching principle prescribes that a company must record its expenses incurred to generate the revenue reported. The full disclosure principle requires a company to report the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements. Decision Insight Revenues for the San Diego Chargers football team include ticket sales, television and cable broadcasts, radio rights, concessions, and advertising. Revenues from ticket sales are earned when the Chargers play each game. Advance ticket sales are not revenues; instead, they represent a liability until the Chargers play the game for which the ticket was sold. At that point, the liability is removed and revenues are reported. Point: For currency conversion: cnnfn.com/markets/currencies Point: Abuse of the entity assumption was a main culprit in Enron’s collapse. Accounting Assumptions There are four accounting assumptions. The going-concern assumption means that accounting information reflects a presumption that the business will continue operating instead of being closed or sold. This implies, for example, that property is reported at cost instead of, say, liquidation values that assume closure. The monetary unit assumption means that we can express transactions and events in monetary, or money, units. Money is the common denominator in business. Examples of monetary units are the dollar in the United States, Canada, Australia, and Singapore; and the peso in Mexico, the Philippines, and Chile. The monetary unit a company uses in its accounting reports usually depends on the country where it operates, but many companies today are expressing reports in more than one monetary unit. The time period assumption presumes that the life of a company can be divided into time periods, such as months and years, and that useful reports can be prepared for those periods. The business entity assumption means that a business is accounted for separately from other business entities, including its owner. The reason for this assumption is that separate information about each business is necessary for good decisions. A business entity can take one of three legal forms: proprietorship, partnership, or corporation. 1. A sole proprietorship, or simply proprietorship, is a business owned by one person. No special legal requirements must be met to start a proprietorship. It is a separate entity for accounting purposes, but it is not a separate legal entity from its owner. This means, for example, that a court can order an owner to sell personal belongings to pay a proprietorship’s debt. This unlimited liability of a proprietorship is a disadvantage. However, an advantage is that a proprietorship’s income is not subject to a business income tax but is instead reported and taxed on the owner’s personal income tax return. Proprietorship characteristics are summarized in Exhibit 1.8, including those for partnerships and corporations. 2. A partnership is a business owned by two or more people, called partners. Like a proprietorship, no special legal requirements must be met in starting a partnership. The only wiL79549_ch01_0002-0045 08/18/2008 9:07 am Page 11 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business Characteristic Business entity . . . . Legal entity . . . . . . . Limited liability . . . . Unlimited life . . . . . Business taxed . . . . One owner allowed Proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Partnership Corporation yes no no* no no yes yes no no* no no no yes yes yes yes yes yes 11 EXHIBIT 1.8 Characteristics of Businesses * Proprietorships and partnerships that are set up as LLCs provide limited liability. requirement is an agreement between partners to run a business together. The agreement can be either oral or written and usually indicates how income and losses are to be shared. A partnership, like a proprietorship, is not legally separate from its owners. This means that each partner’s share of profits is reported and taxed on that partner’s tax return. It also means unlimited liability for its partners. However, at least three types of partnerships limit liability. A limited partnership (LP) includes a general partner(s) with unlimited liability and a limited partner(s) with liability restricted to the amount invested. A limited liability partnership (LLP) restricts partners’ liabilities to their own acts and the acts of individuals under their control. This protects an innocent partner from the negligence of another partner, yet all partners remain responsible for partnership debts. A limited liability company (LLC ) offers the limited liability of a corporation and the tax treatment of a partnership (and proprietorship). Most proprietorships and partnerships are now organized as LLCs. 3. A corporation is a business legally separate from its owners, meaning it is responsible for its own acts and its own debts. Separate legal status means that a corporation can conduct business with the rights, duties, and responsibilities of a person. A corporation acts through its managers, who are its legal agents. Separate legal status also means that its owners, who are called shareholders (or stockholders), are not personally liable for corporate acts and debts. This limited liability is its main advantage. A main disadvantage is what’s called double taxation—meaning that (1) the corporation income is taxed and (2) any distribution of income to its owners through dividends is taxed as part of the owners’ personal income, usually at the 15% rate. (For lower income taxpayers, the dividend tax is less than 15%, and in some cases zero.) An S corporation, a corporation with special characteristics, does not owe corporate income tax. Owners of S corporations report their share of corporate income with their personal income. Ownership of all corporations is divided into units called shares or stock. When a corporation issues only one class of stock, we call it common stock (or capital stock). Point: Proprietorships and partnerships are usually managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who appoint managers to run the business. Decision Ethics boxes are roleplaying exercises that stress ethics in accounting and business. Decision Ethics Entrepreneur You and a friend develop a new design for in-line skates that improves speed by 25% to 30%.You plan to form a business to manufacture and market those skates.You and your friend want to minimize taxes, but your prime concern is potential lawsuits from individuals who might be injured on these skates. What form of organization do you set up? [Answer—p. 25] Sarbanes–Oxley (SOX) Congress passed the Sarbanes–Oxley Act, also called SOX, to help curb financial abuses at companies that issue their stock to the public. SOX requires that these public companies apply both accounting oversight and stringent internal controls. The desired results include more transparency, accountability, and truthfulness in reporting transactions. Compliance with SOX requires documentation and verification of internal controls and increased emphasis on internal control effectiveness. Failure to comply can yield financial penalties, stock market delisting, and criminal prosecution of executives. Management must issue a report stating that internal controls are effective. CEOs and CFOs who knowingly sign off on bogus accounting reports risk millions of dollars in fines and years in prison. Auditors also must verify the effectiveness of internal controls. Point: An audit examines whether financial statements are prepared using GAAP. It does not attest to absolute accuracy of the statements. Point: BusinessWeek reports that external audit costs run about $35,000 for startups, up from $15,000 pre-SOX. wiL79549_ch01_0002-0045 08/18/2008 9:08 am Page 12 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 12 Chapter 1 Accounting in Business A listing of some of the more publicized accounting scandals in recent years follows. Company Enron . . . . . . . . . . . . . . . WorldCom . . . . . . . . . . . Fannie Mae . . . . . . . . . . . Adelphia Communications . AOL Time Warner . . . . . . Xerox . . . . . . . . . . . . . . . Bristol-Myers Squibb . . . . . Nortel Networks . . . . . . . Global Crossing . . . . . . . . Tyco . . . . . . . . . . . . . . . . Halliburton . . . . . . . . . . . . Qwest Communications . . Alleged Accounting Abuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inflated income, hid debt, and bribed officials Understated expenses to inflate income and hid debt Inflated income Understated expenses to inflate income and hid debt Inflated revenues and income Inflated income Inflated revenues and income Understated expenses to inflate income Inflated revenues and income Hid debt, and CEO evaded taxes Inflated revenues and income Inflated revenues and income To reduce the risk of accounting fraud, companies set up governance systems. A company’s governance system includes its owners, managers, employees, board of directors, and other important stakeholders, who work together to reduce the risk of accounting fraud and increase confidence in accounting reports. The impact of SOX regulations for accounting and business is discussed throughout this book. Ethics and investor confidence are key to company success. Lack of confidence in accounting numbers impacts company value as evidenced by huge stock price declines for Enron, WorldCom, Tyco, and ImClone after accounting misconduct was uncovered. Decision Insight IFRSs Like the FASB, the IASB uses a conceptual framework to aid in drafting standards. However, unlike the FASB, the IASB’s conceptual framework is used as a reference when specific guidance is lacking. Also unlike the FASB, the IASB requires that transactions be accounted for according to their substance (not only their legal form). Quick Check 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. Answers—p. 26 What three-step guidelines can help people make ethical decisions? Why are ethics and social responsibility valuable to organizations? Why are ethics crucial in accounting? Who sets U.S. accounting rules? How are U.S. companies affected by international accounting standards? How are the objectivity concept and cost principle related? Why is the business entity assumption important? Why is the revenue recognition principle important? What are the three basic forms of business organization? Identify the owners of corporations and the terminology for ownership units. Transaction Analysis and the Accounting Equation To understand accounting information, we need to know how an accounting system captures relevant data about transactions, and then classifies, records, and reports data. Accounting Equation A1 Define and interpret the accounting equation and each of its components. The accounting system reflects two basic aspects of a company: what it owns and what it owes. Assets are resources with future benefits that are owned or controlled by a company. Examples are cash, supplies, equipment, and land. The claims on a company’s assets—what it owes—are separated into owner and nonowner claims. Liabilities are what a company owes its nonowners (creditors) in future payments, products, or services. Equity (also called owner’s equity or capital) refers to the claims of its owner(s). Together, liabilities and equity are wiL79549_ch01_0002-0045 08/18/2008 9:08 am Page 13 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 13 the source of funds to acquire assets. The relation of assets, liabilities, and equity is reflected in the following accounting equation: ck y Sto Liabilities Best Equity Bu Invoice Bill Assets Liabilities are usually shown before equity in this equation because creditors’ claims must be paid before the claims of owners. (The terms in this equation can be rearranged; for example, Assets Liabilities Equity.) The accounting equation applies to all transactions and events, to all companies and forms of organization, and to all points in time. For example, Best Buy’s assets equal $13,570, its liabilities equal $7,369, and its equity equals $6,201 ($ in millions). Let’s now look at the accounting equation in more detail. Assets are resources owned or controlled by a company. These resources are expected to yield future benefits. Examples are Web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or product on credit is said to have an account receivable from that customer. Lones Videos1.1&1.2 Assets Point: The phrases “on credit” and “on account” imply that cash payment will occur at a future date. Liabilities Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks, and taxes payable to the government. Equity Equity is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. Equity for a noncorporate entity—commonly called owner’s equity—increases and decreases as follows: owner investments and revenues increase equity, whereas owner withdrawals and expenses decrease equity. Owner investments are assets an owner puts into the company and are included under the generic account Owner, Capital. Revenues increase equity and are the assets earned from a company’s earnings activities. Examples are consulting services provided, sales of products, facilities rented to others, and commissions from services. Owner withdrawals are assets an owner takes from the company for personal use. Expenses decrease equity and are the cost of assets or services used to earn revenues. Examples are costs of employee time, use of supplies, and advertising, utilities, and insurance services from others. In sum, equity is the accumulated revenues and owner investments less the accumulated expenses and withdrawals since the company began. This breakdown of equity yields the following expanded accounting equation. Key terms are printed in bold and defined again in the endof-book glossary. Equity Assets Liabilities Owner, Capital Owner, Withdrawals Revenues Expenses Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity. Decision Insight Web Info Most organizations maintain Websites that include accounting data—see Best Buy (BestBuy.com) as an example.The SEC keeps an online database called EDGAR (www.SEC.gov/edgar.shtml), which has accounting information for thousands of companies that issue stock to the public. Information services such as Finance.Google.com and Finance.Yahoo.com offer additional online data and analysis. Transaction Analysis Business activities can be described in terms of transactions and events. External transactions are exchanges of value between two entities, which yield changes in the accounting equation. Internal transactions are exchanges within an entity; they can also affect the accounting equation. An example is a company’s use of its supplies, which are reported as expenses when used. A2 Analyze business transactions using the accounting equation. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 14 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 14 Chapter 1 Accounting in Business Events refer to happenings that affect an entity’s accounting equation and can be reliably measured. They include business events such as changes in the market value of certain assets and liabilities, and natural events such as floods and fires that destroy assets and create losses. They do not include, for example, the signing of service or product contracts, which by themselves do not impact the accounting equation. This section uses the accounting equation to analyze 11 selected transactions and events of FastForward, a start-up consulting (service) business, in its first month of operations. Remember that each transaction and event leaves the equation in balance and that assets always equal the sum of liabilities and equity. Assets (1) Liabilities Equity Cash $30,000 C.Taylor, Capital $30,000 Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of brand name athletic footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It merely changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of athletic footwear are assets because of the expected future benefits from the test results of their performance. This transaction is reflected in the accounting equation as follows: Assets Supplies C.Taylor, Capital $30,000 $2,500 _______ $ 2,500 _______ $30,000 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Cash $30,000 2,500 _______ $27,500 Equity ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (2) New Bal. Liabilities $30,000 $30,000 FastForward spends $26,000 to acquire equipment for testing athletic footwear. Like transaction 2, transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected future benefits from testing athletic footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance. Transaction 3: Purchase Equipment for Cash Assets Cash $27,500 26,000 ________ $ 1,500 Equity Supplies $2,500 Equipment C.Taylor, Capital $30,000 ______ $2,500 $26,000 ________ _ $ 26,000 _______ $30,000 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (3) New Bal. Liabilities ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Point: There are 3 basic types of company operations: (1) Services — providing customer services for profit, (2) Merchandisers —buying products and re-selling them for profit, and (3) Manufacturers —creating products and selling them for profit. Transaction 1: Investment by Owner On December 1, Chuck Taylor forms a consulting business focused on assessing the performance of athletic footwear and accessories, which he names FastForward. He sets it up as a proprietorship. Taylor owns and manages the business. The marketing plan for the business is to focus primarily on consulting with sports clubs, amateur athletes, and others who place orders for athletic footwear and accessories with manufacturers. Taylor personally invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, the cash (an asset) and the owner’s equity each equal $30,000. The source of increase in equity is the owner’s investment, which is included in the column titled C. Taylor, Capital. (Owner investments are always included under the title ‘Owner name,’ Capital.) The effect of this transaction on FastForward is reflected in the accounting equation as follows: $30,000 $30,000 Taylor decides he needs more supplies of athletic footwear and accessories. These additional supplies total $7,100, but as we see from the accounting equation in transaction 3, FastForward has only $1,500 in cash. Taylor Transaction 4: Purchase Supplies on Credit wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 15 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 15 Example: If FastForward pays $500 cash in transaction 4, how does this partial payment affect the liability to CalTech? What would be FastForward’s cash balance? Answers: The liability to CalTech would be reduced to $6,600 and the cash balance would be reduced to $1,000. arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount. The effects of this purchase follow: Assets Liabilities Cash $2,500 7,100 _______ C.Taylor, Capital $26,000 ______ $1,500 $30,000 $7,100 _________ $ 7,100 ________ $26,000 $9,600 ________ $30,000 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ New Bal. $1,500 Accounts Payable Equipment ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (4) Supplies Equity $37,100 $37,100 FastForward earns revenues by consulting with clients about test results on athletic footwear and accessories. It earns net income only if its revenues are greater than its expenses incurred in earning them. In one of its first jobs, FastForward provides consulting services to an athletic club and immediately collects $4,200 cash. The accounting equation reflects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is identified in the far right column under Revenues because the cash received is earned by providing consulting services. Transaction 5: Provide Services for Cash Assets Liabilities Equipment C.Taylor, Capital $30,000 Revenues $26,000 Accounts Payable $7,100 $1,500 4,200 _______ $5,700 $9,600 ______ $9,600 ________ $26,000 ______ $7,100 ________ $30,000 $4,200 _______ $ 4,200 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (5) New Bal. Supplies ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Cash Equity $41,300 $41,300 FastForward pays $1,000 rent to the landlord of the building where its facilities are located. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is reflected in the following accounting equation as transaction 6. FastForward also pays the biweekly $700 salary of the company’s only employee. This is reflected in the accounting equation as transaction 7. Both transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, as opposed to assets, because their benefits are used in December (they have no future benefits after December). These transactions also use up an asset (cash) in carrying out FastForward’s operations. The accounting equation shows that both transactions reduce cash and equity. The far right column identifies these decreases as Expenses. Transactions 6 and 7: Payment of Expenses in Cash Assets Old Bal. (6) Bal. (7) $5,700 1,000 _______ 4,700 700 _______ $9,600 ______ 9,600 ______ $9,600 $4,000 Equipment $26,000 Accounts Payable $7,100 C.Taylor, Capital $30,000 $4,200 _______ 26,000 ______ 7,100 _______ 30,000 _______ 4,200 _______ $26,000 ______ $7,100 _______ $30,000 _______ $4,200 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ New Bal. Supplies $39,600 Equity Revenues Expenses $1,000 1,000 700 ________ $ 1,700 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Cash Liabilities By definition, increases in expenses yield decreases in equity. $39,600 Transaction 8: Provide Services and Facilities for Credit FastForward provides consulting services of $1,600 and rents its test facilities for $300 to an amateur sports club. The rental involves allowing club members to try recommended footwear and accessories at FastForward’s testing area. The sports club is billed for the $1,900 total. This transaction results in a new asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue components reflected in the Revenues column of the accounting equation: wiL79549_ch01_0002-0045 08/18/2008 9:08 am Page 16 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 16 Chapter 1 Accounting in Business Assets Cash $9,600 ______ $9,600 $4,000 Equipment $26,000 Accounts Payable $7,100 C.Taylor, Capital $30,000 _______ $26,000 ______ $7,100 Revenues ______ $4,000 _______ $ 1,900 _______ $30,000 $41,500 $5,900 Liabilities Supplies $9,600 ______ $9,600 0 Equipment Equity C.Taylor, Capital $30,000 Revenues Expenses $26,000 Accounts Payable $7,100 $6,100 $1,700 _______ $26,000 ______ $7,100 _______ $30,000 ______ $6,100 ______ $1,700 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ $ ________ $1,700 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ New Bal. Accounts Receivable $1,900 1,900 ______ _ $4,000 1,900 _______ $6,100 $41,500 Assets Old Bal. (9) $1,700 Transaction 9: Receipt of Cash from Accounts Receivable The client in transaction 8 (the amateur sports club) pays $1,900 to FastForward 10 days after it is billed for consulting services. This transaction 9 does not change the total amount of assets and does not affect liabilities or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward rendered the services in transaction 8, not when the cash is now collected. This emphasis on the earnings process instead of cash flows is a goal of the revenue recognition principle and yields useful information to users. The new balances follow: Point: Receipt of cash is not always a revenue. Cash Expenses $4,200 1,600 300 ______ $1,900 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ New Bal. Supplies Equity ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (8) Accounts Receivable Liabilities $41,500 $41,500 Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (transaction 4), leaving $6,200 unpaid. The accounting equation shows that this transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an expense even though cash flows out of FastForward (instead the expense is recorded when FastForward derives the benefits from these supplies). Assets Cash Equipment $9,600 $26,000 ______ $9,600 _______ $26,000 Accounts Payable $7,100 900 ______ $6,200 C.Taylor, Capital $30,000 Revenues Expenses $6,100 $1,700 _______ $30,000 ______ $6,100 ______ $1,700 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ $5,000 Supplies _______ $ 0 $5,900 900 ______ New Bal. Accounts Receivable $ 0 Equity ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (10) Liabilities $40,600 $40,600 Transaction 11: Withdrawal of Cash by Owner The owner of FastForward withdraws $200 cash for personal use. Withdrawals (decreases in equity) are not reported as expenses because they are not part of the company’s earnings process. Since withdrawals are not company expenses, they are not used in computing net income. Assets Cash $5,000 200 ______ New Bal. $4,800 Supplies $9,600 ______ $ 0 ______ $9,600 Equipment $40,400 Equity C.Taylor, Capital $30,000 C.Taylor, Withdrawals $26,000 Accounts Payable $6,200 _______ $26,000 ______ $6,200 _______ $30,000 $200 _____ $200 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ Old Bal. (11) Accounts Receivable $ 0 Liabilities Revenues Expenses $6,100 $1,700 ______ $6,100 ______ $1,700 ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ By definition, increases in withdrawals yield decreases in equity. $40,400 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 17 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 17 Summary of Transactions We summarize in Exhibit 1.9 the effects of these 11 transactions of FastForward using the accounting equation. First, we see that the accounting equation remains in balance after each transaction. Second, transactions can be analyzed by their effects on components of the accounting equation. For example, in transactions 2, 3, and 9, one asset increased while another asset decreased by equal amounts. Point: Knowing how financial statements are prepared improves our analysis of them. We develop the skills for analysis of financial statements throughout the book. Chapter 17 focuses on financial statement analysis. EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation Assets Cash (1) (2) $30,000 2,500 ________ Bal. (3) 27,500 26,000 ________ Bal. (4) Bal. (5) 1,500 ________ 1,500 4,200 ________ Bal. (6) 5,700 1,000 ________ Bal. (7) 4,700 700 ________ Bal. (8) Accounts Receivable 4,000 Supplies Liabilities Equipment $2,500 _______ 2,500 C.Taylor, Withdrawals $26,000 __ ________ 26,000 Expenses __ ________ 26,000 $7,100 _________ 7,100 ________ 30,000 _______ 9,600 __ ________ 26,000 _________ 7,100 ________ 30,000 $4,200 _ ______ 4,200 _______ 9,600 __ ________ 26,000 _________ 7,100 ________ 30,000 _ ______ 4,200 _______ 9,600 __ ________ 26,000 _________ 7,100 ________ 30,000 _______ 9,600 __ ________ 26,000 _________ 7,100 ________ 30,000 _ ______ 4,200 1,600 _ 300 ______ _________ 7,100 900 _________ ________ 30,000 $1,900 Bal. 5,900 (10) ________ 900 Bal. 5,000 (11) ________ 200 0 _______ 9,600 __ ________ 26,000 __ _____ 0 _______ 9,600 __ ________ 26,000 __ _____ $ 0 _______ $ 9,600 __ ________ $ 26,000 $ 4,800 Revenues _______ 2,500 7,100 _______ 9,600 __ _____ 1,900 1 __ ,900 _____ Bal. C.Taylor, Capital $30,000 ________ 30,000 ________ 4,000 1,900 ________ Bal. (9) Accounts Payable Equity $1,000 __ _____ 1,000 __ 700 _____ 1,700 6,100 __ _____ 1,700 ________ 30,000 _ ______ 6,100 __ _____ 1,700 6,200 ________ 30,000 _ ______ 6,100 __ _____ 1,700 _________ $ 6,200 ________ $ 30,000 _ ______ $6,100 __ _____ $ 1,700 Quick Check $200 _____ $ 200 Answers—p. 26 17. When is the accounting equation in balance, and what does that mean? 18. How can a transaction not affect any liability and equity accounts? 19. Describe a transaction increasing equity and one decreasing it. 20. Identify a transaction that decreases both assets and liabilities. Financial Statements This section introduces us to how financial statements are prepared from the analysis of business transactions. The four financial statements and their purposes are: 1. Income statement —describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities. 2. Statement of owner’s equity—explains changes in equity from net income (or loss) and from any owner investments and withdrawals over a period of time. P1 Identify and prepare basic financial statements and explain how they interrelate. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 18 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 18 Video1.1 3. Balance sheet —describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time. 4. Statement of cash flows —identifies cash inflows (receipts) and cash outflows (payments) over a period of time. We prepare these financial statements using the 11 selected transactions of FastForward. (These statements are technically called unadjusted —we explain this in Chapters 2 and 3.) Income Statement Point: Net income is sometimes called earnings or profit. FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is conveniently taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from transactions 5 and 8 and rental revenue of $300 from transaction 8. Expenses are reported after revenues. (For convenience in this chapter, we list larger amounts first, but we can sort expenses in different ways.) Rent and salary expenses are from transactions 6 and 7. Expenses reflect the costs to generate the revenues reported. Net income (or loss) is reported at the bottom of the statement and is the amount earned in December. Owner’s investments and withdrawals are not part of income. Statement of Owner’s Equity Point: The statement of owner’s equity is also called the statement of changes in owner’s equity. Note: Beg. Capital Net Income Withdrawals Ending Capital The statement of owner’s equity reports information about how equity changes over the reporting period. This statement shows beginning capital, events that increase it (owner investments and net income), and events that decrease it (withdrawals and net loss). Ending capital is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of owner’s equity is the second report in Exhibit 1.10. The beginning capital balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports a beginning balance equal to that as of the end of the prior reporting period (such as from November 30). FastForward’s statement of owner’s equity shows that Taylor’s initial investment created $30,000 of equity. It also shows the $4,400 of net income earned during the period. This links the income statement to the statement of owner’s equity (see line 1 ). The statement also reports Taylor’s $200 cash withdrawal and FastForward’s end-ofperiod capital balance. Balance Sheet Decision Maker boxes are roleplaying exercises that stress the relevance of accounting. FastForward’s balance sheet is the third report in Exhibit 1.10. This statement refers to FastForward’s financial condition at the close of business on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity (capital) balance is $34,200. Line 2 shows the link between the ending balance of the statement of owner’s equity and the equity balance on the balance sheet. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Either presentation is acceptable.) Decision Maker Retailer You open a wholesale business selling entertainment equipment to retail outlets.You find that most of your customers demand to buy on credit. How can you use the balance sheets of these customers to help you decide which ones to extend credit to? [Answer—p. 26] Point: Statement of cash flows has three main sections: operating, investing, and financing. Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year). Statement of Cash Flows FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the $5,100 cash paid for supplies, rent, and employee salaries. Outflows are in parentheses to denote subtraction. Net cash provided by operating activities for December is $1,000. If cash paid exceeded the $5,100 cash received, we would call it “cash used by operating activities.” The second section wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 19 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business EXHIBIT 1.10 FASTFORWARD Income Statement For Month Ended December 31, 2009 Revenues Consulting revenue ($4,200 $1,600) . . . . . . . . . . . . . Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expenses Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Statements and Their Links $ 5,800 _ 300 ________ $ 6,100 Point: A statement’s heading identifies the company, the statement title, and the date or time period. 1,000 _ 700 ________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . _ 1,700 _________ $ 4,400 _ _________ _ _________ FASTFORWARD Statement of Owner’s Equity For Month Ended December 31, 2009 C. Taylor, Capital, December 1, 2009 . . . . . . . . . . . . . . . . . Plus: Investments by owner . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $30,000 4,400 _______ Less: Withdrawals by owner . . . . . . . . . . . . . . . . . . . . . C. Taylor, Capital, December 31, 2009 . . . . . . . . . . . . . . . 0 1 $ 4,800 Supplies . . . . . . . . Equipment . . . . . . 9,600 26,000 Total assets . . . . . . _______ $40,400 _______ _______ Point: Arrow lines show how the statements are linked. 1 Net income is used to compute equity. 2 Owner capital is used to prepare the balance sheet. 3 Cash from the balance sheet is used to reconcile the statement of cash flows. 34,400 _______ 34,400 200 _______ $34,200 _______ _______ Point: The income statement, the statement of owner’s equity, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time. FASTFORWARD Balance Sheet December 31, 2009 Assets Cash . . . . . . . . . . 19 Liabilities Accounts payable . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . Equity C. Taylor, Capital . . . . . . . . . . . . Total liabilities and equity . . . . . $ 6,200 _______ 6,200 2 34,200 _______ $ 40,400 _______ _______ FASTFORWARD Statement of Cash Flows For Month Ended December 31, 2009 3 Cash flows from operating activities Cash received from clients ($4,200 $1,900) Cash paid for supplies ($2,500 $900) . . . . Cash paid for rent . . . . . . . . . . . . . . . . . . . . Cash paid to employee . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . Cash flows from investing activities Purchase of equipment . . . . . . . . . . . . . . . . Net cash used by investing activities . . . . . . Cash flows from financing activities Investments by owner . . . . . . . . . . . . . . . . . Withdrawals by owner . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . Net increase in cash . . . . . . . . . . . . . . . . . . . Cash balance, December 1, 2009 . . . . . . . . . . . Cash balance, December 31, 2009 . . . . . . . . . . . . . . . $ 6,100 (3,400) (1,000) (700) ________ ........ ........ (26,000) ________ . . . . . . 30,000 (200) ________ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000 (26,000) 29,800 _________ $ 4,800 0 _________ $ 4,800 _________ _________ Point: A single ruled line denotes an addition or subtraction. Final totals are double underlined. Negative amounts are often in parentheses. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 20 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 20 Chapter 1 Accounting in Business Point: Investing activities refer to long-term asset investments by the company, not to owner investments. reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include the long-term borrowing and repaying of cash from lenders and the cash investments from, and withdrawals by, the owner. FastForward reports $30,000 from the owner’s initial investment and the $200 cash withdrawal. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows FastForward increased its cash balance by $4,800 in December. Since it started with no cash, the ending balance is also $4,800—see line 3 . Quick Check Answers—p. 26 21. Explain the link between the income statement and the statement of owner’s equity. 22. Describe the link between the balance sheet and the statement of owner’s equity. 23. Discuss the three major sections of the statement of cash flows. Decision Analysis (a section at the end of each chapter) introduces and explains ratios helpful in decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 17. Return on Assets Decision Analysis A3 Compute and interpret return on assets. A Decision Analysis section at the end of each chapter is devoted to financial statement analysis. We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 17 has a ratio listing with definitions and groupings by area. When analyzing ratios, we need benchmarks to identify good, bad, or average levels. Common benchmarks include the company’s prior levels and those of its competitors. This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Dell has its marketing department compute return on assets for every order. Return on assets (ROA), also called return on investment (ROI ), is defined in Exhibit 1.11. EXHIBIT 1.11 Return on assets Return on Assets Net income Average total assets Net income is from the annual income statement, and average total assets is computed by adding the beginning and ending amounts for that same period and dividing by 2. To illustrate, Best Buy reports net income of $1,377 million in 2007. At the beginning of fiscal 2007, its total assets are $11,864 million and at the end of fiscal 2007, they total $13,570 million. Best Buy’s return on assets for 2007 is: $1,377 million 1 $11,864 million $13,570 million 2 2 Return on assets 10.8% Is a 10.8% return on assets good or bad for Best Buy? To help answer this question, we compare (benchmark) Best Buy’s return with its prior performance, the returns of competitors (such as Circuit City, RadioShack, and CompUSA), and the returns from alternative investments. Best Buy’s return for each of the prior five years is in the second column of Exhibit 1.12, which ranges from 1.3% to 10.8%. EXHIBIT 1.12 Best Buy, Circuit City, and Industry Returns Return on Assets Fiscal Year 12% Best Buy Circuit City Industry 10% 8% 6% 4% 2% 0% –2% –4% 2007 2006 Return on Assets: 2005 2004 Circuit City 2003 Best Buy 2007 2006 2005 2004 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.8% 10.3 10.4 8.6 1.3 (1.9)% 3.5 1.6 (2.3) 1.9 3.5% 3.3 3.2 3.1 3.0 wiL79549_ch01_0002-0045 8/25/08 11:23PM Page 21 ntt 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business Best Buy’s returns show an increase in its productive use of assets in recent years. We also compute Circuit City’s returns in the third column of Exhibit 1.12. In four of the five years, Best Buy’s return exceeds Circuit City’s, and its average return is higher for this period. We also compare Best Buy’s return to the normal return for similar merchandisers of electronic products (fourth column). Industry averages are available from services such as Dun & Bradstreet’s Industry Norms and Key Ratios and Robert Morris Associates’ Annual Statement Studies. When compared to the industry, Best Buy performs well. 21 Each Decision Analysis section ends with a role-playing scenario to show the usefulness of ratios. Decision Maker Business Owner You own a small winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you.This manufacturer earns a 19% return on its assets.The industry return for this manufacturer is 14%. Do you purchase this manufacturer? [Answer—p. 26] The Demonstration Problem is a review of key chapter content.The Planning the Solution offers strategies in solving the problem. Demonstration Problem After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month of business. a. b. c. d. e. f. g. h. i. j. k. On August 1, Worthy invested $3,000 cash and $15,000 of equipment in Expressions. On August 2, Expressions paid $600 cash for furniture for the shop. On August 3, Expressions paid $500 cash to rent space in a strip mall for August. On August 4, it purchased $1,200 of equipment on credit for the shop (using a long-term note payable). On August 5, Expressions opened for business. Cash received from haircutting services in the first week and a half of business (ended August 15) was $825. On August 15, it provided $100 of haircutting services on account. On August 17, it received a $100 check for services previously rendered on account. On August 17, it paid $125 cash to an assistant for hours worked during the grand opening. Cash received from services provided during the second half of August was $930. On August 31, it paid a $400 installment toward principal on the note payable entered into on August 4. On August 31, Worthy made a $900 cash withdrawal from the company for personal use. Required 1. Arrange the following asset, liability, and equity titles in a table similar to the one in Exhibit 1.9: 2. 3. 4. 5. 6. Cash; Accounts Receivable; Furniture; Store Equipment; Note Payable; J. Worthy, Capital; J. Worthy, Withdrawals; Revenues; and Expenses. Show the effects of each transaction using the accounting equation. Prepare an income statement for August. Prepare a statement of owner’s equity for August. Prepare a balance sheet as of August 31. Prepare a statement of cash flows for August. Determine the return on assets ratio for August. Planning the Solution • Set up a table like Exhibit 1.9 with the appropriate columns for accounts. • Analyze each transaction and show its effects as increases or decreases in the appropriate columns. • • • • • Be sure the accounting equation remains in balance after each transaction. Prepare the income statement, and identify revenues and expenses. List those items on the statement, compute the difference, and label the result as net income or net loss. Use information in the Equity columns to prepare the statement of owner’s equity. Use information in the last row of the transactions table to prepare the balance sheet. Prepare the statement of cash flows; include all events listed in the Cash column of the transactions table. Classify each cash flow as operating, investing, or financing. Calculate return on assets by dividing net income by average assets. DP1 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 22 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 22 Solution to Demonstration Problem 1. Assets Cash a. b. Bal. c. Bal. d. Bal. e. Bal. f. Liabilities Accounts Receivable $3,000 600 ______ 2,400 500 ______ 1,900 Furniture Store Equipment $15,000 Note Payable Equity J. Worthy, Capital J. Worthy, Withdrawals Revenues Expenses $18,000 $600 __ ___ 600 _______ 15,000 ________ 18,000 __ ___ 600 _______ 15,000 1,200 _______ ________ 18,000 $500 _____ 500 _____ 500 16,200 $1,200 _________ 1,200 ________ 18,000 __ ___ 600 ______ 1,900 825 ______ _______ 16,200 _________ 1,200 ________ 18,000 __ ___ 600 _______ 16,200 _________ 1,200 ________ 18,000 __ ___ 600 2,725 $ ____ 825 ___ 825 100 ___ ____ Bal. g. ______ 2,725 100 ______ $100 _ ____ 100 100 _ ____ Bal. h. 2,825 125 ______ 0 __ ___ 600 _______ 16,200 _________ 1,200 ________ 18,000 ___ ____ 925 Bal. i. 2,700 930 ______ _ ____ 0 __ ___ 600 _______ 16,200 _________ 1,200 ________ 18,000 Bal. j. 3,630 400 ______ _ ____ 0 __ ___ 600 _______ 16,200 ________ 18,000 Bal. k. 3,230 900 ______ _ ____ 0 __ ___ 600 _______ 16,200 _________ 1,200 400 _________ ___ ____ 925 9 ___ 30 ____ Bal. $ 2,330 ______ ______ _ ____ _0 ____ _ ____ __ ___ $600 __ ___ __ ___ _______ $ 16,200 _______ _______ 800 ________ $ 18,000 ________ ________ _____ 500 _____ 500 125 _____ 625 1,855 _____ 625 ___ ____ $1,855 ___ ____ ___ ____ $900 _____ $900 _____ _____ _____ 625 ___ ____ 1,855 ________ 18,000 _________ $ 800 _________ _________ 925 _____ 500 _____ $625 _____ _____ 2. EXPRESSIONS Income Statement For Month Ended August 31 Revenues Haircutting services revenue . . . . . . . . Expenses Rent expense . . . . . . . . . . . . . . . . . . Wages expense . . . . . . . . . . . . . . . . . $1,855 $500 _ 125 ___ Total expenses . . . . . . . . . . . . . . . . . . __ 625 ____ $1,230 ___ ___ ___ ___ Net Income . . . . . . . . . . . . . . . . . . . . . 3. EXPRESSIONS Statement of Owner’s Equity For Month Ended August 31 J. Worthy, Capital, August 1* . . . . . . . . . Plus: Investments by owner . . . . . . . . Net income . . . . . . . . . . . . . . . . Less: Withdrawals by owner . . . . . . . . J. Worthy, Capital, August 31 . . . . . . . . . $ $18,000 1,230 ____ ___ 0 19,230 ____ ___ 19,230 900 ____ ___ $18,330 ____ ___ ____ ___ * If Expressions had been an existing business from a prior period, the beginning capital balance would equal the Capital account balance from the end of the prior period. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 23 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 23 4. EXPRESSIONS Balance Sheet August 31 Assets Cash . . . . . . . . . . . . . . . . Furniture . . . . . . . . . . . . . Store equipment . . . . . . . . $ 2,330 600 16,200 ____ ___ Liabilities Note payable . . . . . . . . . . . . . . . . Equity J. Worthy, Capital . . . . . . . . . . . . . . Total assets . . . . . . . . . . . $19,130 ____ ___ ____ ___ Total liabilities and equity . . . . . . . $ 800 18,330 ____ ___ $19,130 ____ ___ ____ ___ 5. EXPRESSIONS Statement of Cash Flows For Month Ended August 31 Cash flows from operating activities Cash received from customers . . . . . . . . . . . . . . . . . . . Cash paid for rent . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for wages . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . Cash flows from investing activities Cash paid for furniture . . . . . . . . . . . . . . . . Cash flows from financing activities Cash investments by owner . . . . . . . . . . . . . Cash withdrawals by owner . . . . . . . . . . . . Partial repayment of (long-term) note payable $1,855 (500) (125) ___ ___ ........ $1,230 ........ ........ ........ ........ (600) 3,000 (900) (400) ___ ___ Net cash provided by financing activities . . . . . . . . . . . . Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash balance, August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 ___ ___ $2,330 ___ 0 ___ Cash balance, August 31 . . . . . . . . . . . . . . . . . . . . . . . . . $2,330 ___ ___ ___ ___ 6. Return on assets Net income Average assets $1,230 1 $18,000* $19,130 2 2 $1,230 $18,565 6.63 % * Uses the initial $18,000 investment as the beginning balance for the startup period only. APPENDIX 1A Return and Risk Analysis This appendix explains return and risk analysis and its role in business and accounting. Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest return such as 4%. If we invest in a savings account or in U.S. Treasury bills, we expect a return of around 2% to 7%. We could also invest in a company’s stock, or even start our own business. How do we decide among these investment options? The answer depends on our trade-off between return and risk. A4 Explain the relation between return and risk. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 24 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 24 EXHIBIT 1A.1 Average Returns for Bonds with Different Risks Risk is the uncertainty about the return we will earn. All business investments involve risk, but some investments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts from default). If we buy a share of eBay or any other company, we might obtain a large return. However, we have no guarantee of any return; there is even the risk of loss. The bar graph in Exhibit 1A.1 shows recent returns for 30-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds U.S. Treasury 5.1% provide a low expected return, but they also offer Low-risk corporate 5.8% low risk since they are backed by the U.S. government. High-risk corporate bonds offer a much Medium-risk corporate 6.9% larger potential return but with much higher risk. The trade-off between return and risk is a norHigh-risk corporate 7.8% mal part of business. Higher risk implies higher, but riskier, expected returns. To help us make bet0% 2% 4% 6% 8% ter decisions, we use accounting information to asAnnual Return sess both return and risk. APPENDIX 1B C6 Identify and describe the three major activities of organizations. Business Activities and the Accounting Equation This appendix explains how the accounting equation is derived from business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning involves defining an organization’s ideas, goals, and actions. Most public corporations use the Management Discussion and Analysis section in their annual reports to communicate plans. However, planning is not cast in stone. This adds risk to both setting plans and analyzing them. Financing Financing activities provide the means organizations use to pay for resources such as Point: Management must understand accounting data to set financial goals, make financing and investing decisions, and evaluate operating performance. Point: Investing (assets) and financing (liabilities plus equity) totals are always equal. land, buildings, and equipment to carry out plans. Organizations are careful in acquiring and managing financing activities because they can determine success or failure. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources contributed by creditors (lenders). Financial management is the task of planning how to obtain these resources and to set the right mix between owner and creditor financing. Investing Investing activities are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services. Assets are funded by an organization’s financing. Organizations differ on the amount and makeup of assets. Some require land and factories to operate. Others need only an office. Determining the amount and type of assets for operations is called asset management. Invested amounts are referred to as assets. Financing is made up of creditor and owner financing, which hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This basic equality is called the accounting equation and can be written as: Assets Liabilities Equity. Operating Operating activities involve using resources to research, develop, purchase, produce, distribute, and market products and services. Sales and revenues are the inflow of assets from selling wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 25 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business EXHIBIT 1B.1 Activities of Organizations ck t Buy Sto Planni ng Invoic e Bill Bes Lones nning Pla products and services. Costs and expenses are the outflow of assets to support operating activities. Strategic management is the process of determining the right mix of operating activities for the type of organization, its plans, and its market. Exhibit 1B.1 summarizes business activities. Planning is part of each activity and gives them meaning and focus. Investing (assets) and financing (liabilities and equity) are set opposite each other to stress their balance. Operating activities are below investing and financing activities to show that operating activities are the result of investing and financing. 25 P l a n nin g A Summary organized by learning objectives concludes each chapter. Summary C1 Explain the purpose and importance of accounting in the information age. Accounting is an information and measurement system that aims to identify, record, and communicate relevant, reliable, and comparable information about business activities. It helps assess opportunities, products, investments, and social and community responsibilities. Identify users and uses of accounting. Users of accounting are both internal and external. Some users and uses of accounting include (a) managers in controlling, monitoring, and planning; (b) lenders for measuring the risk and return of loans; (c) shareholders for assessing the return and risk of stock; (d) directors for overseeing management; and (e) employees for judging employment opportunities. Identify opportunities in accounting and related fields. Opportunities in accounting include financial, managerial, and tax accounting. They also include accounting-related fields such as lending, consulting, managing, and planning. Explain why ethics are crucial to accounting. The goal of accounting is to provide useful information for decision making. For information to be useful, it must be trusted. This demands ethical behavior in accounting. Explain generally accepted accounting principles and define and apply several accounting principles. Generally accepted accounting principles are a common set of standards applied by accountants. Accounting principles aid in producing relevant, reliable, and comparable information. Four principles underlying financial statements were introduced: cost, revenue recognition, matching, and full disclosure. Financial statements also reflect four assumptions: going-concern, monetary unit, time period, and business entity. B Identify and describe the three major activities of organizations. Organizations carry out three major activities: C2 C3 C4 C5 C6 financing, investing, and operating. Financing is the means used to pay for resources such as land, buildings, and machines. Investing refers to the buying and selling of resources used in acquiring and selling products and services. Operating activities are those necessary for carrying out the organization’s plans. Define and interpret the accounting equation and each of its components. The accounting equation is: Assets Liabilities Equity. Assets are resources owned by a company. Liabilities are creditors’ claims on assets. Equity is the owner’s claim on assets (the residual). The expanded accounting equation is: Assets Liabilities [Owner Capital Owner Withdrawals Revenues Expenses]. Analyze business transactions using the accounting equation. A transaction is an exchange of economic consideration between two parties. Examples include exchanges of products, services, money, and rights to collect money. Transactions always have at least two effects on one or more components of the accounting equation. This equation is always in balance. Compute and interpret return on assets. Return on assets is computed as net income divided by average assets. For example, if we have an average balance of $100 in a savings account and it earns $5 interest for the year, the return on assets is $5/$100, or 5%. A Explain the relation between return and risk. Return refers to income, and risk is the uncertainty about the return we hope to make. All investments involve risk. The lower the risk of an investment, the lower is its expected return. Higher risk implies higher, but riskier, expected return. Identify and prepare basic financial statements and explain how they interrelate. Four financial statements report on an organization’s activities: balance sheet, income statement, statement of owner’s equity, and statement of cash flows. A1 A2 A3 A4 P1 Guidance Answers to Decision Maker and Decision Ethics Entrepreneur (p. 11) You should probably form the business as a corporation if potential lawsuits are of prime concern. The corporate form of organization protects your personal property from lawsuits directed at the business and places only the corporation’s resources at risk. A downside of the corporate form is double taxation: The corporation must pay taxes on its income, and you normally must pay taxes on any money distributed to you from the business (even though the corporation already paid taxes on this money). You wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 26 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 26 should also examine the ethical and socially responsible aspects of starting a business in which you anticipate injuries to others. Formation as an LLC or S corp. should also be explored. (p. 18) You can use the accounting equation (Assets Liabilities Equity) to help identify risky customers to whom you would likely not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would be to extend credit. A low equity means the business has little value that does not already have creditor claims to it. Retailer (p. 21) The 19% return on assets for the manufacturer exceeds the 14% industry return (and many others). This is a positive factor for a potential purchase. Also, the purchase of this manufacturer is an opportunity to spread your risk over two businesses as opposed to one. Still, you should hesitate to purchase a business whose return of 19% is lower than your current resort’s return of 21%. You are probably better off directing efforts to increase investment in your resort, assuming you can continue to earn a 21% return. Business Owner Guidance Answers to Quick Checks 1. Accounting is an information and measurement system that 13. Users desire information about the performance of a specific en- identifies, records, and communicates relevant information to help people make better decisions. Recordkeeping, also called bookkeeping, is the recording of financial transactions and events, either manually or electronically. Recordkeeping is essential to data reliability; but accounting is this and much more. Accounting includes identifying, measuring, recording, reporting, and analyzing business events and transactions. Technology offers increased accuracy, speed, efficiency, and convenience in accounting. External users of accounting include lenders, shareholders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. Internal users of accounting include managers, officers, and other internal decision makers involved with strategic and operating decisions. Internal users (managers) include those from research and development, purchasing, human resources, production, distribution, marketing, and servicing. Internal controls are procedures set up to protect assets, ensure reliable accounting reports, promote efficiency, and encourage adherence to company policies. Internal controls are crucial for relevant and reliable information. Ethical guidelines are threefold: (1) identify ethical concerns using personal ethics, (2) analyze options considering all good and bad consequences, and (3) make ethical decisions after weighing all consequences. Ethics and social responsibility yield good behavior, and they often result in higher income and a better working environment. For accounting to provide useful information for decisions, it must be trusted. Trust requires ethics in accounting. Two major participants in setting rules include the SEC and the FASB. (Note: Accounting rules reflect society’s needs, not those of accountants or any other single constituency.) Most U.S. companies are not directly affected by international accounting standards. International standards are put forth as preferred accounting practices. However, stock exchanges and other parties are increasing the pressure to narrow differences in worldwide accounting practices. International accounting standards are playing an important role in that process. The objectivity concept and cost principle are related in that most users consider information based on cost as objective. Information prepared using both is considered highly reliable and often relevant. tity. If information is mixed between two or more entities, its usefulness decreases. The revenue recognition principle gives preparers guidelines on when to recognize (record) revenue. This is important; for example, if revenue is recognized too early, the statements report revenue sooner than it should and the business looks more profitable than it is. The reverse is also true. The three basic forms of business organization are sole proprietorships, partnerships, and corporations. Owners of corporations are called shareholders (or stockholders). Corporate ownership is divided into units called shares (or stock). The most basic of corporate shares is common stock (or capital stock). The accounting equation is: Assets Liabilities Equity. This equation is always in balance, both before and after each transaction. A transaction that changes the makeup of assets would not affect liability and equity accounts. FastForward’s transactions 2 and 3 are examples. Each exchanges one asset for another. Earning revenue by performing services, as in FastForward’s transaction 5, increases equity (and assets). Incurring expenses while servicing clients, such as in transactions 6 and 7, decreases equity (and assets). Other examples include owner investments that increase equity and withdrawals that decrease equity. Paying a liability with an asset reduces both asset and liability totals. One example is FastForward’s transaction 10 that reduces a payable by paying cash. An income statement reports a company’s revenues and expenses along with the resulting net income or loss. A statement of owner’s equity shows changes in equity, including that from net income or loss. Both statements report transactions occurring over a period of time. The balance sheet describes a company’s financial position (assets, liabilities, and equity) at a point in time. The equity amount in the balance sheet is obtained from the statement of owner’s equity. Cash flows from operating activities report cash receipts and payments from the primary business the company engages in. Cash flows from investing activities involve cash transactions from buying and selling long-term assets. Cash flows from financing activities include long-term cash borrowings and repayments to lenders and the cash investments from and withdrawals by the owner. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. wiL79549_ch01_0002-0045 08/18/2008 10:00 am Page 27 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 27 A list of key terms with page references concludes each chapter (a complete glossary is at the end of the book and also on the book’s Website). mhhe.com/wildFAP19e Key Terms Key Terms are available at the book’s Website for learning and testing in an online Flashcard Format. Accounting (p. 4) Accounting equation (p. 13) Assets (p. 12) Auditors (p. 11) Balance sheet (p. 18) Bookkeeping (p. 4) Business entity assumption (p. 10) Common stock (p. 11) Corporation (p. 11) Cost principle (p. 9) Equity (p. 12) Ethics (p. 8) Events (p. 14) Expanded accounting equation (p. 13) Expenses (p. 13) External transactions (p. 13) External users (p. 5) Financial accounting (p. 5) Financial Accounting Standards Board (FASB) (p. 9) Multiple Choice Quiz Full disclosure principle (p. 10) Generally Accepted Accounting Principles (GAAP) (p. 8) Going-concern assumption (p. 10) Income statement (p. 17) Internal transactions (p. 13) Internal users (p. 6) International Accounting Standards Board (IASB) (p. 9) Liabilities (p. 12) Managerial accounting (p. 6) Matching principle (p. 10) Monetary unit assumption (p. 10) Net income (p. 13) Net loss (p. 13) Owner, Capital (p. 13) Owner investment (p. 13) Owner withdrawals (p. 13) Partnership (p. 10) Proprietorship (p. 10) Answers on p. 45 Recordkeeping (p. 4) Return (p. 23) Return on assets (p. 20) Revenue recognition principle (p. 10) Revenues (p. 13) Risk (p. 24) Sarbanes–Oxley Act (p. 11) Securities and Exchange Commission (SEC) (p. 9) Shareholders (p. 11) Shares (p. 11) Sole proprietorship (p. 10) Statement of cash flows (p. 18) Statement of owner’s equity (p. 17) Stock (p. 11) Stockholders (p. 11) Time period assumption (p. 10) Withdrawals (p. 13) mhhe.com/wildFAP19e Additional Quiz Questions are available at the book’s Website. 1. A building is offered for sale at $500,000 but is currently as- sessed at $400,000. The purchaser of the building believes the building is worth $475,000, but ultimately purchases the building for $450,000. The purchaser records the building at: a. $50,000 b. $400,000 c. $450,000 d. $475,000 e. $500,000 2. On December 30, 2008, KPMG signs a $150,000 contract to provide accounting services to one of its clients in 2009. KPMG has a December 31 year-end. Which accounting principle or assumption requires KPMG to record the accounting services revenue from this client in 2009 and not 2008? a. Business entity assumption b. Revenue recognition principle c. Monetary unit assumption d. Cost principle e. Going-concern assumption 3. If the assets of a company increase by $100,000 during the year and its liabilities increase by $35,000 during the same year, then the change in equity of the company during the year must have been: a. An increase of $135,000. b. A decrease of $135,000. c. A decrease of $65,000. d. An increase of $65,000. e. An increase of $100,000. Quiz1 4. Brunswick borrows $50,000 cash from Third National Bank. How does this transaction affect the accounting equation for Brunswick? a. Assets increase by $50,000; liabilities increase by $50,000; no effect on equity. b. Assets increase by $50,000; no effect on liabilities; equity increases by $50,000. c. Assets increase by $50,000; liabilities decrease by $50,000; no effect on equity. d. No effect on assets; liabilities increase by $50,000; equity increases by $50,000. e. No effect on assets; liabilities increase by $50,000; equity decreases by $50,000. 5. Geek Squad performs services for a customer and bills the customer for $500. How would Geek Squad record this transaction? a. Accounts receivable increase by $500; revenues increase by $500. b. Cash increases by $500; revenues increase by $500. c. Accounts receivable increase by $500; revenues decrease by $500. d. Accounts receivable increase by $500; accounts payable increase by $500. e. Accounts payable increase by $500; revenues increase by $500. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 28 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 28 Superscript letter A ( B) denotes assignments based on Appendix 1A (1B). Discussion Questions 1. What is the purpose of accounting in society? 2. Technology is increasingly used to process accounting data. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. Why then must we study and understand accounting? Identify four kinds of external users and describe how they use accounting information. What are at least three questions business owners and managers might be able to answer by looking at accounting information? Identify three actual businesses that offer services and three actual businesses that offer products. Describe the internal role of accounting for organizations. Identify three types of services typically offered by accounting professionals. What type of accounting information might be useful to the marketing managers of a business? Why is accounting described as a service activity? What are some accounting-related professions? How do ethics rules affect auditors’ choice of clients? What work do tax accounting professionals perform in addition to preparing tax returns? What does the concept of objectivity imply for information reported in financial statements? Why? A business reports its own office stationery on the balance sheet at its $400 cost, although it cannot be sold for more than $10 as scrap paper. Which accounting principle and/or assumption justifies this treatment? Why is the revenue recognition principle needed? What does it demand? Describe the three basic forms of business organization and their key characteristics. Define (a) assets, (b) liabilities, (c) equity, and (d ) net assets. 18. What events or transactions change equity? 19. Identify the two main categories of accounting principles. 20. What do accountants mean by the term revenue? 21. Define net income and explain its computation. 22. Identify the four basic financial statements of a business. 23. What information is reported in an income statement? 24. Give two examples of expenses a business might incur. 25. What is the purpose of the statement of owner’s equity? 26. What information is reported in a balance sheet? 27. The statement of cash flows reports on what major activities? 28. Define and explain return on assets. 29.A Define return and risk. Discuss the trade-off between them. 30.BDescribe the three major business activities in organizations. 31.BExplain why investing (assets) and financing (liabilities and equity) totals are always equal. 32. Refer to the financial statements of Best Buy in Appendix A near the end of the book. To what level of significance are dollar amounts rounded? What time period does its income statement cover? 33. Refer to Circuit City’s balance sheet in Appendix A near the end of the book. Confirm that its total assets equal its total liabilities plus total equity. 34. Identify the dollar amounts of RadioShack’s 2006 assets, liabilities, and equity as reported in its statements in Appendix A near the end of the book. 35. Access the SEC EDGAR database (www.SEC.gov) and retrieve Apple’s 2006 10-K (filed 12-29-2006). Identify its auditor. What responsibility does its independent auditor claim regarding Apple’s financial statements? Denotes Discussion Questions that involve decision making. Quick Study exercises give readers a brief test of key elements. Homework Manager repeats assignments on the book’s Website, which allows instructors to monitor, promote, and assess student learning. It can be used in practice, homework, or exam mode. Available with McGraw-Hill’s Homework Manager QUICK STUDY QS 1-1 Identifying accounting users Identify the following a. Shareholders b. Lenders c. Controllers users as either external users (E) or internal users (I). d. FBI and IRS g. Customers j. Business press e. Consumer group h. Suppliers k. Managers f. Sales staff i. Brokers l. District attorney C2 QS 1-2 Identifying accounting terms C1 QS 1-3 Accounting opportunities C3 Reading and interpreting accounting reports requires some knowledge of accounting terminology. (a) Identify the meaning of these accounting-related acronyms: GAAP, SEC, FASB and IASB. (b) Briefly explain the importance of the knowledge base or organization that is referred to for each of the accountingrelated acronyms. There are many job opportunities for those with accounting knowledge. Identify at least three main areas of opportunities for accounting professionals. For each area, identify at least three job possibilities linked to accounting. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 29 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 29 An important responsibility of many accounting professionals is to design and implement internal control procedures for organizations. Explain the purpose of internal control procedures. Provide two examples of internal controls applied by companies. QS 1-4 Identify which accounting principle or assumption best describes each of the following practices: a. In December 2009, Ace Landscaping received a customer’s order and cash prepayment to install sod at a new house that would not be ready for installation until March 2010. Ace should record the revenue from the customer order in March 2010, not in December 2009. b. If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000. c. Jay Keren owns both Sailing Passions and Dockside Supplies. In preparing financial statements for Dockside Supplies, Keren makes sure that the expense transactions of Sailing Passions are kept separate from Dockside’s statements. QS 1-5 Accounting professionals must sometimes choose between two or more acceptable methods of accounting for business transactions and events. Explain why these situations can involve difficult matters of ethical concern. QS 1-6 Use the accounting equation to compute the missing financial statement amounts (a), (b), and (c). QS 1-7 Company Assets Liabilities Equity 1 $375,000 $250,000 2 $ _____ ( ___b) $185,000 $ ____ ( ___ a) $90,000 C1 Identifying accounting principles C5 This icon highlights assignments that enhance decisionmaking skills. Identifying ethical concerns C4 Applying the accounting equation $160,000 $60,000 Explaining internal control $ (c____ ____ ) _ 3 A1 a. Total assets of Charter Company equal $500,000 and its equity is $320,000. What is the amount of QS 1-8 its liabilities? b. Total assets of Golfland equal $900,000 and its liabilities and equity amounts are equal to each other. What is the amount of its liabilities? What is the amount of its equity? Applying the accounting equation Use Apple’s September 30, 2006, financial statements, in Appendix A near the end of the book, to answer the following: a. Identify the dollar amounts of Apple’s 2006 (1) assets, (2) liabilities, and (3) equity. b. Using Apple’s amounts from part a, verify that Assets Liabilities Equity. QS 1-9 Accounting provides information about an organization’s business transactions and events that both affect the accounting equation and can be reliably measured. Identify at least two examples of both (a) business transactions and (b) business events that meet these requirements. QS 1-10 A1 Identifying and computing assets, liabilities, and equity A2 Identifying transactions and events A2 Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), statement of owner’s equity (OE), or statement of cash flows (CF). a. Equipment d. Net decrease (or increase) in cash g. Assets b. Expenses e. Revenues h. Cash from operating activities c. Liabilities f. Total liabilities and equity i. Withdrawals QS 1-11 In a recent year’s financial statements, Home Depot reported the following results. Compute and interpret Home Depot’s return on assets (assume competitors average a 12% return on assets). QS 1-12 Sales . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . Average total assets . . . . . . . . $90,837 million 5,761 million 48,334 million Identifying items with financial statements P1 Computing and interpreting return on assets A3 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 30 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 30 Chapter 1 Accounting in Business Available with McGraw-Hill’s Homework Manager EXERCISES Exercise 1-1 Identifying accounting users and uses Much of accounting is directed at servicing the information needs of those users that are external to an organization. (a) Identify at least three external users of accounting information and indicate two questions they might seek to answer through their use of accounting information. (b) Identify at least three internal users of accounting information and describe how each might use accounting information in their jobs. C2 Exercise 1-2 Describing accounting responsibilities C2 C3 Exercise 1-3 Identifying ethical concerns C4 Exercise 1-4 Identifying accounting principles and assumptions C5 Exercise 1-5 Distinguishing business organizations C5 Many accounting professionals work in one of the following three areas: A. Financial accounting B. Managerial accounting C. Tax accounting Identify the area of accounting that is most involved in each of the following responsibilities: 1. Investigating violations of tax laws. 5. Internal auditing. 2. Planning transactions to minimize taxes. 6. External auditing. 3. Preparing external financial statements. 7. Cost accounting. 4. Reviewing reports for SEC compliance. 8. Budgeting. Assume the following role and describe a situation in which ethical considerations play an important part in guiding your decisions and actions: a. You are an accounting professional with audit clients that are competitors in business. b. You are an accounting professional preparing tax returns for clients. c. You are a manager with responsibility for several employees. d. You are a student in an introductory accounting course. Match each of the numbered descriptions with the principle or assumption it best reflects. Enter the letter for the appropriate principle or assumption in the blank space next to each description. A. General accounting principle E. Specific accounting principle B. Cost principle F. Full disclosure principle C. Business entity assumption G. Going-concern assumption D. Revenue recognition principle H. Matching principle 1. Usually created by a pronouncement from an authoritative body. 2. Financial statements reflect the assumption that the business continues operating. 3. Derived from long-used and generally accepted accounting practices. 4. Every business is accounted for separately from its owner or owners. 5. Revenue is recorded only when the earnings process is complete. 6. Information is based on actual costs incurred in transactions. 7. A company reports details behind financial statements that would impact users’ decisions. 8. A company records the expenses incurred to generate the revenues reported. The following describe several different business organizations. Determine whether the description refers to a sole proprietorship, partnership, or corporation. a. Wallingford is owned by Gary Malone, who is personally liable for the company’s debts. b. Ava Fong and Elijah Logan own Financial Services, a financial services provider. Neither Fong nor Logan has personal responsibility for the debts of Financial Services. c. IBC Services does not have separate legal existence apart from the one person who owns it. d. Computing Services pays its own income taxes and has two owners. e. Ownership of Zander Company is divided into 1,000 shares of stock. f. Emma Bailey and Dylan Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the business. g. Physio Products does not pay income taxes and has one owner. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 31 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business Exercise 1-6 Determine the missing amount from each of the separate situations a, b, and c below. Assets Liabilities $164,000 $ 39,000 ? Using the accounting equation Equity a. ? b. $ 90,000 c. $201,000 31 $16,000 ? $62,000 A1 Match each of the numbered descriptions with the term or phrase it best reflects. Indicate your answer by writing the letter for the term or phrase in the blank provided. A. Audit C. Ethics E. SEC G. Net income B. GAAP D. Tax accounting F. Public accountants H. IASB 1. An accounting area that includes planning future transactions to minimize taxes paid. 2. Amount a business earns after paying all expenses and costs associated with its sales and revenues. 3. Principles that determine whether an action is right or wrong. 4. Accounting professionals who provide services to many clients. 5. An examination of an organization’s accounting system and records that adds credibility to financial statements. Exercise 1-7 Answer the following questions. (Hint: Use the accounting equation.) a. Office Supplies has assets equal to $137,000 and liabilities equal to $110,000 at year-end. What is the total equity for Office Supplies at year-end? b. At the beginning of the year, Addison Company’s assets are $259,000 and its equity is $194,250. During the year, assets increase $80,000 and liabilities increase $52,643. What is the equity at the end of the year? c. At the beginning of the year, Quasar Company’s liabilities equal $57,000. During the year, assets increase by $60,000, and at year-end assets equal $190,000. Liabilities decrease $16,000 during the year. What are the beginning and ending amounts of equity? Exercise 1-8 Provide an example of a transaction that creates the described effects for the separate cases a through g. a. Increases an asset and increases a liability. e. Increases a liability and decreases equity. b. Decreases a liability and increases a liability. f. Increases an asset and increases equity. c. Decreases an asset and decreases a liability. g. Decreases an asset and decreases equity. d. Increases an asset and decreases an asset. Exercise 1-9 Zen began a new consulting firm on January 5. The accounting equation showed the following balances after each of the company’s first five transactions. Analyze the accounting equation for each transaction and describe each of the five transactions with their amounts. Exercise 1-10 Learning the language of business C1–C4 Using the accounting equation A1 A2 Check (c) Beg. equity, $73,000 Identifying effects of transactions on the accounting equation A1 A2 Analysis using the accounting equation A1 A2 Assets Transaction a. b. c. d. e. Cash $20,000 18,000 10,000 10,000 11,000 Accounts Receivable $ 0 0 0 6,000 6,000 Liabilities Office Supplies $ 0 3,000 3,000 3,000 3,000 Office Furniture $ 0 0 8,000 8,000 8,000 Accounts Payable $ 0 1,000 1,000 1,000 1,000 Equity Zen, Capital $20,000 20,000 20,000 20,000 20,000 Revenues $ 0 0 0 6,000 7,000 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 32 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 32 Chapter 1 Accounting in Business Exercise 1-11 The following table shows the effects of five transactions (a through e) on the assets, liabilities, and equity of Trista’s Boutique. Write short descriptions of the probable nature of each transaction. Identifying effects of transactions on accounting equation Assets A1 A2 Cash a. b. c. d. e. Exercise 1-12 Identifying effects of transactions using the accounting equation A1 A2 $ 21,000 4,000 Accounts Receivable $ 0 Liabilities Office Supplies $3,000 Land $ 19,000 4,000 1,000 Equity Accounts Payable $ 0 Trista, Capital $43,000 $ 0 1,000 1,900 1,000 1,900 _____ ___ $ 17,900 _____ ___ _____ ___ Revenues 1,900 1,000 1,900 _______ $ 0 _______ _______ ______ _ $4,000 ______ __ ______ _____ ___ $ 23,000 _____ ___ _____ ___ _______ _ $_0 _______ _______ _ ____ ___ $43,000 ____ ___ ____ ___ ______ _ $ 1,900 ______ _ ______ _ Leora Diamond began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Diamond (the owner) completed these transactions: a. Owner invested $70,000 cash in the company along with equipment that had a $20,000 market value. b. The company paid $2,000 cash for rent of office space for the month. c. The company purchased $25,000 of additional equipment on credit (payment due within 30 days). d. The company completed work for a client and immediately collected the $3,000 cash earned. e. The company completed work for a client and sent a bill for $9,500 to be received within 30 days. f. The company purchased additional equipment for $5,000 cash. g. The company paid an assistant $3,500 cash as wages for the month. h. The company collected $6,500 cash as a partial payment for the amount owed by the client in transaction e. i. The company paid $25,000 cash to settle the liability created in transaction c. j. Owner withdrew $1,500 cash from the company for personal use. Required Check Net income, $7,000 Create a table like the one in Exhibit 1.9, using the following headings for columns: Cash; Accounts Receivable; Equipment; Accounts Payable; L. Diamond, Capital; L. Diamond, Withdrawals; Revenues; and Expenses. Then use additions and subtractions to show the effects of the transactions on individual items of the accounting equation. Show new balances after each transaction. Exercise 1-13 On October 1, Keisha King organized Real Answers, a new consulting firm. On October 31, the company’s records show the following items and amounts. Use this information to prepare an October income statement for the business. Preparing an income statement P1 Check Net income, $4,540 Exercise 1-14 Cash . . . . . . . . . . Accounts receivable Office supplies . . . Land . . . . . . . . . . . Office equipment . Accounts payable . Owner investments .. . .. .. .. .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,500 12,000 24,437 46,000 18,000 25,037 84,360 Cash withdrawals by owner Consulting fees earned . . . Rent expense . . . . . . . . . . Salaries expense . . . . . . . . Telephone expense . . . . . . Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000 14,000 2,520 5,600 760 580 Use the information in Exercise 1-13 to prepare an October statement of owner’s equity for Real Answers. Preparing a statement of owner’s equity P1 Exercise 1-15 Preparing a balance sheet P1 Use the information in Exercise 1-13 (if completed, you can also use your solution to Exercise 1-14) to prepare an October 31 balance sheet for Real Answers. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 33 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 33 Use the information in Exercise 1-13 to prepare an October 31 statement of cash flows for Real Answers. Also assume the following: a. The owner’s initial investment consists of $38,360 cash and $46,000 in land. b. The company’s $18,000 equipment purchase is paid in cash. c. The accounts payable balance of $25,037 consists of the $24,437 office supplies purchase and $600 in employee salaries yet to be paid. d. The company’s rent, telephone, and miscellaneous expenses are paid in cash. e. $2,000 has been collected on the $14,000 consulting fees earned. Exercise 1-16 Indicate the section where each of the following would appear on the statement of cash flows. O. Cash flows from operating activity I. Cash flows from investing activity F. Cash flows from financing activity 1. Cash paid for rent 5. Cash paid for advertising 2. Cash paid on an account payable 6. Cash paid for wages 3. Cash investment by owner 7. Cash withdrawal by owner 4. Cash received from clients 8. Cash purchase of equipment Exercise 1-17 Iowa Group reports net income of $36,000 for 2009. At the beginning of 2009, Iowa Group had $135,000 in assets. By the end of 2009, assets had grown to $185,000. What is Iowa Group’s 2009 return on assets? How would you assess its performance if competitors average a 10% return on assets? Exercise 1-18 Match each transaction or event to one of the following activities of an organization: financing activities (F), investing activities (I), or operating activities (O). a. An organization purchases equipment. b. An organization advertises a new product. c. The organization borrows money from a bank. d. An owner contributes resources to the business. e. An organization sells some of its land. Exercise 1-19B Preparing a statement of cash flows P1 Check Net increase in cash, $11,500 Identifying sections of the statement of cash flows P1 Analysis of return on assets A3 Identifying business activities C6 Problem Set B located at the end of Problem Set A is provided for each problem to reinforce the learning process. Available with McGraw-Hill’s Homework Manager PROBLEM SET A The following financial statement information is from five separate companies: Company A December 31, 2008 Assets . . . . . . . . . . . . . . Liabilities . . . . . . . . . . . . December 31, 2009 Assets . . . . . . . . . . . . . . Liabilities . . . . . . . . . . . . During year 2009 Owner investments . . . . Net income (loss) . . . . . Owner cash withdrawals Company B Company C Company D Company E ....... ....... $33,000 27,060 $25,740 18,018 $21,120 11,404 $58,740 40,530 $90,090 ? ....... ....... 36,000 ? 25,920 17,625 ? 11,818 65,520 31,449 99,360 78,494 ....... ....... ....... 6,000 7,760 3,500 1,400 ? 2,000 9,750 (1,289) 5,875 ? 8,861 0 6,500 7,348 11,000 Problem 1-1A Computing missing information using accounting knowledge A1 A2 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 34 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 34 Required Check (1b) $16,200 (2c) $1,173 (3) $24,120 Problem 1-2A Identifying effects of transactions on financial statements A1 A2 1. Answer the following questions about Company A: a. What is the amount of equity on December 31, 2008? b. What is the amount of equity on December 31, 2009? c. What is the amount of liabilities on December 31, 2009? 2. Answer the following questions about Company B: a. What is the amount of equity on December 31, 2008? b. What is the amount of equity on December 31, 2009? c. What is net income for year 2009? 3. Calculate the amount of assets for Company C on December 31, 2009. 4. Calculate the amount of owner investments for Company D during year 2009. 5. Calculate the amount of liabilities for Company E on December 31, 2008. Identify how each of the following separate transactions affects financial statements. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from financing activities, and cash flows from investing activities. For increases, place a “ ” in the column or columns. For decreases, place a “ ” in the column or columns. If both an increase and a decrease occur, place a “ ” in the column or columns. The first transaction is completed as an example. Income Statement Balance Sheet Total Assets Transaction 1 Financing Activities Investing Activities Incurs legal costs on credit 5 Operating Activities Pays cash for employee wages 4 Net Income Receives cash for services provided 3 Total Equity Owner invests cash in business 2 Total Liab. Statement of Cash Flows Borrows cash by signing long-term note payable 6 Buys land by signing note payable 7 Provides services on credit 8 Buys office equipment for cash 9 10 Collects cash on receivable from (7) Owner withdraws cash Problem 1-3A Preparing an income statement P1 The following is selected financial information for Elko Energy Company for the year ended December 31, 2009: revenues, $66,000; expenses, $51,348; net income, $14,652. Required Prepare the 2009 calendar-year income statement for Elko Energy Company. Problem 1-4A Preparing a balance sheet P1 The following is selected financial information for Amity Company as of December 31, 2009: liabilities, $54,244; equity, $87,756; assets, $142,000. Required Prepare the balance sheet for Amity Company as of December 31, 2009. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 35 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business Following is selected financial information of Fortune Co. for the year ended December 31, 2009. Cash used by investing activities Net increase in cash . . . . . . . . Cash used by financing activities Cash from operating activities . Cash, December 31, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Problem 1-5A Preparing a statement of cash flows $(3,250) 750 (4,050) 8,050 4,100 P1 Check Cash balance, Dec. 31, 2009, $4,850 Required Prepare the 2009 statement of cash flows for Fortune Company. Following is selected financial information for Atlee Co. for the year ended December 31, 2009. A. Atlee, Capital, Dec. 31, 2009 . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . $16,750 7,750 A. Atlee, Withdrawals . . . . . . . . . . . . . . A. Atlee, Capital, Dec. 31, 2008 . . . . . . . . $ 2,000 11,000 Problem 1-6A Preparing a statement of owner’s equity P1 Required Prepare the 2009 statement of owner’s equity for Atlee Company. Holden Graham started The Graham Co., a new business that began operations on May 1. The Graham Co. completed the following transactions during its first month of operations. May 1 1 3 5 8 12 15 20 22 25 26 27 28 30 30 31 H. Graham invested $43,000 cash in the company. The company rented a furnished office and paid $2,200 cash for May’s rent. The company purchased $1,940 of office equipment on credit. The company paid $750 cash for this month’s cleaning services. The company provided consulting services for a client and immediately collected $5,800 cash. The company provided $2,800 of consulting services for a client on credit. The company paid $850 cash for an assistant’s salary for the first half of this month. The company received $2,800 cash payment for the services provided on May 12. The company provided $4,000 of consulting services on credit. The company received $4,000 cash payment for the services provided on May 22. The company paid $1,940 cash for the office equipment purchased on May 3. The company purchased $85 of advertising in this month’s (May) local paper on credit; cash payment is due June 1. The company paid $850 cash for an assistant’s salary for the second half of this month. The company paid $400 cash for this month’s telephone bill. The company paid $260 cash for this month’s utilities. H. Graham withdrew $2,000 cash from the company for personal use. Problem 1-7A Analyzing transactions and preparing financial statements C5 A2 P1 x e cel mhhe.com/wildFAP19e Required 1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Office Equipment; Accounts Payable; H. Graham, Capital; H. Graham, Withdrawals; Revenues; and Expenses. 2. Show effects of the transactions on the accounts of the accounting equation by recording increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance. 3. Prepare an income statement for May, a statement of owner’s equity for May, a May 31 balance sheet, and a statement of cash flows for May. Check (2) Ending balances: Cash, $46,350; Expenses, $5,395 (3) Net income, $7,205; Total assets, $48,290 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 36 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 36 Chapter 1 Accounting in Business Problem 1-8A Helga Anderson started a new business and completed these transactions during December. Analyzing transactions and preparing financial statements Dec. 1 C5 A2 P1 x e cel mhhe.com/wildFAP19e 2 3 5 6 8 15 18 20 24 28 29 30 31 Helga Anderson transferred $68,800 cash from a personal savings account to a checking account in the name of Anderson Electric. The company rented office space and paid $1,800 cash for the December rent. The company purchased $13,000 of electrical equipment by paying $4,800 cash and agreeing to pay the $8,200 balance in 30 days. The company purchased office supplies by paying $1,000 cash. The company completed electrical work and immediately collected $1,600 cash for these services. The company purchased $2,680 of office equipment on credit. The company completed electrical work on credit in the amount of $6,000. The company purchased $360 of office supplies on credit. The company paid $2,680 cash for the office equipment purchased on December 8. The company billed a client $1,000 for electrical work completed; the balance is due in 30 days. The company received $6,000 cash for the work completed on December 15. The company paid the assistant’s salary of $1,500 cash for this month. The company paid $570 cash for this month’s utility bill. H. Anderson withdrew $900 cash from the company for personal use. Required 1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Check (2) Ending balances: Cash, $63,150, Accounts Payable, $8,560 (3) Net income, $4,730; Total assets, $81,190 Receivable; Office Supplies; Office Equipment; Electrical Equipment; Accounts Payable; H. Anderson, Capital; H. Anderson, Withdrawals; Revenues; and Expenses. 2. Use additions and subtractions to show the effects of each transaction on the accounts in the accounting equation. Show new balances after each transaction. 3. Use the increases and decreases in the columns of the table from part 2 to prepare an income statement, a statement of owner’s equity, and a statement of cash flows—each of these for the current month. Also prepare a balance sheet as of the end of the month. Analysis Component 4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $68,800 and that Anderson Electric obtained another $19,800 in cash by borrowing it from a bank. Explain the effect of this change on total assets, total liabilities, and total equity. Problem 1-9A Analyzing effects of transactions C5 P1 A1 A2 Inez Lopez started Wiz Consulting, a new business, and completed the following transactions during its first year of operations. a. I. Lopez invests $67,000 cash and office equipment valued at $11,000 in the company. b. The company purchased a $144,000 building to use as an office. Wiz paid $15,000 in cash and signed a note payable promising to pay the $129,000 balance over the next ten years. c. The company purchased office equipment for $12,000 cash. d. The company purchased $1,000 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $460 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,400 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash fee. h. I. Lopez withdrew $3,025 cash from the company for personal use. i. The company received $1,800 cash as partial payment from the client described in transaction f. j. The company made a partial payment of $500 cash on the equipment purchased in transaction d. k. The company paid $1,800 cash for the office secretary’s wages for this period. Required 1. Create a table like the one in Exhibit 1.9, using the following headings for the columns: Cash; Accounts Check (2) Ending balances: Cash, $40,015; Expenses, $2,260; Notes Payable, $129,000 (3) Net income, $4,140 Receivable; Office Supplies; Office Equipment; Building; Accounts Payable; Notes Payable; I. Lopez, Capital; I. Lopez, Withdrawals; Revenues; and Expenses. 2. Use additions and subtractions within the table created in part 1 to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. 3. Once you have completed the table, determine the company’s net income. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 37 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures (in $ millions) for these businesses over the past year follow. Key Figures ($ millions) Sales . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . Average assets . . . . . . . . . . . . . . . Coca-Cola PepsiCo $24,088 5,080 29,695 37 Problem 1-10A Computing and interpreting return on assets $35,187 5,642 30,829 A3 Required 1. Compute return on assets for (a) Coca-Cola and (b) PepsiCo. 2. Which company is more successful in its total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested? Check (1a) 17.1%; (1b) 18.3% Analysis Component 4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.) Notaro manufactures, markets, and sells cellular telephones. The average total assets for Notaro is $250,000. In its most recent year, Notaro reported net income of $64,000 on revenues of $468,000. Problem 1-11A Required A1 A3 Determining expenses, liabilities, equity, and return on assets 1. What is Notaro’s return on assets? 2. Does return on assets seem satisfactory for Notaro given that its competitors average a 9.5% return on assets? 3. What are total expenses for Notaro in its most recent year? 4. What is the average total amount of liabilities plus equity for Notaro? Check (3) $404,000 All business decisions involve aspects of risk and return. Problem 1-12AA (4) $250,000 Identifying risk and return Required A4 Identify both the risk and the return in each of the following activities: 1. Investing $10,000 in Yahoo! stock. 2. Placing a $2,500 bet on your favorite sports team. 3. Investing $2,000 in a 5% savings account. 4. Taking out a $7,500 college loan to earn an accounting degree. A start-up company often engages in the following transactions in its first year of operations. Classify those transactions in one of the three major categories of an organization’s business activities. F. Financing I. Investing O. Operating 1. Purchasing equipment. 5. Owner investing land in business. 2. Selling and distributing products. 6. Purchasing a building. 3. Paying for advertising. 7. Purchasing land. 4. Paying employee wages. 8. Borrowing cash from a bank. Problem 1-13AB An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity. Problem 1-14AB Describing organizational activities C6 Describing organizational activities C6 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 38 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 38 Chapter 1 Accounting in Business PROBLEM SET B The following financial statement information is from five separate companies. Company V Company W Company X Company Y Company Z ....... ....... $36,000 29,520 $ 28,080 19,656 $23,040 12,441 $64,080 44,215 $ 98,280 ? ....... ....... 39,000 21,450 28,080 ? 26,130 12,803 ? 34,070 107,640 85,035 ....... ....... ....... 6,000 ? 3,500 1,400 1,162 2,000 ? (1,147) 5,875 7,000 10,045 0 6,500 7,449 11,000 Problem 1-1B Computing missing information using accounting knowledge December 31, 2008 Assets . . . . . . . . . . . . . . Liabilities . . . . . . . . . . . . December 31, 2009 Assets . . . . . . . . . . . . . . Liabilities . . . . . . . . . . . . During year 2009 Owner investments . . . . Net income or (loss) . . . Owner cash withdrawals A1 A2 Required Check (1b) $17,550 (2c) $19,094 (4) $70,980 Problem 1-2B Identifying effects of transactions on financial statements A1 A2 1. Answer the following questions about Company V: a. What is the amount of equity on December 31, 2008? b. What is the amount of equity on December 31, 2009? c. What is the net income or loss for the year 2009? 2. Answer the following questions about Company W: a. What is the amount of equity on December 31, 2008? b. What is the amount of equity on December 31, 2009? c. What is the amount of liabilities on December 31, 2009? 3. Calculate the amount of owner investments for Company X during 2009. 4. Calculate the amount of assets for Company Y on December 31, 2009. 5. Calculate the amount of liabilities for Company Z on December 31, 2008. Identify how each of the following separate transactions affects financial statements. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from financing activities, and cash flows from investing activities. For increases, place a “ ” in the column or columns. For decreases, place a “ ” in the column or columns. If both an increase and a decrease occur, place “ ” in the column or columns. The first transaction is completed as an example. Income Statement Balance Sheet Transaction 1 Owner invests cash in business 2 Buys building by signing note payable 3 Pays cash for salaries incurred 4 Provides services for cash 5 Pays cash for rent incurred 6 Incurs utilities costs on credit 7 Buys store equipment for cash 8 Provides services on credit 9 Collects cash on receivable from (8) 10 Owner withdraws cash Total Assets Total Liab. Total Equity Net Income Statement of Cash Flows Operating Activities Financing Activities Investing Activities wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 39 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business Selected financial information for Onshore Co. for the year ended December 31, 2009, follows. Revenues . . . . . . . $69,000 Expenses . . . . . . . $53,682 Net income . . . . . . . $15,318 39 Problem 1-3B Preparing an income statement P1 Required Prepare the 2009 income statement for Onshore Company. The following is selected financial information for NuTech Company as of December 31, 2009. Problem 1-4B Preparing a balance sheet Liabilities . . . . . . . $46,222 Equity . . . . . . . $74,778 Assets . . . . . . . $121,000 P1 Required Prepare the balance sheet for NuTech Company as of December 31, 2009. Selected financial information of HalfLife Co. for the year ended December 31, 2009, follows. Cash used by investing activities Net increase in cash . . . . . . . . Cash used by financing activities Cash from operating activities . Cash, December 31, 2008 . . . . ....... ....... ....... ....... ....... . . . . . Problem 1-5B Preparing a statement of cash flows $(3,750) 250 (4,550) 8,550 3,700 P1 Required Prepare the 2009 statement of cash flows for HalfLife Company. Following is selected financial information of Act First for the year ended December 31, 2009. I. Firstact, Capital, Dec. 31, 2009 . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . $10,500 7,000 I. Firstact, Withdrawals . . . . . . . . . . . . . . I. Firstact, Capital, Dec. 31, 2008 . . . . . . . $ 2,000 5,500 Problem 1-6B Preparing a statement of owner’s equity P1 Required Prepare the 2009 statement of owner’s equity for Act First. Nikolas Benton launched a new business, Benton’s Maintenance Co., that began operations on June 1. The following transactions were completed by the company during that first month. June 1 2 4 6 8 14 16 20 24 25 26 27 28 29 30 30 N. Benton invested $41,000 cash in the company. The company rented a furnished office and paid $2,200 cash for June’s rent. The company purchased $1,860 of equipment on credit. The company paid $780 cash for this month’s advertising of the opening of the business. The company completed maintenance services for a customer and immediately collected $5,700 cash. The company completed $2,400 of maintenance services for City Center on credit. The company paid $810 cash for an assistant’s salary for the first half of the month. The company received $2,400 cash payment for services completed for City Center on June 14. The company completed $3,300 of maintenance services for Build-It Coop on credit. The company received $3,300 cash payment from Build-It Coop for the work completed on June 24. The company made payment of $1,860 cash for the equipment purchased on June 4. The company purchased $80 of product advertising in this month’s (June) local newspaper on credit; cash payment is due July 1. The company paid $810 cash for an assistant’s salary for the second half of this month. N. Benton withdrew $1,600 cash from the company for personal use. The company paid $250 cash for this month’s telephone bill. The company paid $300 cash for this month’s utilities. Problem 1-7B Analyzing transactions and preparing financial statements C5 A2 P1 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 40 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 40 Required 1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Check (2) Ending balances: Cash, $43,790; Expenses, $5,230 (3) Net income, $6,170; Total assets, $45,650 Problem 1-8B Analyzing transactions and preparing financial statements C5 A2 P1 Receivable; Equipment; Accounts Payable; N. Benton, Capital; N. Benton, Withdrawals; Revenues; and Expenses. 2. Show the effects of the transactions on the accounts of the accounting equation by recording increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance. 3. Prepare a June income statement, a June statement of owner’s equity, a June 30 balance sheet, and a June statement of cash flows. Truro Excavating Co., owned by Raul Truro, began operations in July and completed these transactions during that first month of operations. July 1 R. Truro invested $68,600 cash in the company. 2 The company rented office space and paid $1,300 cash for the July rent. 3 The company purchased excavating equipment for $14,600 by paying $6,400 cash and agreeing to pay the $8,200 balance in 30 days. 6 The company purchased office supplies for $900 cash. 8 The company completed work for a customer and immediately collected $2,000 cash for the work. 10 The company purchased $2,720 of office equipment on credit. 15 The company completed work for a customer on credit in the amount of $4,300. 17 The company purchased $350 of office supplies on credit. 23 The company paid $2,720 cash for the office equipment purchased on July 10. 25 The company billed a customer $1,000 for work completed; the balance is due in 30 days. 28 The company received $4,300 cash for the work completed on July 15. 30 The company paid an assistant’s salary of $1,900 cash for this month. 31 The company paid $590 cash for this month’s utility bill. 31 R. Truro withdrew $900 cash from the company for personal use. Required 1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Check (2) Ending balances: Cash, $60,190; Accounts Payable, $8,550 (3) Net income, $3,510; Total assets, $79,760 Receivable; Office Supplies; Office Equipment; Excavating Equipment; Accounts Payable; R. Truro, Capital; R. Truro, Withdrawals; Revenues; and Expenses. 2. Use additions and subtractions to show the effects of each transaction on the accounts in the accounting equation. Show new balances after each transaction. 3. Use the increases and decreases in the columns of the table from part 2 to prepare an income statement, a statement of owner’s equity, and a statement of cash flows—each of these for the current month. Also prepare a balance sheet as of the end of the month. Analysis Component 4. Assume that the $14,600 purchase of excavating equipment on July 3 was financed from an owner investment of another $14,600 cash in the business (instead of the purchase conditions described in the transaction). Explain the effect of this change on total assets, total liabilities, and total equity. Problem 1-9B Analyzing effects of transactions C5 P1 A1 A2 Nico Mitchell started a new business, Financial Management, and completed the following transactions during its first year of operations. a. N. Mitchell invests $70,000 cash and office equipment valued at $12,000 in the company. b. The company purchased a $141,000 building to use as an office. It paid $15,000 in cash and signed a note payable promising to pay the $126,000 balance over the next ten years. c. The company purchased office equipment for $11,000 cash. d. The company purchased $600 of office supplies and $1,300 of office equipment on credit. e. The company paid a local newspaper $500 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,400 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash fee. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 41 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business h. i. j. k. 41 N. Mitchell withdrew $3,325 cash from the company for personal use. The company received $1,750 cash as a partial payment from the client described in transaction f. The company made a partial payment of $700 cash on the equipment purchased in transaction d. The company paid $1,750 cash for the office secretary’s wages. Required 1. Create a table like the one in Exhibit 1.9, using the following headings for the columns: Cash; Accounts Receivable; Office Supplies; Office Equipment; Building; Accounts Payable; Notes Payable; N. Mitchell, Capital; N. Mitchell, Withdrawals; Revenues; and Expenses. 2. Use additions and subtractions within the table created in part 1 to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. 3. Once you have completed the table, determine the company’s net income. AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures (in $ millions) for these businesses over the past year follow. Key Figures ($ millions) AT&T Verizon Sales . . . . . . . . . . . . . . . . . . . . . . $ 63,055 7,356 208,133 (3) Net income, $4,150 Problem 1-10B Computing and interpreting return on assets $ 84,144 Net income . . . . . . . . . . . . . . . . . Average assets . . . . . . . . . . . . . . . Check (2) Ending balances: Cash, $43,475; Expenses, $2,250; Notes Payable, $126,000 6,197 178,467 A3 Required 1. Compute return on assets for (a) AT&T and (b) Verizon. 2. Which company is more successful in the total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested? Check (1a) 3.5%; (1b) 3.5% Analysis Component 4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.) Carbondale Company manufactures, markets, and sells ATV and snowmobile equipment and accessories. The average total assets for Carbondale is $243,000. In its most recent year, Carbondale reported net income of $62,500 on revenues of $473,000. Required Problem 1-11B Determining expenses, liabilities, equity, and return on assets A1 A3 1. What is Carbondale Company’s return on assets? 2. Does return on assets seem satisfactory for Carbondale given that its competitors average a 10% re- turn on assets? 3. What are the total expenses for Carbondale Company in its most recent year? 4. What is the average total amount of liabilities plus equity for Carbondale Company? Check (3) $410,500 All business decisions involve aspects of risk and return. Problem 1-12BA (4) $243,000 Identifying risk and return Required Identify both the risk and the return in each of the following activities: 1. 2. 3. 4. Investing $20,000 in Nike stock. Placing a $250 bet on a horse running in the Kentucky Derby. Stashing $500 cash under your mattress. Investing $35,000 in U.S. Savings Bonds. A4 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 42 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 42 Chapter 1 Accounting in Business Problem 1-13BB A start-up company often engages in the following activities during its first year of operations. Classify each of the following activities into one of the three major activities of an organization. F. Financing I. Investing O. Operating 1. Supervising workers. 5. Providing client services. 2. Owner investing money in business. 6. Obtaining a bank loan. 3. Renting office space. 7. Purchasing machinery. 4. Paying utilities expenses. 8. Research for its products. Describing organizational activities C6 Problem 1-14BB Describing organizational activities C6 Identify in outline format the three major business activities of an organization. For each of these activities, identify at least two specific transactions or events normally undertaken by the business’s owners or its managers. This serial problem starts in this chapter and continues throughout most chapters of the book. It is most readily solved if you use the Working Papers that accompany this book. SERIAL PROBLEM Success Systems SP 1 On October 1, 2009, Adriana Lopez launched a computer services company, Success Systems, that is organized as a proprietorship and provides consulting services, computer system installations, and custom program development. Lopez adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2009. Required Create a table like the one in Exhibit 1.9 using the following headings for columns: Cash; Accounts Receivable; Computer Supplies; Computer System; Office Equipment; Accounts Payable; A. Lopez, Capital; A. Lopez, Withdrawals; Revenues; and Expenses. Then use additions and subtractions within the table created to show the dollar effects for each of the following October transactions for Success Systems on the individual items of the accounting equation. Show new balances after each transaction. Oct. 1 3 6 8 Check Ending balances: Cash, $52,560; Revenues, $11,408; Expenses, $3,620 10 12 15 17 20 22 28 31 31 Adriana Lopez invested $55,000 cash, a $20,000 computer system, and $8,000 of office equipment in the company. The company purchased $1,420 of computer supplies on credit from Harris Office Products. The company billed Easy Leasing $4,800 for services performed in installing a new Web server. The company paid $1,420 cash for the computer supplies purchased from Harris Office Products on October 3. The company hired Lyn Addie as a part-time assistant for $125 per day, as needed. The company billed Easy Leasing another $1,400 for services performed. The company received $4,800 cash from Easy Leasing as partial payment toward its account. The company paid $805 cash to repair computer equipment damaged when moving it. The company paid $1,940 cash for an advertisement in the local newspaper. The company received $1,400 cash from Easy Leasing toward its account. The company billed IFM Company $5,208 for services performed. The company paid $875 cash for Lyn Addie’s wages for seven days of work this month. A. Lopez withdrew $3,600 cash from the company for personal use. Beyond the Numbers (BTN) is a special problem section aimed to refine communication, conceptual, analysis, and research skills. It includes many activities helpful in developing an active learning environment. BEYOND THE NUMBERS REPORTING IN ACTION BTN 1-1 Key financial figures for Best Buy’s fiscal year ended March 3, 2007, follow. A1 A3 A4 Key Figure Liabilities Equity . . . . . . . Net income . . . . . . . . . . . . Revenues . . . . . . . . . . . . . . In Millions $13,570 1,377 35,934 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 43 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business 43 Required 1. 2. 3. 4. What is the total amount of assets invested in Best Buy? What is Best Buy’s return on assets? Its assets at February 25, 2006, equal $11,864 (in millions). How much are total expenses for Best Buy for the year ended March 3, 2007? Does Best Buy’s return on assets seem satisfactory if competitors average an 8.1% return? Check (2) 10.8% Fast Forward 5. Access Best Buy’s financial statements (Form 10-K) for fiscal years ending after March 3, 2007, from its Website (BestBuy.com) or from the SEC Website (www.SEC.gov) and compute its return on assets for those fiscal years. Compare the March 3, 2007, fiscal year-end return on assets to any subsequent years’ returns you are able to compute, and interpret the results. BTN 1-2 Key comparative figures ($ millions) for both Best Buy and RadioShack follow. Key Figure Best Buy RadioShack Liabilities Equity . . . . . . . . Net income . . . . . . . . . . . . . $13,570 1,377 $2,070 73 Revenues and sales . . . . . . . 35,934 COMPARATIVE ANALYSIS 4,778 A1 A3 A4 Required 1. What is the total amount of assets invested in (a) Best Buy and (b) RadioShack? 2. What is the return on assets for (a) Best Buy and (b) RadioShack? Best Buy’s beginning-year assets Check (2b) 3.4% equal $11,864 (in millions) and RadioShack’s beginning-year assets equal $2,205 (in millions). 3. How much are expenses for (a) Best Buy and (b) RadioShack? 4. Is return on assets satisfactory for (a) Best Buy and (b) RadioShack? (Assume competitors average an 8.1% return.) 5. What can you conclude about Best Buy and RadioShack from these computations? BTN 1-3 Liz Thorne works in a public accounting firm and hopes to eventually be a partner. The management of Allnet Company invites Thorne to prepare a bid to audit Allnet’s financial statements. In discussing the audit fee, Allnet’s management suggests a fee range in which the amount depends on the reported profit of Allnet. The higher its profit, the higher will be the audit fee paid to Thorne’s firm. ETHICS CHALLENGE C4 C5 Required 1. 2. 3. 4. Identify the parties potentially affected by this audit and the fee plan proposed. What are the ethical factors in this situation? Explain. Would you recommend that Thorne accept this audit fee arrangement? Why or why not? Describe some ethical considerations guiding your recommendation. BTN 1-4 Refer to this chapter’s opening feature about Life is good.® Assume that Bert and John Jacobs desire to expand their manufacturing facilities to meet customer demand. They decide to meet with their banker to discuss a loan to allow them to expand. Required 1. Prepare a half-page report outlining the information you would request from the Jacobs brothers if you were the loan officer. 2. Indicate whether the information you request and your loan decision are affected by the form of busi- ness organization for Life is good. COMMUNICATING IN PRACTICE A1 C2 wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 44 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: 44 Chapter 1 Accounting in Business TAKING IT TO THE NET BTN 1-5 Visit the EDGAR database at (www.SEC.gov). Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker RMCF) filed on May 14, 2007, covering its 2007 fiscal year. A3 Required 1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2004–2007. How would you describe the revenue trend for RMCF over this four-year period? 2. Has RMCF been profitable (see net income) over this four-year period? Support your answer. TEAMWORK IN ACTION C1 BTN 1-6 Teamwork is important in today’s business world. Successful teams schedule convenient meetings, maintain regular communications, and cooperate with and support their members. This assignment aims to establish support/learning teams, initiate discussions, and set meeting times. Required 1. Form teams and open a team discussion to determine a regular time and place for your team to meet between each scheduled class meeting. Notify your instructor via a memorandum or e-mail message as to when and where your team will hold regularly scheduled meetings. 2. Develop a list of telephone numbers and/or e-mail addresses of your teammates. ENTREPRENEURIAL DECISION A1 A2 BTN 1-7 Refer to this chapter’s opening feature about Life is good. Assume that Bert and John Jacobs decide to open a new manufacturing facility to produce sunscreen. This new company will be called LifeScreen Manufacturing Company. Required 1. LifeScreen Manufacturing obtains a $500,000 loan and the Jacobs brothers contribute $250,000 of Check (2) 10.7% HITTING THE ROAD C2 their own assets in the new company. a. What is the new company’s total amount of liabilities plus equity? b. What is the new company’s total amount of assets? 2. If the new company earns $80,000 in net income in the first year of operation, compute its return on asset (assume average assets equal $750,000). Assess its performance if competitors average a 10% return. BTN 1-8 You are to interview a local business owner. (This can be a friend or relative.) Opening lines of communication with members of the business community can provide personal benefits of business networking. If you do not know the owner, you should call ahead to introduce yourself and explain your position as a student and your assignment requirements. You should request a thirty minute appointment for a face-to-face or phone interview to discuss the form of organization and operations of the business. Be prepared to make a good impression. Required 1. Identify and describe the main operating activities and the form of organization for this business. 2. Determine and explain why the owner(s) chose this particular form of organization. 3. Identify any special advantages and/or disadvantages the owner(s) experiences in operating with this form of business organization. wiL79549_ch01_0002-0045 07/25/2008 7:01 pm Page 45 pinnacle 201:MHBR055:mhwiL19:wiL19ch01: Chapter 1 Accounting in Business BTN 1-9 DSG international plc (www.DSGiplc.com) is the leading European retailer of consumer electronics and competes with both Best Buy and RadioShack. Key financial figures for DSG follow. Key Figure* Average assets . Net income . . . Revenues . . . . . Return on assets Pounds in Millions .... .... .... ... . . . . . . . . . . . . £4,048 207 7,930 5.2% * Figures prepared in accordance with International Financial Reporting Standards. Required 1. Identify any concerns you have in comparing DSG’s income and revenue figures to those of Best Buy and RadioShack (in BTN 1-2) for purposes of making business decisions. 2. Identify any concerns you have in comparing DSG’s return on assets ratio to those of Best Buy and RadioShack (computed for BTN 1-2) for purposes of making business decisions. ANSWERS TO MULTIPLE CHOICE QUIZ 1. c; $450,000 is the actual cost incurred. 2. b; revenue is recorded when earned. 3. d; Assets Liabilities $100,000 Change in equity 4. a 5. a 35,000 $100,000 $35,000 Equity ? $65,000 45 GLOBAL DECISION A1 A3 A4 ...
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