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Principles of Accounting ELEVENTH EDITION Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A. DePaul University Marian Powers, Ph.D. Northwestern University Susan V. Crosson, M.S. Accounting, C.P.A Santa Fe College Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Principles of Accounting, Eleventh Edition © 2011, 2008 South-Western, Cengage Learning Belverd Needles, Marian Powers, Susan Crosson ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced, transmitted, stored, or used Vice President of Editorial, Business: in any form or by any means graphic, electronic, or mechanical, Jack W. Calhoun including but not limited to photocopying, recording, scanning, Editor in Chief: Rob Dewey digitizing, taping, web distribution, information networks, or Executive Editor: Sharon Oblinger information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, Supervising Developmental Editor: without the prior written permission of the publisher. Katie Yanos Sr. Marketing Manager: Kristen Hurd Marketing Coordinator: Heather Mooney For product information and technology assistance, contact Sr. Marketing Communications Manager: us at Cengage Learning Customer & Sales Support, Libby Shipp 1-800-354-9706 Content Project Manager: Darrell Frye For permission to use material from this text or product, submit Media Editor: Bryan England all requests online at www.cengage.com/permissions Further permissions questions can be emailed to Editorial Assistant: Julie Warwick permissionrequest@cengage.com Frontlist Buyer, Manufacturing: Doug Wilke Production Service: S4Carlisle Publishing Services ExamView® is a registered trademark of eInstruction Corp. Windows is a registered trademark of the Microsoft Corporation Sr. Art Director: Stacy Jenkins Shirley used herein under license. Macintosh and Power Macintosh are Cover and Internal Designer: registered trademarks of Apple Computer, Inc. used herein under Grannan Graphic Design license. Cover Image: © Getty Images/Image Bank Permissions Account Manager: John Hill © 2011 Cengage Learning. All Rights Reserved. Cengage Learning WebTutor™ is a trademark of Cengage Learning. Library of Congress Control Number: 2009941180 Student Edition ISBN 10: 1-4390-3774-4 Student Edition ISBN 13: 978-1-4390-3774-4 Instructors Edition ISBN 10: 0-538-75528-8 Instructors Edition ISBN 13: 978-0-538-75528-3 Loose-leaf Edition ISBN 10: 0-538-75519-9 Loose-leaf Edition ISBN 13: 978-0-538-75519-1 South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cengage Learning products are represented in Canada by Nelson Education, Ltd. For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.CengageBrain.com Printed in the United States of America 1 2 3 4 5 6 7 13 12 11 10 09 BRIEF CONTENTS 1 Uses of Accounting Information and the Financial Statements 2 2 Analyzing Business Transactions 48 3 Measuring Business Income 98 4 Completing the Accounting Cycle 142 5 Financial Reporting and Analysis 180 SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 226 6 The Operating Cycle and Merchandising Operations 266 SUPPLEMENT TO CHAPTER 6 Special-Purpose Journals 302 7 Internal Control 318 8 Inventories 350 9 Cash and Receivables 390 10 Current Liabilities and Fair Value Accounting 430 11 Long-Term Assets 472 12 Contributed Capital 518 13 Long-Term Liabilities 562 14 The Corporate Income Statement and the Statement of Stockholders’ Equity 614 15 The Statement of Cash Flows 656 16 Financial Performance Measurement 706 17 Partnerships 754 18 The Changing Business Environment: A Manager’s Perspective 794 19 Cost Concepts and Cost Allocation 836 iii iv Brief Contents 20 Costing Systems: Job Order Costing 882 21 Costing Systems: Process Costing 920 22 Value-Based Systems: ABM and Lean 958 23 Cost Behavior Analysis 988 24 The Budgeting Process 1040 25 Performance Management and Evaluation 1092

26 Standard Costing and Variance Analysis 1136 27 Short-Run Decision Analysis 1184 28 Capital Investment Analysis 1224 APPENDIX A Accounting for investments 1262 APPENDIX B Present Value Tables 1276 CONTENTS Preface xvii About the Authors xxxvii CHAPTER 1 Uses of Accounting Information and the Financial Statements 2 DECISION POINT (cid:2) A USER’S FOCUS KEEP-FIT CENTER 3 Financial Position and the Accounting Equation 17 Accounting as an Information System 4 Business Goals, Activities, and Performance Assets 18 Measures 4 Liabilities 18 Financial and Management Accounting 7 Owner’s Equity 18 Processing Accounting Information 7 Financial Statements 19 Ethical Financial Reporting 8 Income Statement 19 Decision Makers: The Users of Accounting Statement of Owner’s Equity 20 Information 10 The Balance Sheet 20 Management 10 Statement of Cash Flows 21 Users with a Direct Financial Interest 11 Relationships Among the Financial Statements 21 Users with an Indirect Financial Interest 12 Generally Accepted Accounting Principles 24 Governmental and Not-for-Profit Organizations 12 GAAP and the Independent CPA’s Report 25 Accounting Measurement 13 Organizations That Issue Accounting Standards 26 Business Transactions 14 Other Organizations That Influence GAAP 26 Money Measure 14 Professional Conduct 27 Separate Entity 15 Corporate Governance 27 The Forms of Business Organization 15 (cid:2) KEEP-FIT CENTER: REVIEW PROBLEM 28 Characteristics of Corporations, Sole Proprietorships, STOP & REVIEW 31 and Partnerships 15 CHAPTER ASSIGNMENTS 33 CHAPTER 2 Analyzing Business Transactions 48 DECISION POINT (cid:2) A USER’S FOCUS PAWS AND HOOFS Business Transaction Analysis 58 CLINIC 49 Owner’s Investment to Form the Business 58 Measurement Issues 50 Economic Event That Is Not a Business Recognition 50 Transaction 59 Valuation 51 Prepayment of Expenses in Cash 59 Classification 53 Purchase of an Asset on Credit 59 Ethics and Measurement Issues 53 Purchase of an Asset Partly in Cash and Partly on Credit 60 Double-Entry System 54 Payment of a Liability 60 Accounts 54 Revenue in Cash 61 The T Account 54 Revenue on Credit 61 The T Account Illustrated 55 Revenue Collected in Advance 61 Rules of Double-Entry Accounting 55 Collection on Account 62 Normal Balance 56 Expense Paid in Cash 62 Owner’s Equity Accounts 56 v vi Contents Expense to Be Paid Later 63 Recording and Posting Transactions 70 Withdrawals 63 Chart of Accounts 70 Summary of Transactions 65 General Journal 70 The Trial Balance 65 General Ledger 72 Preparation and Use of a Trial Balance 65 Some Notes on Presentation 73 Finding Trial Balance Errors 67 (cid:2) PAWS AND HOOFS CLINIC: REVIEW PROBLEM 75 Cash Flows and the Timing STOP & REVIEW 79 of Transactions 68 CHAPTER ASSIGNMENTS 81 CHAPTER 3 Measuring Business Income 98 DECISION POINT (cid:2) A USER’S FOCUS RELIABLE Type 2 Adjustment: Recognizing Unrecorded, ANSWERING SERVICE 99 Incurred Expenses (Accrued Expenses) 111 Profitability Measurement: Issues and Type 3 Adjustment: Allocating Recorded, Unearned Ethics 100 Revenues (Deferred Revenues) 113 Net Income 100 Type 4 Adjustment: Recognizing Unrecorded, Earned Revenues (Accrued Revenues) 114 Income Measurement Assumptions 101 A Note About Journal Entries 115 Ethics and the Matching Rule 102 Using the Adjusted Trial Balance to Prepare Accrual Accounting 104 Financial Statements 116 Recognizing Revenues 104 Cash Flows from Accrual-Based Recognizing Expenses 105 Information 119 Adjusting the Accounts 105 (cid:2) RELIABLE ANSWERING SERVICE: REVIEW Adjustments and Ethics 106 PROBLEM 121 The Adjustment Process 107 STOP & REVIEW 125 Type 1 Adjustment: Allocating Recorded Costs CHAPTER ASSIGNMENTS 127 (Deferred Expenses) 107 CHAPTER 4 Completing the Accounting Cycle 142 DECISION POINT (cid:2) A USER’S FOCUS WESTWOOD The Accounts After Posting 148 MOVERS 143 The Post-Closing Trial Balance 150 From Transactions to Financial Reversing Entries: An Optional First Statements 144 Step 152 The Accounting Cycle 144 The Work Sheet: An Accountant’s Tool 154 Closing Entries 144 Preparing the Work Sheet 154 Preparing Closing Entries 147

Using the Work Sheet 157 Step 1: Closing the Credit Balances 147 (cid:2) WESTWOOD MOVERS: REVIEW PROBLEM 158 Step 2: Closing the Debit Balances 147 STOP & REVIEW 160 Step 3: Closing the Income Summary Account CHAPTER ASSIGNMENTS 162 Balance 147 Step 4: Closing the Withdrawals Account Balance 147 vii Contents CHAPTER 5 Financial Reporting and Analysis 180 DECISION POINT (cid:2) A USER’S FOCUS FUN-FOR-FEET Classified Balance Sheet 190 COMPANY 181 Assets 190 Foundations of Financial Reporting 182 Liabilities 192 Objective of Financial Reporting 182 Owner’s Equity 193 Qualitative Characteristics of Accounting Dell’s Balance Sheets 194 Information 182 Forms of the Income Statement 196 Accounting Conventions 184 Multistep Income Statement 196 Ethical Financial Reporting 184 Dell’s Income Statements 199 Accounting Conventions for Preparing Single-Step Income Statement 200 Financial Statements 185 Using Classified Financial Statements 201 Consistency 185 Evaluation of Liquidity 201 Full Disclosure (Transparency) 186 Evaluation of Profitability 202 Materiality 187 (cid:2) FUN-FOR-FEET COMPANY: REVIEW PROBLEM 208 Conservatism 187 STOP & REVIEW 210 Cost-Benefit 188 CHAPTER ASSIGNMENTS 212 SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 226 The Components of an Annual Report 226 Financial Statements 228 Letter to the Stockholders 227 Notes to the Financial Statements 233 Financial Highlights 227 Reports of Management’s Responsibilities 234 Description of the Company 227 Reports of Certified Public Accountants 234 Management’s Discussion and Analysis 227 CHAPTER 6 The Operating Cycle and Merchandising Operations 266 DECISION POINT (cid:2) A USER’S FOCUS FONG Perpetual Inventory System 275 COMPANY 267 Purchases of Merchandise 275 Managing Merchandising Businesses 268 Sales of Merchandise 277 Operating Cycle 268 Periodic Inventory System 281 Choice of Inventory System 270 Purchases of Merchandise 282 Foreign Business Transactions 270 Sales of Merchandise 284 Terms of Sale 272 (cid:2) FONG COMPANY: REVIEW PROBLEM 286 Sales and Purchases Discounts 272 STOP & REVIEW 289 Transportation Costs 273 CHAPTER ASSIGNMENTS 290 Terms of Debit and Credit Card Sales 274 SUPPLEMENT TO CHAPTER 6 Special-Purpose Journals 302 Sales Journal 302 Cash Receipts Journal 308 Purchases Journal 306 Cash Payments Journal 311 viii Contents CHAPTER 7 Internal Control 318 DECISION POINT (cid:2) A USER’S FOCUS FISHER’S Internal Control over Merchandising GRILL 319 Transactions 325 Management Issues Related to Internal Internal Control and Management Goals 325 Control 320 Control of Cash 326 The Need for Internal Controls 320 Control of Cash Receipts 326 Management’s Responsibility for Internal Control of Purchases and Cash Disbursements 327 Control 321 Petty Cash Funds 332 Independent Accountant’s Audit of Internal Establishing the Petty Cash Fund 332 Control 322 Making Disbursements from the Petty Cash Internal Control: Components, Activities, Fund 333 and Limitations 322 Reimbursing the Petty Cash Fund 333 Components of Internal Control 322 (cid:2) FISHER’S GRILL: REVIEW PROBLEM 335 Control Activities 323 STOP & REVIEW 337 Limitations of Internal Control 324 CHAPTER ASSIGNMENTS 338 CHAPTER 8 Inventories 350 DECISION POINT (cid:2) A USER’S FOCUS SNUGS First-In, First-Out (FIFO) Method 362 COMPANY 351 Last-In, First-Out (LIFO) Method 363 Managing Inventories 352 Summary of Inventory Costing Methods 364 Inventory Decisions 352 Impact of Inventory Decisions 365 Evaluating the Level of Inventory 353 Effects on the Financial Statements 365 Effects of Inventory Misstatements on Income Effects on Income Taxes 365 Measurement 355 Effects on Cash Flows 367 Inventory Cost and Valuation 358 Inventory Cost Under the Perpetual Goods Flows and Cost Flows 358 Inventory System 367 Lower-of-Cost-or-Market (LCM) Rule 359 Valuing Inventory by Estimation 370 Disclosure of Inventory Methods 360 Retail Method 370 Inventory Cost Under the Periodic Gross Profit Method 371 Inventory System 361 (cid:2) SNUGS COMPANY: REVIEW PROBLEM 373 Specific Identification Method 361 STOP & REVIEW 376 Average-Cost Method 362

CHAPTER ASSIGNMENTS 378 CHAPTER 9 Cash and Receivables 390 DECISION POINT (cid:2) A USER’S FOCUS PENTE COMPUTER Financing Receivables 396 COMPANY 391 Ethics and Estimates in Accounting for Management Issues Related to Cash Receivables 398 and Receivables 392 Cash Equivalents and Cash Control 399 Cash Management 392 Cash Equivalents 399 Accounts Receivable and Credit Policies 393 Fair Value of Cash and Cash Equivalents 399 Evaluating the Level of Accounts Receivable 394 Cash Control Methods 400 ix Contents Bank Reconciliations 401 Duration of a Note 413 Uncollectible Accounts 403 Interest and Interest Rate 413 The Allowance Method 404 Maturity Value 414 Disclosure of Uncollectible Accounts 404 Accrued Interest 414 Estimating Uncollectible Accounts Expense 405 Dishonored Note 414 Writing Off Uncollectible Accounts 409 (cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM 415 Notes Receivable 411 STOP & REVIEW 417 Maturity Date 412 CHAPTER ASSIGNMENTS 419 CHAPTER 10 Current Liabilities and Fair Value Accounting 430 DECISION POINT (cid:2) A USER’S FOCUS MEGGIE’S FITNESS Valuation Approaches to Fair Value CENTER 431 Accounting 448 Management Issues Related to Current Interest and the Time Value of Money 448 Liabilities 432 Calculating Present Value 449 Managing Liquidity and Cash Flows 432 Applications Using Present Value 453 Evaluating Accounts Payable 432 Valuing an Asset 453 Reporting Liabilities 434 Deferred Payment 454 Common Types of Current Liabilities 436 Other Applications 455 Definitely Determinable Liabilities 436 (cid:2) MEGGIE’S FITNESS CENTER: REVIEW PROBLEM 456 Estimated Liabilities 443 STOP & REVIEW 458 Contingent Liabilities and CHAPTER ASSIGNMENTS 460 Commitments 447 CHAPTER 11 Long-Term Assets 472 DECISION POINT (cid:2) A USER’S FOCUS CAMPUS Disposal of Depreciable Assets 490 CLEANERS 473 Discarded Plant Assets 491 Management Issues Related to Long-Term Plant Assets Sold for Cash 491 Assets 474 Exchanges of Plant Assets 493 Acquiring Long-Term Assets 476 Natural Resources 494 Financing Long-Term Assets 477 Depletion 494 Applying the Matching Rule 478 Depreciation of Related Plant Assets 495 Acquisition Cost of Property, Plant, and Development and Exploration Costs in the Oil and Equipment 479 Gas Industry 495 General Approach to Acquisition Costs 480 Intangible Assets 497 Specific Applications 480 Research and Development Costs 500 Depreciation 483 Computer Software Costs 500 Factors in Computing Depreciation 484 Goodwill 500 Methods of Computing Depreciation 484 (cid:2) CAMPUS CLEANERS: REVIEW PROBLEM 502 Special Issues in Depreciation 488 STOP & REVIEW 505 CHAPTER ASSIGNMENTS 507 x Contents CHAPTER 12 Contributed Capital 518 DECISION POINT (cid:2) A USER’S FOCUS GAMMON, INC. 519 Preference as to Assets 532 Management Issues Related to Contributed Convertible Preferred Stock 532 Capital 520 Callable Preferred Stock 533 The Corporate Form of Business 520 Issuance of Common Stock 534 Advantages and Disadvantages of Par Value Stock 535 Incorporation 521 No-Par Stock 536 Equity Financing 522 Issuance of Stock for Noncash Assets 537 Dividend Policies 524 Accounting for Treasury Stock 539 Using Return on Equity to Measure Purchase of Treasury Stock 539 Performance 526 Sale of Treasury Stock 540 Stock Options as Compensation 527 Retirement of Treasury Stock 542 Cash Flow Information 527 (cid:2) GAMMON, INC.: REVIEW PROBLEM 544 Components of Stockholders’ Equity 528 STOP & REVIEW 547 Preferred Stock 531 CHAPTER ASSIGNMENTS 549 Preference as to Dividends 531 CHAPTER 13 Long-Term Liabilities 562 DECISION POINT (cid:2) A USER’S FOCUS WILSON Case 1: Market Rate Above Face Rate 579 MANUFACTURING COMPANY 563 Case 2: Market Rate Below Face Rate 580 Management Issues Related to Issuing Long- Amortization of Bond Discounts Term Debt 564 and Premiums 581 Deciding to Issue Long-Term Debt 564 Amortizing a Bond Discount 581 Evaluating Long-Term Debt 565 Amortizing a Bond Premium 586 Types of Long-Term Debt 566 Retirement of Bonds 590 Cash Flow Information 572 Calling Bonds 590 The Nature of Bonds 573 Converting Bonds 591 Bond Issue: Prices and Interest Rates 573 Other Bonds Payable Issues 592

Characteristics of Bonds 574 Sale of Bonds Between Interest Dates 592 Accounting for the Issuance of Bonds 575 Year-End Accrual of Bond Interest Expense 593 Bonds Issued at Face Value 575 (cid:2) WILSON MANUFACTURING COMPANY: Bonds Issued at a Discount 576 REVIEW PROBLEM 596 Bonds Issued at a Premium 577 STOP & REVIEW 599 Bond Issue Costs 578 CHAPTER ASSIGNMENTS 602 Using Present Value to Value a Bond 579 T he Corporate Income Statement and the Statement CHAPTER 14 of Stockholders’ Equity 614 DECISION POINT (cid:2) A USER’S FOCUS KOWALSKI, Gains and Losses 619 INC. 615 Write-Downs and Restructurings 619 Performance Measurement: Quality of Nonoperating Items 620 Earnings Issues 616 Income Taxes 621 The Effect of Accounting Estimates and Deferred Income Taxes 622 Methods 617 xi Contents Net of Taxes 623 Retained Earnings 629 Earnings per Share 625 Stock Dividends and Stock Splits 630 Basic Earnings per Share 626 Stock Dividends 630 Diluted Earnings per Share 626 Stock Splits 633 Comprehensive Income and the Statement Book Value 635 of Stockholders’ Equity 627 (cid:2) KOWALSKI, INC.: REVIEW PROBLEM 637 Comprehensive Income 627 STOP & REVIEW 640 The Statement of Stockholders’ Equity 629 CHAPTER ASSIGNMENTS 642 CHAPTER 15 The Statement of Cash Flows 656 DECISION POINT (cid:2) A USER’S FOCUS LOPATA Operating Activities 668 CORPORATION 657 Depreciation 670 Overview of the Statement Gains and Losses 671 of Cash Flows 658 Changes in Current Assets 671 Purposes of the Statement of Cash Flows 658 Changes in Current Liabilities 672 Uses of the Statement of Cash Flows 658 Schedule of Cash Flows from Operating Classification of Cash Flows 658 Activities 673 Required Disclosure of Noncash Investing Investing Activities 674 and Financing Transactions 660 Investments 675 Format of the Statement of Cash Flows 660 Plant Assets 675 Ethical Considerations and the Statement Financing Activities 678 of Cash Flows 662 Bonds Payable 678 Analyzing Cash Flows 663 Common Stock 678 Can a Company Have Too Much Cash? 663 Retained Earnings 679 Cash-Generating Efficiency 663 Treasury Stock 681 Asking the Right Questions About the Statement of Cash Flows 665 (cid:2) LOPATA CORPORATION: REVIEW PROBLEM 682 Free Cash Flow 665 STOP & REVIEW 686 CHAPTER ASSIGNMENTS 688 CHAPTER 16 Financial Performance Measurement 706 DECISION POINT (cid:2) A USER’S FOCUS WASHINGTON Trend Analysis 718 INVESTMENTS 707 Vertical Analysis 718 Foundations of Financial Performance Ratio Analysis 721 Measurement 708 Comprehensive Illustration of Ratio Financial Performance Measurement: Management’s Analysis 722 Objectives 708 Evaluating Liquidity 723 Financial Performance Measurement: Evaluating Profitability 723 Creditors’ and Investors’ Objectives 708 Evaluating Long-Term Solvency 726 Standards of Comparison 709 Evaluating the Adequacy of Cash Flows 727 Sources of Information 711 Evaluating Market Strength 729 Executive Compensation 712 (cid:2) WASHINGTON INVESTMENTS: REVIEW PROBLEM 731 Tools and Techniques of Financial Analysis 715 STOP & REVIEW 735 Horizontal Analysis 715 CHAPTER ASSIGNMENTS 737 xii Contents CHAPTER 17 Partnerships 754 DECISION POINT (cid:2) A USER’S FOCUS HOLDER Dissolution of a Partnership 767 AND WILLIAMS PARTNERSHIP 755 Admission of a New Partner 767 Partnership Characteristics 756 Withdrawal of a Partner 770 Characteristics of Partnerships 756 Death of a Partner 772 Advantages and Disadvantages of Partnerships 757 Liquidation of a Partnership 772 Limited Partnerships and Joint Ventures 757 Gain on Sale of Assets 773 Accounting for Partners’ Equity 759 Loss on Sale of Assets 775 Distribution of Partnership Income (cid:2) HOLDER AND WILLIAMS PARTNERSHIP: and Losses 761 REVIEW PROBLEM 778 Stated Ratios 761 STOP & REVIEW 781 Capital Balance Ratios 762 CHAPTER ASSIGNMENTS 783 Salaries, Interest, and Stated Ratios 763 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective 794 DECISION POINT (cid:2) A MANAGER’S FOCUS GOOD Achieving Continuous Improvement 809 FOODS STORE 795 Performance Measures: A Key to Achieving The Role of Management Accounting 796 Organizational Objectives 811

Management Accounting and Financial Accounting: Using Performance Measures in the Management A Comparison 796 Process 811 Management Accounting and the Management The Balanced Scorecard 812 Process 797 Benchmarking 814 Value Chain Analysis 803 Standards of Ethical Conduct 814 Primary Processes and Support Services 803 (cid:2) GOOD FOODS STORE: REVIEW PROBLEM 816 Advantages of Value Chain Analysis 805 STOP & REVIEW 819 Managers and Value Chain Analysis 805 CHAPTER ASSIGNMENTS 821 Continuous Improvement 807 Cookie Company (Continuing Case) 835 Management Tools for Continuous Improvement 807 CHAPTER 19 Cost Concepts and Cost Allocation 836 DECISION POINT (cid:2) A MANAGER’S FOCUS THE CHOICE Statement of Cost of Goods Manufactured 844 CANDY COMPANY 837 Cost of Goods Sold and a Manufacturer’s Income Cost Information 838 Statement 845 Managers’ Use of Cost Information 838 Inventory Accounts in Manufacturing Cost Information and Organizations 838 Organizations 846 Cost Classifications and Their Uses 838 Document Flows and Cost Flows Through the Inventory Accounts 846 Cost Traceability 839 The Manufacturing Cost Flow 847 Cost Behavior 840 Elements of Product Costs 850 Value-Adding Versus Nonvalue-Adding Costs 840 Cost Classifications for Financial Reporting 841 Prime Costs and Conversion Costs 851 Computing Product Unit Cost 852 Financial Statements and the Reporting of Costs 842 Product Cost Measurement Methods 852 Income Statement and Accounting for Computing Service Unit Cost 854 Inventories 842 xiii Contents Cost Allocation 855 (cid:2) THE CHOICE CANDY COMPANY: Allocating the Costs of Overhead 855 REVIEW PROBLEM 861 STOP & REVIEW 863 Allocating Overhead: The Traditional Approach 857 CHAPTER ASSIGNMENTS 866 Allocating Overhead: The ABC Approach 859 Cookie Company (Continuing Case) 880 Costing Systems: Job Order Costing 882 CHAPTER 20 DECISION POINT (cid:2) A MANAGER’S FOCUS AUGUSTA Completed Units 891 CUSTOM GOLF CARTS, INC. 883 Sold Units 891 Product Unit Cost Information and the Reconciliation of Overhead Costs 892 Management Process 884 A Job Order Cost Card and the Computation Planning 884 of Unit Cost 893 Performing 884 A Manufacturer’s Job Order Cost Card and the Evaluating 884 Computation of Unit Cost 893 Communicating 884 Job Order Costing in a Service Organization 894 Product Costing Systems 885 (cid:2) AUGUSTA CUSTOM GOLF CARTS, INC.: Job Order Costing in a Manufacturing REVIEW PROBLEM 897 Company 887 STOP & REVIEW 899 Materials 888 CHAPTER ASSIGNMENTS 901 Labor 890 Cookie Company (Continuing Case) 919 Overhead 890 Costing Systems: Process Costing 920 CHAPTER 21 DECISION POINT (cid:2) A MANAGER’S FOCUS MILK PRODUCTS Accounting for Costs 931 COMPANY 921 Assigning Costs 931 The Process Costing System 922 Process Costing for Two or More Production Patterns of Product Flows and Cost Flow Departments 933 Methods 923 Preparing a Process Cost Report Using the Cost Flows Through the Work in Process Inventory Average Costing Method 935 Accounts 924 Accounting for Units 935 Computing Equivalent Production 925 Accounting for Costs 937 Equivalent Production for Direct Materials 926 Assigning Costs 937 Equivalent Production for Conversion Costs 927 (cid:2) MILK PRODUCTS COMPANY: REVIEW PROBLEM 940 Summary of Equivalent Production 927 STOP & REVIEW 943 Preparing a Process Cost Report Using the CHAPTER ASSIGNMENTS 945 FIFO Costing Method 928 Cookie Company (Continuing Case) 957 Accounting for Units 928 xiv Contents Value-Based Systems: ABM and Lean 958 CHAPTER 22 DECISION POINT (cid:2) A MANAGER’S FOCUS BEAN BAG The New Operating Environment and Lean CONVERTIBLES, INC. 959 Operations 968 Value-Based Systems and Management 960 Just-in-Time (JIT) 968 Value Chains and Supply Chains 961 Continuous Improvement of the Work Process Value Analysis 962 Environment 970 Value-Adding and Non-Value-Adding Accounting for Product Costs in a JIT Operating Activities 963 Environment 970 Value-Based Systems 963 Backflush Costing 972 Activity-Based Management 963 Comparison of ABM and Lean 976 Managing Lean Operations 964 (cid:2) BEAN BAG CONVERTIBLES, INC.: REVIEW PROBLEM 977

Activity-Based Costing 964 STOP & REVIEW 980 The Cost Hierarchy and the Bill of CHAPTER ASSIGNMENTS 982 Activities 965 Cookie Company (Continuing Case) 997 Cost Behavior Analysis 998 CHAPTER 23 DECISION POINT (cid:2) A MANAGER’S FOCUS MY MEDIA Cost-Volume-Profit Analysis 1010 PLACE 999 Breakeven Analysis 1012 Cost Behavior and Management 1000 Using an Equation to Determine the Breakeven The Behavior of Costs 1001 Point 1013 Mixed Costs and the Contribution Margin The Breakeven Point for Multiple Products 1014 Income Statement 1006 Using C-V-P Analysis to Plan Future Sales, The Engineering Method 1006 Costs, and Profits 1017 The Scatter Diagram Method 1006 Applying C-V-P to Target Profits 1017 The High-Low Method 1007 (cid:2) MY MEDIA PLACE: REVIEW PROBLEM 1020 Statistical Methods 1009 STOP & REVIEW 1023 Contribution Margin Income Statements 1009 CHAPTER ASSIGNMENTS 1025 Cookie Company (Continuing Case) 1038 The Budgeting Process 1040 CHAPTER 24 DECISION POINT (cid:2) A MANAGER’S FOCUS FRAMECRAFT The Overhead Budget 1053 COMPANY 1041 The Selling and Administrative Expense The Budgeting Process 1042 Budget 1054 Advantages of Budgeting 1042 The Cost of Goods Manufactured Budget 1055 Budgeting and Goals 1043 Financial Budgets 1057 Budgeting Basics 1043 The Budgeted Income Statement 1057 The Master Budget 1045 The Capital Expenditures Budget 1058 Preparation of a Master Budget 1045 The Cash Budget 1058 Budget Procedures 1048 The Budgeted Balance Sheet 1061 Operating Budgets 1049 (cid:2) FRAMECRAFT COMPANY: REVIEW PROBLEM 1063 The Sales Budget 1049 STOP & REVIEW 1066 The Production Budget 1050 CHAPTER ASSIGNMENTS 1068 The Direct Materials Purchases Budget 1051 Cookie Company (Continuing Case) 1091 The Direct Labor Budget 1053 xv Contents Performance Management and Evaluation 1092 CHAPTER 25 DECISION POINT (cid:2) A MANAGER’S FOCUS WINTER Performance Evaluation of Investment WONDERLAND RESORT 1093 Centers 1105 Performance Measurement 1094 Return on Investment 1105 What to Measure, How to Measure 1094 Residual Income 1107 Other Measurement Issues 1094 Economic Value Added 1108 Organizational Goals and the Balanced The Importance of Multiple Performance Scorecard 1095 Measures 1110 The Balanced Scorecard and Management 1095 Performance Incentives and Goals 1111 Responsibility Accounting 1097 Linking Goals, Performance Objectives, Measures, Types of Responsibility Centers 1098 and Performance Targets 1111 Organizational Structure and Performance Performance-Based Pay 1112 Management 1100 The Coordination of Goals 1112 Performance Evaluation of Cost Centers and (cid:2) WINTER WONDERLAND RESORT: Profit Centers 1102 REVIEW PROBLEM 1115 Evaluating Cost Center Performance Using Flexible STOP & REVIEW 1118 Budgeting 1102 CHAPTER ASSIGNMENTS 1120 Evaluating Profit Center Performance Using Cookie Company (Continuing Case) 1135 Variable Costing 1103 Standard Costing and Variance Analysis 1136 CHAPTER 26 DECISION POINT (cid:2) A MANAGER’S FOCUS ICU, INC. 1137 Computing and Analyzing Direct Labor Standard Costing 1138 Variances 1150 Standard Costs and Managers 1138 Computing Direct Labor Variances 1150 Computing Standard Costs 1139 Analyzing and Correcting Direct Labor Variances 1152 Standard Direct Materials Cost 1139 Computing and Analyzing Overhead Standard Direct Labor Cost 1139 Variances 1154 Standard Overhead Cost 1140 Using a Flexible Budget to Analyze Overhead Total Standard Unit Cost 1141 Variances 1154 Variance Analysis 1142 Computing Overhead Variances 1154 The Role of Flexible Budgets in Variance Analyzing and Correcting Overhead Variances 1159 Analysis 1142 Using Cost Variances to Evaluate Managers’ Using Variance Analysis to Control Costs 1145 Performance 1161 Computing and Analyzing Direct Materials (cid:2) ICU, INC.: REVIEW PROBLEM 1163 Variances 1147 STOP & REVIEW 1168 Computing Direct Materials Variances 1147 CHAPTER ASSIGNMENTS 1170 Analyzing and Correcting Direct Materials Cookie Company (Continuing Case) 1183 Variances 1149 Short-Run Decision Analysis 1184 CHAPTER 27 DECISION POINT (cid:2) A MANAGER’S FOCUS HOME STATE Incremental Analysis for Short-Run Decisions 1186

BANK 1185 Incremental Analysis for Outsourcing Short-Run Decision Analysis and the Decisions 1189 Management Process 1186 xvi Contents Incremental Analysis for Special Order Incremental Analysis for Sell or Process- Decisions 1191 Further Decisions 1199 Incremental Analysis for Segment (cid:2) HOME STATE BANK: REVIEW PROBLEM 1202 Profitability Decisions 1194 STOP & REVIEW 1205 Incremental Analysis for Sales Mix CHAPTER ASSIGNMENTS 1207 Decisions 1196 Cookie Company (Continuing Case) 1223 Capital Investment Analysis 1224 CHAPTER 28 DECISION POINT (cid:2) A MANAGER’S FOCUS The Time Value of Money 1234 NEIGHBORHOOD COMMUNICATIONS 1225 Interest 1234 The Capital Investment Process 1226 Present Value 1235 Capital Investment Analysis 1226 Present Value of a Single Sum Due in the Capital Investment Analysis in the Management Future 1236 Process 1227 Present Value of an Ordinary Annuity 1236 The Minimum Rate of Return on Investment 1229 The Net Present Value Method 1238 Cost of Capital 1229 Advantages of the Net Present Value Method 1238 Other Measures for Determining Minimum Rate of The Net Present Value Method Illustrated 1238 Return 1230 Other Methods of Capital Investment Ranking Capital Investment Proposals 1230 Analysis 1241 Measures Used in Capital Investment The Payback Period Method 1241 Analysis 1231 The Accounting Rate-of-Return Method 1242 Expected Benefits from a Capital Investment 1231 (cid:2) NEIGHBORHOOD COMMUNICATIONS: Equal Versus Unequal Cash Flows 1232 REVIEW PROBLEM 1244 Carrying Value of Assets 1232 STOP & REVIEW 1246 Depreciation Expense and Income Taxes 1232 CHAPTER ASSIGNMENTS 1248 Disposal or Residual Values 1233 Cookie Company (Continuing Case) 1260 APPENDIX A Accounting for Investments 1262 Management Issues Related to Investments 1262 Trading Securities 1264 Available-for-Sale Securities 1267 Long-Term Investments in Equity Securities 1267 Investments in Debt Securities 1271 Long-Term Investments in Bonds 1272 STOP & REVIEW 1273 APPENDIX B Present Value Tables 1276 Endnotes 1280 Company Index 1284 Subject Index 1285 PREFACE Accounting This revision of Principles of Accounting is based on an understanding of the in Motion! nature, culture, and motivations of today’s undergraduate students and on exten- sive feedback from many instructors who use our book. These substantial changes meet the needs of these students, who not only face a business world increasingly complicated by ethical issues, globalization, and technology but who also have more demands on their time. To assist them to meet these challenges, the authors carefully show them how the effects of business transactions, which are the result of business decisions, are recorded in a way that will be reflected on the finan- cial statements. Instructors will find that building on the text’s historically strong pedagogy, the authors have strengthened transaction analysis and its link to the accounting cycle. Updated Content, Strengthened Transaction Analysis Organization Maintaining a solid foundation in double-entry accounting, we increased the and Pedagogy number of in-text journal entries and have used T accounts linked to these journal-entry illustrations throughout the financial accounting chapters. In Chapter 2, “Analyzing Business Transactions,” for example, we clarified the rela- tionship of transaction analysis to the accounting cycle. In Chapter 6, “The Oper- ating Cycle and Merchandising Accounting,” we include transaction illustrations for all transactions mentioned in the chapter. At the same time, we reduced exces- sive detail, shortened headings, simplified explanations, and increased readability in an effort to reduce the length of each chapter. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH WAGES EXPENSE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 26 4,800 10 2,800 6 13,320 19 1,400 9 2,600 22 5,000 26 4,800 Entry in Journal Form: Dr. Cr. July 26 Wages Expense 4,800 Cash 4,800 Content and Organization: Partnerships, Special-Purpose Journals, and Investments Based on user input, Chapter 17 introduces a new topic of partnerships to the

text. To make room for this, the investments chapter is now located in Appendix A with ample assignment material to provide greater flexibility of coverage. xvii xviii Preface Also based on user desires, we have inserted a supplement on special-purpose journals with assignment material after Chapter 6. Strong Pedagogical System Principles of Accounting originated the pedagogical system of Integrated Learn- ing Objectives. The system supports both learning and teaching by providing flexibility in support of the instructor’s teaching of first-year accounting. The chapter review and all assignments identify the applicable learning objective(s) for easy reference. Each learning objective refers to a specific content area, usually either con- ceptual content or procedural techniques, in short and easily understandable seg- ments. Each segment is followed by a “Stop and Apply” section that illustrates and solves a short exercise related to the learning objective. STOP & APPLY Match the letter of each item below with the numbers of the related items: a. An inventory cost ____ 3. Application of the LCM rule b. An assumption used in the valuation of ____ 4. Goods flow inventory ____ 5. Transportation charge for mer- c. Full disclosure convention chandise shipped FOB shipping d. Conservatism convention point e. Consistency convention ____ 6. Cost flow f. Not an inventory cost or assumed flow ____ 7. Choosing a method and sticking with it ____ 1. Cost of consigned goods ____ 8. Transportation charge for mer- ____ 2. A note to the financial statements chandise shipped FOB destination explaining inventory policies SOLUTION 1. f; 2. c; 3. d; 4. b; 5. a; 6. f; 7. e; 8. f To make the text more visually appealing and readable, it is divided into student-friendly sections with brief bulleted lists, new art, photographs, and end- of-section review material. Cash Flows To avoid financial distress, a company must be able to pay its bills on time. Because and the Timing the timing of cash flows is critical to maintaining adequate liquidity to pay bills, managers and other users of financial information must understand the difference of Transactions between transactions that generate immediate cash and those that do not. Con- sider the transactions of Miller Design Studio shown in Figure 2-3. Most of them LO5 Show how the timing involve either an inflow or outflow of cash. of transactions affects cash As you can see in Figure 2-3, Miller’s Cash account has more transactions flows and liquidity. than any of its other accounts. Look at the transactions of July 10, 15, and 22: (cid:2) July 10: Miller received a cash payment of $2,800. (cid:2) July 15: The firm billed a customer $9,600 for a service it had already per- formed. (cid:2) July 22: The firm received a partial payment of $5,000 from the customer, but it had not received the remaining $4,600 by the end of the month. Because Miller incurred expenses in providing this service, it must pay careful attention to its cash flows and liquidity. One way Miller can manage its expenditures is to rely on its creditors to give it time to pay. Compare the transactions of July 3, 5, and 9 in Figure 2-3. xix Preface Further, to reduce distractions, the margins of the text include only Study Study Note Notes, which alert students to common misunderstandings of concepts and tech- niques; key ratio and cash flow icons, which highlight discussions of profitability After Step 1 has been completed, and liquidity; and accounting equations. Icons and equations appear in the finan- the Income Summary account cial chapters (Chapters 1–17). reflects the account balance of the Design Revenue account before it was closed. Enhanced Real- IFRS, Fair Value, and Other Updates World Examples International Financial Reporting Standards and fair value have been integrated Demonstrate throughout the book where accounting standards have changed and also in the Business Focus features where applicable. All current events, statistics, and tables Accounting have been updated with the latest data. in Motion FOCUS ON BUSINESS PRACTICE

IFRS: The Arrival of International Financial Reporting Standards in the United States Over the next few years, international financial and Exchange Commission (SEC) recently voted to reporting standards (IFRS) will become much more allow foreign registrants in the United States. This important in the United States and globally. The is a major development because in the past, the International Accounting Standards Board (IASB) SEC required foreign registrants to explain how the has been working with the Financial Accounting standards used in their statements differed from Standards Board (FASB) and similar boards in other U.S. standards. This change affects approximately 10 nations to achieve identical or nearly identical stan- percent of all public U.S. companies. In addition, the dards worldwide. IFRS are now required in many SEC may in the near future allow U.S. companies to parts of the world, including Europe. The Securities- use IFRS.11 Use of Small, Diverse Companies Each chapter begins with a Decision Point, a real-world scenario about a small company that challenges students to see the connection between accounting information and management decisions. DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How can Pente Computer PENTE COMPUTER COMPANY Company manage its cash needs? (cid:2) How can the company Pente Computer Company sells computer products for cash reduce the level of or on credit. The company’s peak sales occur in August and uncollectible accounts and September, when students are shopping for computers increase the likelihood that and computer-related supplies, and during the pre-holiday accounts receivable will be season in November and D ecember. It is now January, and paid on time? Andre Pente, the company’s owner, has been reviewing the (cid:2) How can the company company’s performance over the past two years. He has evaluate the effectiveness determined that in those years, approximately 1.5 p ercent of its credit policies and of net sales have been uncollectible, and he is concerned the level of its accounts receivable? that this year, the company may not have enough cash to cover operations before sales begin to increase again in late summer. In this chapter, we discuss concepts and tech- niques that would help Pente manage his cash and accounts receivable so that the company maintains its liquidity. xx Preface These company examples come full circle at the end of the chapter by linking directly to the Review Problem. Smaller, diverse company examples illustrate accounting concepts and encourage students to apply what they have learned. (cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM In this chapter’s Decision Point, we posed the following questions: • How can Pente Computer Company manage its cash needs? • How can the company reduce the level of uncollectible accounts and increase the likelihood that accounts receivable will be paid on time? • How can the company evaluate the effectiveness of its credit policies and the level of its accounts receivable? During the months when sales are at their peak, Pente Computer Company may have excess cash available that it can invest in a way that earns a return but still permits ready access to cash. At other times, it may have to arrange for short-term borrowing. To ensure that it can borrow funds when it needs to, the company must maintain good relations with its bank. Use of Well-Known Public Companies This textbook also offers examples from highly recognizable public companies, such as CVS Caremark, Southwest Airlines, Dell Computer, and Netflix, to relate basic accounting concepts and techniques to the real world. Chapter 5, “Finan- cial Reporting and Analysis,” helps students interpret financial information. The latest available data is used in exhibits to incorporate the most recent FASB pronouncements. The authors illustrate current practices in financial reporting by referring to data from Accounting Trends and Techniques (AICPA) and integrate international topics wherever appropriate. Consolidated means that data from all CVS Caremark Corporation CVS’s fiscal year ends on the Saturday

companies owned by CVS are combined. Consolidated Statements of Operations closest to December 31. Fiscal Year Ended Dec. 31, 2008 Dec. 29, 2007 Dec. 30, 2006 (In millions, except per share amounts) (52 weeks) (52 weeks) (53 weeks) Net revenues $87,471.9 $76,329.5 $43,821.4 Cost of revenues 69,181.5 60,221.8 32,079.2 Gross profit 18,290.4 16,107.7 11,742.2 Total operating expenses 12,244.2 11,314.4 9,300.6 Operating profit1 6,046.2 4,793.3 2,441.6 Interest expense, net2 509.5 434.6 215.8 Earnings before income tax provision 5,536.7 4,358.7 2,225.8 Loss from discontinued operations, (132) — — net of income tax benefit of $82.4 Income tax provision 2,192.6 1,721.7 856.9v Net earnings3 3,212.1 2,637.0 1,368.9 Preference dividends, net of income tax benefit4 14.1 14.2 13.9 Net earnings available to common shareholders $ 3,198.0 $ 2,622.8 $ 1,355.0 BASIC EARNINGS PER COMMON SHARE:5 Net earnings $ 2.23 $ 1.97 $ 1.65 Weighted average common shares outstanding 1,433.5 1,328.2 820.6 DILUTED EARNINGS PER COMMON SHARE: Net earnings $ 2.18 $ 1.92 $ 1.60 Weighted average common shares outstanding 1,469.1 1,371.8 853.2 xxi Preface Revised and Expanded Assignments Assignments have been carefully scrutinized for direct relevancy to the learning objectives in the chapters. Names and numbers for all Short Exercises, Exercises, and Problems have been changed except those used on videos. We have reversed the alternate and main problems from the previous edition. Most importantly, alternative problems have been expanded so that there are ample problems for any course. All of the cases have been updated as appropriate and the number of cases in each chapter has been reduced in response to user preferences. The variety of cases in each chapter depends on their relevance to the chapter topics, but throughout the text there are cases involving conceptual understanding, ethical dilemmas, interpreting financial reports, group activities, business communication, and the Internet. Annual report cases based on CVS Caremark and Southwest Airlines can be found at the end of the chapter. Specific Chapter Changes The following chapter-specific changes have been made in this edition of Principles of Accounting: Chapter 1: Uses of Accounting Information and the Financial Statements • Discussion of performance measures revised using CVS and General Motors as examples of how these measures relate to profitability and liquidity • Discussion of the statement of cash flows revised to relate the statement to business activities and goals • Updated and enhanced coverage of the roles of the Financial Account- ing Standards Board (FASB) and the International Accounting Standards Board (IASB) • New Focus on Business Practice box on SEC’s decision to let foreign com- panies registered in the United States use international financial reporting standards (IFRS) • New study note on the role of the Public Company Accounting Oversight Board (PCAOB) Chapter 2: Analyzing Business Transactions • Learning Objective (LO) 3 revised to clarify and emphasize the role of T accounts, journal form, and their relationship to the general ledger • New example of recognition violation • Section on valuation revised to address fair value and IFRS • New Focus on Business Practice box on fair value accounting in an interna- tional marketplace • Cash flow discussion edited for clearer delineation of the sequence of transactions Chapter 3: Measuring Business Income • New example of earnings management focusing on Dell Computer • New Focus on Business Practice box describing the FASB’s rules for revenue recognition and the one broad principle (IFRS) that the IASB uses Chapter 4: Completing the Accounting Cycle • In-text examples focusing on Miller Design Studio simplified by using fewer accounts, thus clarifying the process of preparing closing entries and the worksheet xxii Preface Chapter 5: Financial Reporting and Analysis • Section on the objective of financial reporting revised to reflect FASB’s empha- sis on the needs of capital providers and other users of financial reports

• Coverage of qualitative characteristics simplified and shortened • New Focus on Business Practice box on convergence of U.S. GAAP and IFRS and their effect on accounting standards • New Focus on Business Practice box on how convergence of U.S. GAAP and IFRS can make financial analysis more difficult • New Focus on Business Practice box on the use of ratios (performance mea- sures) in executive compensation Chapter 6: The Operating Cycle and Merchandising Transactions • Discussion of the operating cycle revised for greater clarity • T accounts and journal entries used to illustrate accounting for merchandis- ing transactions under both the perpetual and periodic inventory systems • Updated Focus on Business Practice box on the increased use of credit and debit cards • Clearer differentiation between the cost of goods available for sale and the cost of goods sold in LO4 • New supplement on Special-Purpose Journals Chapter 7: Internal Control • New Focus on Business Practice box on the effectiveness of the Sarbanes- Oxley Act in preventing fraud • New Focus on Business Practice box on methods of preventing shoplifting • Material reformatted to clarify discussion of documents used in an internal control plan for purchases and cash disbursements Chapter 8: Inventories • Discussion of disclosure of inventory methods shortened for greater clarity • New Focus on Business Practice box on the lower-of-cost-or-market rule • New Focus on Business Practice box on the use of LIFO inside and outside the United States • New Focus on Business Practice box on how IFRS and U.S. standards define fair value Chapter 9: Cash and Receivables • Concept of fair value introduced at various points throughout the chapter • Revised Focus on Business Practice box on estimating cash collections • New coverage of subprime loans Chapter 10: Current Liabilities and Fair Value Accounting • Chapter revised to include coverage of fair value accounting • Discussion and assignments related to future value deleted to emphasize pres- ent value and fair value, which are more directly related to this course • New study note on the disclosure of the fair value of short-term debt Chapter 11: Long-Term Assets • Coverage of tax laws revised to address the Economic Stimulus Act of 2008 • Coverage of intangible assets revised to reflect current standards • Revised Focus on Business Practice box on customer lists xxiii Preface Chapter 12: Contributed Capital • Revised Focus on Business Practice box on politics and accounting for stock options • Section on cash flow information added to LO1 • Updated Focus on Business Practice box on share buybacks Chapter 13: Long-Term Liabilities • Bonds interest rates changed so that they are more realistic and less compli- cated than in previous edition • Updated discussion of accounting for defined pension plans • New Focus on Business Practice box on post-retirement liabilities • Section on cash flow information added to LO1 Chapter 14: The Corporate Income Statement and the Statement of Stock- holders’ Equity • Nonoperating items, which were covered in LO3 in previous edition, now discussed in LO1 • New Focus on Business Practice box on looking beyond the bottom line • Revised Focus on Business Practice box on pro-forma earnings Chapter 15: The Statement of Cash Flows • Clarification of required disclosure of noncash investing and financing activi- ties in LO1 • Sections on the risks of having too much cash and on interpreting the state- ment of cash flows added to LO2 • New Focus on Business Practice box on the IASB’s support of the direct method Chapter 16: Financial Performance Measurement • Updated Focus on Business Practice box on pro-forma earnings • Revised Focus on Business Practice box on performance measurement Chapter 17: Partnerships • New chapter added in response to users’ requests Chapter 18: The Changing Business Environment: A Manager’s Perspective • Updated definition of management accounting • Lean production introduced as a key term • Sections on total quality management and activity based management revised

• Updated Focus on Business Practice box on how to blow the whistle on fraud Chapter 19: Cost Concepts and Cost Allocation • Discussions of costs in LO2 in previous edition incorporated in LO1 • Section on document and cost flows through the inventory accounts in new LO3 revised • Introduction to methods of product cost measurement added and section on computing service unit cost shortened in new LO4 • LO7 and LO8 streamlined and incorporated in new LO5 Chapter 20: Costing Systems: Job Order Costing • Chapter 20 in previous edition separated into two chapters, with new C hapter 20 focusing on job order costing and new Chapter 21 focusing on process costing • Operations costing system introduced as a key concept xxiv Preface • Discussions of manufacturer’s job order cost card, computation of unit cost, and job order costing in a service organization included in new LO4 • New Focus on Business Practice box on the use of project costing Chapter 21: Costing Systems: Process Costing • New chapter (part of Chapter 20 in previous edition) Chapter 22: Value-Based Systems: ABM and Lean • LO1 and LO2 in last edition combined and revised • Section on process value analysis included in LO1 • New listing of ABC’s disadvantages in LO2 • New focus on lean operations in LO3 Chapter 23: Cost Behavior Analysis • LO1 and LO2 in last edition combined and revised • Discussions of variable, fixed, and mixed costs and discussions of step costs and linear relationships included in LO1 • Discussion of contribution margin income statement included in LO2 • LO5 revised to clarify concepts Chapter 24: The Budgeting Process • Section on advantages of budgeting and three key terms—static budget, con- tinuous budget, and zero-based budgeting—added to revised LO1 Chapter 25: Performance Management and Evaluation • LO1 and LO2 in last edition combined and revised Chapter 26: Standard Costing and Variance Analysis • LO1 and LO2 in last edition combined and revised Chapter 27: Short-Run Decision Analysis • Chapter revised to focus on short-run decisions and incremental analysis; cap- ital investment analysis and time value of money now covered in Chapter 28 Chapter 28: Capital Investment Analysis • New chapter Online Solutions South-Western, a division of Cengage Learning, offers a vast array of online solu- for Every Learning tions to suit your course and your students’ learning styles. Choose the product that best meets your classroom needs and course goals. Please check with your Style sales representative for more details and ordering information. CengageNOW™ CengageNOW for Needles/Powers Principles of Accounting, 11e is a powerful and fully integrated online teaching and learning system that provides you with flexibility and control. This complete digital solution offers a comprehensive set of digital tools to power your course. CengageNOW offers the following: (cid:2) Homework, including algorithmic variations (cid:2) Integrated e-book (cid:2) Personalized study plans, which include a variety of multimedia assets (from exercise demonstrations to videos to iPod content) for students as they m aster the chapter materials xxv Preface (cid:2) Assessment options, including the full test bank and algorithmic variations (cid:2) Reporting capability based on AACSB, AICPA, and IMA competencies and standards (cid:2) Course Management tools, including grade book (cid:2) WebCT and Blackboard Integration Visit www.cengage.com/tlc for more information. ® WebTutor™ on Blackboard and WebCT™ WebTutor™ is available packaged with Needles/Powers Principles of Accounting, 11e or for individual student purchase. Jump-start your course and customize rich, text-specific content with your Course Management System. (cid:2) Jump-start: Simply load a WebTutor cartridge into your Course Manage- ment System. (cid:2) Customize content: Easily blend, add, edit, reorganize, or delete content. Content includes media assets, quizzing, test bank, web links, discussion top- ics, interactive games and exercises, and more. Visit www.cengage.com/webtutor for more information.

Teaching Tools (cid:2) Instructor’s Resource CD-ROM: Included on this CD set are the key sup- for Instructors plements designed to aid instructors, including the Solutions Manual, Exam- View Test Bank, Word Test Bank, and Lecture PowerPoint slides. (cid:2) Solutions Manual: The Solutions Manual contains answers to all exercises, problems, and activities that appear in the text. As always, the solutions are author-written and verified multiple times for numerical accuracy and consis- tency with the core text. (cid:2) ExamView® Pro Testing Software: This intuitive software allows you to easily customize exams, practice tests, and tutorials and deliver them over a network, on the Internet, or in printed form. In addition, ExamView comes with searching capabilities that make sorting the wealth of questions from the printed test bank easy. The software and files are found on the IRCD. (cid:2) Lecture PowerPoint® Slides: Instructors will have access to PowerPoint slides online and on the IRCD. These slides are conveniently designed around learning objectives for partial chapter teaching and include art for dynamic presentations. There are also lecture outline slides for each chapter for those instructors who prefer them. (cid:2) Instructor’s Companion Website: The instructor website contains a vari- ety of resources for instructors, including the Instructor’s Resource Manual (which has chapter planning matrices, chapter resource materials and outlines, chapter reviews, difficulty and time charts, etc.), and PowerPoint slides. www. cengage.com/accounting/needles (cid:2) Klooster & Allen’s General Ledger Software: Prepared by Dale Klooster and Warren Allen, this best-selling, educational, general ledger package introduces students to the world of computerized accounting through a more intuitive, user-friendly system than the commercial software they will use in the future. In addition, students have access to general ledger files xxvi Preface with information based on problems from the textbook and practice sets. This context allows them to see the difference between manual and com- puterized accounting systems firsthand. Also, the program is enhanced with a problem checker that enables students to determine if their entries are correct. Klooster & Allen emulates commercial general ledger pack- ages more closely than other educational packages. Problems that can be used with Klooster/Allen are highlighted by an icon. The Inspector Files found on the IRCD allow instructors to grade students’ work. A free Net- work Version is available to schools whose students purchase Klooster/ Allen’s General Ledger Software. Learning CengageNOW™ Resources for CengageNOW for Needles/Powers Principles of Accounting, 11e is a powerful Students and fully integrated online teaching and learning system that provides you with flexibility and control. This complete digital solution offers a comprehensive set of digital tools to power your course. CengageNOW offers the following: (cid:2) Homework, including algorithmic variations (cid:2) Integrated e-book (cid:2) Personalized study plans, which include a variety of multimedia assets (from exercise demonstrations to videos to iPod content) for students as they master the chapter materials (cid:2) Assessment options, including the full test bank and algorithmic variations (cid:2) Reporting capability based on AACSB, AICPA, and IMA competencies and standards (cid:2) Course Management tools, including grade book (cid:2) WebCT and Blackboard Integration Visit www.cengage.com/tlc for more information. WebTutor™ on Blackboard® and WebCT™ (cid:2) WebTutor™ is available packaged with Needles/Powers Principles of Account- ing, 11e or for individual student purchase. Jump-start your course and cus- tomize rich, text-specific content with your Course Management System. (cid:2) Jump-start: Simply load a WebTutor cartridge into your Course Manage- ment System. (cid:2) Customize content: Easily blend, add, edit, reorganize, or delete content. Content includes media assets, quizzing, test bank, web links, discussion top-

ics, interactive games and exercises, and more. Visit www..cengage.com/webtutor for more information. Klooster & Allen’s General Ledger Software: This best-selling, educational, general ledger software package introduces you to the world of computerized accounting through a more intuitive, user-friendly system than the commercial software you’ll use in the future. Also, the program is enhanced with a problem checker that provides feedback on selected activities and emulates commercial general ledger packages more closely than other educational packages. Problems that can be used with Klooster/Allen are highlighted by an icon. xxvii Preface Working Papers (Printed): A set of preformatted pages allow students to more easily work end-of-chapter problems and journal entries. Student CD-ROM for Peachtree®: You will have access to Peachtree so you can familiarize yourself with computerized accounting systems used in the real world. You will gain experience from working with actual software, which will make you more desirable as a potential employee. Electronic Working Papers in Excel® Passkey Access (for sale online): Students can now work end-of-chapter assignments electronically in Excel with easy-to follow, preformatted worksheets. This option is available via an online download with a passkey. Companion Website: The student website contains a variety of educational resources for students, including online quizzing, the Glossary, Flashcards, and Learning Objectives. www.cengage.com/accounting/needles Acknowledgements A successful textbook is a collaborative effort. We are grateful to the many pro- fessors, other professional colleagues, and students who have taught and studied from our book, and we thank all of them for their constructive comments. In the space available, we cannot possibly mention everyone who has been helpful, but we do want to recognize those who made special contributions to our efforts in preparing the eleventh edition of Principles of Accounting. We wish to express deep appreciation to colleagues at DePaul University, who have been extremely supportive and encouraging. Very important to the quality of this book are our proofreaders, Margaret Kearney and Cathy Larson, to whom we give special thanks. We also appreci- ate the support of our Supervising Development Editor, Katie Yanos; Execu- tive Editor, Sharon Oblinger; Senior Marketing Manager, Kristen Hurd; and Content Project Manager, Darrell Frye. Others who have had a major impact on this book through their reviews, suggestions, and participation in surveys, interviews, and focus groups are listed below. We cannot begin to say how grateful we are for the feedback from the many instructors who have generously shared their responses and teaching experi- ences with us. Daneen Adams, Santa Fe College Sidney Askew, Borough of Manhattan Community College Nancy Atwater, College of St. Scholastica Algis Backaitis, Wayne County Community College Abdul Baten, Northern Virginia Community College Robert Beebe, Morrisville State College Teri Bernstein, Santa Monica College Martin Bertisch, York College Tes Bireda, Hillsborough Community College James Bryant, Catonsville Community College Earl Butler, Broward Community College Lloyd Carroll, Borough of Manhattan Community College Stanley Carroll, New York City College of Technology Roy Carson, Anne Arundel Community College Janet Caruso, Nassau Community College Sandra Cereola, Winthrop University James J. Chimenti, Jamestown Community College xxviii Preface Carolyn Christesen, SUNY Westchester Community College Stan Chu, Borough of Manhattan Community College Jay Cohen, Oakton Community College Sandra Cohen, Columbia College Scott Collins, The Pennsylvania State University Joan Cook, Milwaukee Area Tech College—Downtown Barry Cooper, Borough of Manhattan Community College Michael Cornick, Winthrop University Robert Davis, Canisius College Ron Deaton, Grays Harbor College Jim Delisa, Highline Community College Tim Dempsey, DeVry College of Technology Vern Disney, University of South Carolina Sumter

Eileen Eichler, Farmingdale State College Mary Ewanechko, Monroe Community College Cliff Frederickson, Grays Harbor College John Gabelman, Columbus State Community College Lucille Genduso, Kaplan University Nashwa George, Berkeley Rom Gilbert, Santa Fe College Janet Grange, Chicago State University Tom Grant, Kutztown Tim Griffin, Hillsborough Community College—Ybor City Campus Sara Harris, Arapahoe Community College Lori Hatchell, Aims Community College Roger Hehman, Raymond Walters College/University of Cincinnati Sueann Hely, West Kentucky Community & Technical College Many Hernandez, Borough of Manhattan Community College Michele Hill, Schoolcraft College Cindy Hinz, Jamestown Community College Jackie Holloway, National Park Community College Phillip Imel, Southwest Virginia Community College Jeff Jackson, San Jacinto College Irene Joanette-Gallio, Western Nevada Community College Vicki Jobst, Benedictine University Doug Johnson, Southwest Community College Jeff Kahn, Woodbury University John Karayan, Woodbury University Miriam Keller-Perkins, University of California-Berkeley Randy Kidd, Longview Community College David Knight, Borough of Manhattan Community College Emil Koren, Saint Leo University Bill Lasher, Jamestown Business College Jennifer LeSure, Ivy Tech State College Archish Maharaja, Point Park University Harvey Man, Borough of Manhattan Community College Robert Maxwell, College Of The Canyons Stuart McCrary, Northwestern University Noel McKeon, Florida Community College—Jacksonville Terri Meta, Seminole Community College Roger Moore, Arkansas State University—Beebe Carol Murphy, Quinsigamond Community College Carl Muzio, Saint John’s University Mary Beth Nelson, North Shore Community College xxix Preface Andreas Nicolaou, Bowling Green State University Patricia Diane Nipper, Southside Virginia Community College Tim Nygaard, Madisonville Community College Susan L. Pallas, Southeast Community College Clarence Perkins, Bronx Community College Janet Pitera, Broome Community College Eric Platt, Saint John’s University Shirley Powell, Arkansas State University—Beebe LaVonda Ramey, Schoolcraft College Michelle Randall, Schoolcraft College Eric Rothenburg, Kingsborough Community College Rosemarie Ruiz, York College—CUNY Michael Schaefer, Blinn College Sarah Shepard, West Hills College Coalinga Linda Sherman, Walla Walla Community College Deborah Stephenson, Winston-Salem State University Ira Stolzenberg, SUNY—Old Westbury David Swarts, Clinton Community College Linda Tarrago, Hillsborough Community College—Main Campus Thomas Thompson, Savannah Technical College Peter Vander Weyst, Edmonds Community College Lynnwood Dale Walker, Arkansas State University—Beebe Doris Warmflash, Westchester Community College Wanda Watson, San Jacinto College—Central Andy Williams, Edmonds Community College—Lynnwood Josh Wolfson, Borough of Manhattan Community College Paul Woodward, Santa Fe College Allen Wright, Hillsborough Community College—Main Campus Jian Zhou, SUNY at Binghamton This page intentionally left blank ABOUT THE AUTHORS Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A. DePaul University Belverd Needles is an internationally recognized expert in accounting education. He has published in leading journals and is the author or editor of more than 20 books and monographs. His current research relates to international finan- cial reporting, performance measurement, and corporate governance of high- performance companies in the United States, Europe, India, and Australia. His textbooks are used throughout the world and have received many awards, includ- ing the 2008 McGuffey Award from the Text and Academic Authors Associa- tion. Dr. Needles was named Educator of the Year by the American Institute of CPAs, Accountant of the Year for Education by the national honorary soci- ety Beta Alpha Psi, and Outstanding International Accounting Educator by the American Accounting Association. Among the numerous other awards he has received are the Excellence in Teaching Award from DePaul University and the Illinois CPA Society’s Outstanding Educator Award and Life-Time Achievement

Award. Active in many academic and professional organizations, he has served as the U.S. representative on several international accounting committees, includ- ing the Education Committee of the International Federation of Accountants (IFAC). He is currently vice president of education of the American Accounting Association. Marian Powers, Ph.D. Northwestern University Internationally recognized as a dynamic teacher in executive education, Marian Powers specializes in teaching managers how to read and understand financial reports, including the impact that international financial reporting standards have on their companies. More than 1,000 executives per year from countries throughout the world, including France, the Czech Republic, Australia, India, China, and Brazil, attend her classes. She has taught at the Kellogg’s Allen Cen- ter for Executive Education at Northwestern University since 1987 and at the Center for Corporate Financial Leadership since 2002. Dr. Powers’s research on international financial reporting, performance measurement, and corporate governance has been published in leading journals, among them The Accounting Review; The International Journal of Accounting; Issues in Accounting Education; The Journal of Accountancy; The Journal of Business, Finance and Accounting; and Financial Management. She has also coauthored three interactive multime- dia software products: Fingraph Financial Analyst™ (financial analysis software); Financial Analysis and Decision Making, a goal-based learning simulation focused on interpreting financial reports; and Introduction to Financial Accounting, a goal-based simulation that uses the Financial Consequences Model to introduce financial accounting and financial statements to those unfamiliar with account- ing. Dr. Powers is a member of the American Accounting Association, European Accounting Association, International Association of Accounting Education and Research, and Illinois CPA Society. She currently serves on the board of directors of the Illinois CPA Society and the board of the CPA Endowment Fund of Illi- nois. She has served as vice president of Programs and secretary of the Educational Foundation. xxxi xxxii About the Authors Susan V. Crosson, Santa Fe College Susan V. Crosson is the accounting program coordinator and a professor of accounting at Santa Fe College, Gainesville, FL. Susan has also enjoyed teach- ing at the University of Florida, Washington University in St. Louis, Univer- sity of Oklahoma, Johnson County Community College in Kansas, and Kansas City Kansas Community College. She is known for her innovative application of pedagogical strategies online and in the classroom. She is a recipient of the Outstanding Educator Award from the American Accounting Association’s Two Year College Section, an Institute of Management Accountants’ Fac- ulty Development Grant to blend technology into the classroom, the Florida Association of Community Colleges Professor of the Year Award for Instruc- tional Excellence, and the University of Oklahoma’s Halliburton Education Award for Excellence. Susan is active in many academic and professional organizations. She served in the American Institute of CPA Pre- certification Education Executive Committee and is on the Florida Institute of CPAs Relations with Accounting Educators committee and the Florida Association of Accounting Educators Steering Committee. She has served as the Ameri- can Accounting Association’s Vice President for Sections and Regions and as a council member-at-large, chairperson of the Membership Committee, and was chairperson of the Two-Year Accounting Section. Previously she served as chairperson of the Florida Institute of CPAs Accounting Careers and Edu- cation Committee and was chair of the Florida Institute of CPAs Relations with Accounting Educators Committee. Susan was on the American Institute of CPAs’ Core Competencies Best Practices Task Force also. Susan co-authors accounting textbooks for Cengage Learning: Principles of Accounting and Financial and Managerial Accounting, and Managerial Accounting with Bel

Needles and Marian Powers. Susan holds a BBA in Economics and Account- ing from Southern Methodist University and a MS in Accounting from Texas Tech University. Principles of Accounting ELEVENTH EDITION C H A P T E R Uses of Accounting 1 Information and the Financial Statements Today, more people than ever before recognize the impor- Making a Statement tance of accounting information and the profound effect that unethical and misleading financial reports can have on a business, INCOME STATEMENT its owners, its employees, its lenders, and the financial markets. In Revenues this chapter, we discuss the importance of ethical financial report- – Expenses ing, the uses and users of accounting information, and the financial = Net Income statements that accountants prepare. We end the chapter with a discussion of generally accepted accounting principles. STATEMENT OF OWNER’S EQUITY Beginning Balance LEARNING OBJECTIVES + Net Income – Withdrawals LO1 Define accounting and describe its role in making informed = Ending Balance decisions, identify business goals and activities, and explain the importance of ethics in accounting. (pp. 4–10) BALANCE SHEET Assets Liabilities LO2 Identify the users of accounting information. (pp. 10–13) LO3 Explain the importance of business transactions, money Owner’s Equity measure, and separate entity. (pp. 13–15) A = L + OE LO4 Identify the three basic forms of business organization. (pp. 15–16) STATEMENT OF CASH FLOWS Operating activities LO5 Define financial position, and state the accounting + Investing activities + Financing activities equation. (pp. 17–19) = Change in Cash + Beginning Balance LO6 Identify the four basic financial statements. (pp. 19–23) = Ending Cash Balance LO7 Explain how generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) relate to Financial statements financial statements and the independent CPA’s report, and measure how well a identify the organizations that influence GAAP. (pp. 24–27) business is run. 2 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Is Keep-Fit Center meeting its goal of profitability? KEEP-FIT CENTER (cid:2) As owner of Keep-Fit Center, what financial knowledge does On January 1, 2010, Lilian Jackson, an experienced fitness coach, Lilian Jackson need to measure started a business called Keep-Fit Center, which offers classes and progress toward the company’s goals? private instruction in aerobics, yoga, and Pilates. By December 31, 2010, the center had generated fees of $375,500, and its clients were (cid:2) In deciding whether to make giving it high marks for excellent service. Lilian is therefore now con- a loan to Keep-Fit Center, what financial knowledge sidering expanding the business. To do so, she would need a bank would a bank need to evaluate loan, and to qualify for one, both she and the bank would have to use the company’s financial various financial measures to determine the business’s profitability performance? and liquidity (i.e., its ability to repay the loan). Whether a business is small like Keep-Fit Center or large like CVS, the same financial measures are used to evaluate it. In this chapter, as you learn more about accounting and the business environment, you will become familiar with these financial measures and be able to answer questions such as those on the right. 33 4 CHAPTER 1 Uses of Accounting Information and the Financial Statements Accounting as Accounting is an information system that measures, processes, and communicates an Information financial information about an economic entity.1 An economic entity is a unit that exists independently, such as a business, a hospital, or a governmental body. Although System the central focus of this book is on business entities, we include other economic units at appropriate points in the text and end-of-chapter assignments. LO1 Define accounting and Accountants focus on the needs of decision makers who use financial informa- describe its role in making tion, whether those decision makers are inside or outside a business or other economic

informed decisions, identify entity. Accountants provide a vital service by supplying the information decision mak- business goals and activities, and ers need to make “reasoned choices among alternative uses of scarce resources in the explain the importance of ethics conduct of business and economic activities.”2 As shown in Figure 1-1, accounting is in accounting. a link between business activities and decision makers. 1. Accounting measures business activities by recording data about them for future use. 2. The data are stored until needed and then processed to become useful information. 3. The information is communicated through reports to decision makers. In other words, data about business activities are the input to the accounting system, and useful information for decision makers is the output. Business Goals, Activities, and Performance Measures A business is an economic unit that aims to sell goods and services to customers at prices that will provide an adequate return to its owners. The list that follows contains the names of some well-known businesses and the principal goods or services that they sell. BUSINESS ACTIVITIES DECISION MAKERS Actions Data Information ACCOUNTING MEASUREMENT PROCESSING COMMUNICATION SALES INVOICE $5,200 A F AUNN AICNANI TROPER L L FIGURE 1-1 Accounting as an Information System Purchase Order Accounting as an Information System 5 FIGURE 1-2 BUSINESS GOALS BUSINESS ACTIVITIES Business Goals and Activities FIRST BANK PROFITABILITY FINANCING OPERATING TITLE DEED LIQUIDITY INVESTING Wal-Mart Corp. Comprehensive discount store Reebok International Ltd. Athletic footwear and clothing Best Buy Co. Consumer electronics, personal computers Wendy’s International Inc. Food service Starbucks Corp. Coffee Southwest Airlines Co. Passenger airline Despite their differences, these businesses have similar goals and engage in similar activities, as shown in Figure 1-2. The two major goals of all businesses are profitability and liquidity. Study Note (cid:2) Profitability is the ability to earn enough income to attract and hold invest- Users of accounting information ment capital. focus on a company’s (cid:2) Liquidity is the ability to have enough cash to pay debts when they are due. profitability and liquidity. Thus, more than one measure of For example, Toyota may meet the goal of profitability by selling many cars performance is of interest to at a price that earns a profit, but if its customers do not pay for their cars quickly them. For example, lenders are enough to enable Toyota to pay its suppliers and employees, the company may concerned primarily with cash fail to meet the goal of liquidity. If a company is to survive and be successful, it flow, and owners are concerned must meet both goals. with earnings and withdrawals. All businesses, including Lilian Jackson’s Keep-Fit Center, pursue their goals by engaging in operating, investing, and financing activities. (cid:2) Operating activities include selling goods and services to customers, employ- ing managers and workers, buying and producing goods and services, and paying taxes. (cid:2) Investing activities involve spending the capital a company receives in pro- ductive ways that will help it achieve its objectives. These activities include buying land, buildings, equipment, and other resources that are needed to operate the business and selling them when they are no longer needed. 6 CHAPTER 1 Uses of Accounting Information and the Financial Statements FOCUS ON BUSINESS PRACTICE What Does CVS Have to Say About Itself? CVS, a major drug store chain, describes the company’s progress in meeting its major business objectives as follows: FINANCING: OPERATING: Obtains Funds from Sells Products and Liquidity: “Along with our strong free cash flow generation, . . . — Stockholders Services Through we faced virtually none of the liquidity issues that sent — Investors More Than — Banks and 3,500 Drugstores shockwaves across so much of the business landscape in Other Creditors and Pharmacies 2008. CVS Caremark has a solid balance sheet and an invest-

ment grade credit rating, and we maintain a commercial INVESTING: paper program currently backed by $4 billion in committed Invests Funds in bank facilities.” — Furniture, Fixtures and Equipment — Improvements Profitability: “CVS Caremark generated record revenue and earn- to Buildings ings, achieved industry-leading same-store sales growth, — Computer Equipment and continued to gain share across our businesses.”3 CVS’s main business activities are shown at the right. (cid:2) Financing activities involve obtaining adequate funds, or capital, to begin operations and to continue operating. These activities include obtaining capi- tal from creditors, such as banks and suppliers, and from owners. They also include repaying creditors and paying a return to the owners. An important function of accounting is to provide performance measures, which indicate whether managers are achieving their business goals and whether the business activities are well managed. The evaluation and interpretation of financial statements and related performance measures is called financial analy- sis. For financial analysis to be useful, performance measures must be well aligned with the two major goals of business—profitability and liquidity. Profitability is commonly measured in terms of earnings or income, and cash flows are a common measure of liquidity. In 2008, the drug and pharmacy chain CVS projected earnings of $3.5 billion and cash flows from operating activities of $4.5 billion in 2009. These figures indicate that CVS was achieving both profit- ability and liquidity in difficult financial times.4 Not all companies were so fortu- nate in 2008. For instance, General Motors reported that it would have to curtail spending on new auto and truck models because its earnings (or profitability) and cash flows were negative; in fact, they were the largest in the history of the U.S. auto industry. Clearly, General Motors was not meeting either its profitability or liquidity goals to such an extent that management had to go to the government for a bailout in the billions of dollars. In spite of the bailout, the company was forced to declare bankruptcy in 2009. Although it is important to know the amounts of earnings and cash flows in any given period and whether they are rising or falling, ratios of accounting measures are also useful tools of financial analysis. For example, to assess Keep- Fit Center’s profitability, it would be helpful to consider the ratio of its earnings to total assets, and for liquidity, the ratio of its cash flows to total assets. In addi- tion, ratios of accounting measures allow for comparisons from one period to another and from one company to another. Accounting as an Information System 7 FOCUS ON BUSINESS PRACTICE Cash Bonuses Depend on Accounting Numbers! Nearly all businesses use the amounts reported in their selecting measures that are not easily manipulated is impor- financial statements as a basis for rewarding management. tant. Equally important is maintaining a balance of measures Because managers act to achieve these accounting measures, that reflect the goals of profitability and liquidity.5 Financial and Management Accounting Accounting’s role of assisting decision makers by measuring, processing, and com- municating financial information is usually divided into the categories of manage- ment accounting and financial accounting. Although the functions of management accounting and financial accounting overlap, the two can be distinguished by the principal users of the information they provide. Management accounting provides internal decision makers, who are charged with achieving the goals of profitability and liquidity, with information about operating, investing, and financing activities. Managers and employees who conduct the activities of the business need information that tells them how they have done in the past and what they can expect in the future. For example, The Gap, a retail clothing business, needs an operating report on each outlet that tells how much was sold at that outlet and what costs were

incurred, and it needs a budget for each outlet that projects the sales and costs for the next year. Financial accounting generates reports and communicates them to exter- nal decision makers so they can evaluate how well the business has achieved its goals. These reports are called financial statements. CVS, whose stock is traded on the New York Stock Exchange, sends its financial statements to its owners (called stockholders), its banks and other creditors, and government regulators. Financial statements report directly on the goals of profitability and liquid- ity and are used extensively both inside and outside a business to evaluate the business’s success. It is important for every person involved with a business to understand financial statements. They are a central feature of accounting and a primary focus of this book. Processing Accounting Information It is important to distinguish accounting from the ways in which accounting information is processed by bookkeeping, computers, and management informa- tion systems. Accounting includes the design of an information system that meets users’ needs, and its major goals are the analysis, interpretation, and use of information. Bookkeeping, on the other hand, is mechanical and repetitive; it is the process of recording financial transactions and keeping financial records. It is a small—but important—part of accounting. Today, computers collect, organize, and communicate vast amounts of information with great speed. They can perform both routine bookkeeping chores and complex calculations. Accountants were among the earliest and most enthusiastic users of computers, and today they use computers in all aspects of their work. 8 CHAPTER 1 Uses of Accounting Information and the Financial Statements Computers make it possible to create a management information system to Study Note organize a business’s many information needs. A management information sys- tem (MIS) consists of the interconnected subsystems that provide the information Computerized accounting needed to run a business. The accounting information system is the most important information is only as reliable and useful as the data that go subsystem because it plays the key role of managing the flow of economic data to all into the system. The accountant parts of a business and to interested parties outside the business. must have a thorough under- standing of the concepts Ethical Financial Reporting that underlie accounting to ensure the data’s reliability and Ethics is a code of conduct that applies to everyday life. It addresses the question usefulness. of whether actions are right or wrong. Actions—whether ethical or unethical, right or wrong—are the product of individual decisions. Thus, when an organi- zation acts unethically by using false advertising, cheating customers, polluting the environment, or treating employees unfairly, it is not the organization that is responsible—it is the members of management and other employees who have made a conscious decision to act in this manner. Ethics is especially important in preparing financial reports because users of these reports must depend on the good faith of the people involved in their preparation. Users have no other assurance that the reports are accurate and fully disclose all relevant facts. The intentional preparation of misleading financial statements is called fraud- ulent financial reporting.6 It can result from the distortion of records (e.g., the manipulation of inventory records), falsified transactions (e.g., fictitious sales), or the misapplication of various accounting principles. There are a number of motives for fraudulent reporting—for instance, to cover up financial weakness to obtain a higher price when a company is sold; to meet the expectations of inves- tors, owners, and financial analysts; or to obtain a loan. The incentive can also be personal gain, such as additional compensation, promotion, or avoidance of penalties for poor performance. Whatever the motive for fraudulent financial reporting, it can have dire con-

sequences, as the accounting scandals that erupted at Enron Corporation and WorldCom attest. Unethical financial reporting and accounting practices at those two major corporations caused thousands of people to lose their jobs, their invest- ment incomes, and their pensions. They also resulted in prison sentences and fines for the corporate executives who were involved. FOCUS ON BUSINESS PRACTICE How Did Accounting Develop? Accounting is a very old discipline. Forms of it have been famous Italian mathematician, scholar, and philosopher essential to commerce for more than 5,000 years. Account- Fra Luca Pacioli. In 1494, Pacioli published his most impor- ing, in a version close to what we know today, gained tant work, Summa de Arithmetica, Geometrica, Proportioni et widespread use in the 1400s, especially in Italy, where it Proportionalita, which contained a detailed description of was instrumental in the development of shipping, trade, accounting as practiced in that age. This book became the construction, and other forms of commerce. This system most widely read book on mathematics in Italy and firmly of double-entry bookkeeping was documented by the established Pacioli as the “Father of Accounting.” Accounting as an Information System 9 Unethical accounting practices at Enron led to the collapse of the company and the loss of thousands of jobs and pensions. This photograph shows the former Enron building in Houston, Texas. Courtesy of Paul S. Wolf, 2009/Used under license from Shutterstock.com. In 2002, Congress passed the Sarbanes-Oxley Act to regulate financial reporting and the accounting profession, among other things. This legislation ordered the Securities and Exchange Commission (SEC) to draw up rules requir- ing the chief executives and chief financial officers of all publicly traded U.S. companies to swear that, based on their knowledge, the quarterly statements and annual reports that their companies file with the SEC are accurate and complete. Violation can result in criminal penalties. A company’s management expresses its duty to ensure that financial reports are not false or misleading in the manage- ment report that appears in the company’s annual report. For example, Target Corporation’s management report includes the following statement: Management is responsible for the consistency, integrity and presentation of the information in the Annual Report.7 However, it is accountants, not management, who physically prepare and audit financial reports. To meet the high ethical standards of the accounting pro- fession, they must apply accounting concepts in such a way as to present a fair view of a company’s operations and financial position and to avoid misleading readers of their reports. Like the conduct of a company, the ethical conduct of a profession is a collection of individual actions. As a member of a profession, each accountant has a responsibility—not only to the profession but also to employers, clients, and society as a whole—to ensure that any report he or she prepares or audits provides accurate, reliable information. The high regard that the public has historically had for the accounting profes- sion is evidence that an overwhelming number of accountants have upheld the ethics of the profession. Even as the Enron and WorldCom scandals were making headlines, a Gallup Poll showed an increase of 28 percent in the accounting pro- fession’s reputation between 2002 and 2005, placing it among the most highly rated professions.8 Accountants and top managers are, of course, not the only people responsible for ethical financial reporting. Managers and employees at all levels must be con- scious of their responsibility for providing accurate financial information to the people who rely on it. 10 CHAPTER 1 Uses of Accounting Information and the Financial Statements STOP & APPLY Match the terms below with the definitions (some answers may be used more than once): _____ 1. Management accounting a. An unethical practice _____ 2. Liquidity b. A business goal _____ 3. Financial accounting c. Engaged in by all businesses

_____ 4. Investing activities d. Major function of accounting _____ 5. Operating activities _____ 6. Financing activities _____ 7. Profitability _____ 8. Fraudulent financial reporting SOLUTION 1. d; 2. b; 3. d; 4. c; 5. c; 6. c; 7. b; 8. a Decision Makers: As shown in Figure 1-3, the people who use accounting information to make The Users of decisions fall into three categories: Accounting 1. Those who manage a business Information 2. Those outside a business enterprise who have a direct financial interest in the business LO2 Identify the users of 3. Those who have an indirect financial interest in a business accounting information. These categories apply to governmental and not-for-profit organizations as well as to profit-oriented ventures. Management MManagement refers to the people who are responsible for operating a business and Study Note mmeeting its goals of profitability and liquidity. In a small business, management may cconsist solely of the owners. In a large business, managers must decide what to do, Managers are internal users of accounting information. hhow to do it, and whether the results match their original plans. Successful managers cconsistently make the right decisions based on timely and valid information. FIGURE 1-3 DECISION MAKERS The Users of Accounting Information MANAGEMENT THOSE WITH DIRECT THOSE WITH INDIRECT FINANCIAL INTEREST FINANCIAL INTEREST Finance Investment Investors Tax Authorities Operations and Creditors Regulatory Agencies Production Labor Unions Marketing Customers Human Resources Economic Planners Information Systems Accounting Decision Makers: The Users of Accounting Information 11 To make good decisions, Lilian Jackson and other owners and managers need answers to such questions as: (cid:2) What were the company’s earnings during the past quarter? (cid:2) Is the rate of return to the owners adequate? (cid:2) Does the company have enough cash? (cid:2) Which products or services are most profitable? Because so many key decisions are based on accounting data, management is one of the most important users of accounting information. In its decision-making process, management performs functions that are essential to the operation of a business. The same basic functions must be per- formed in all businesses, and each requires accounting information on which to base decisions. The basic management functions are: Financing the business: obtaining funds so that a company can begin and con- tinue operating Investing resources: investing assets in productive ways that support a company’s goals Producing goods and services: managing the production of goods and services Marketing goods and services: overseeing how goods or services are advertised, sold, and distributed Managing employees: overseeing the hiring, evaluation, and compensation of employees Providing information to decision makers: gathering data about all aspects of a company’s operations, organizing the data into usable information, and provid- ing reports to managers and appropriate outside parties. Accounting plays a key role in this function. Users with a Direct Financial Interest Another group of decision makers who need accounting information are those with a direct financial interest in a business. They depend on accounting to measure and report information about how a business has performed. Most businesses periodi- cally publish a set of general-purpose financial statements that report their success in meeting the goals of profitability and liquidity. These statements show what has happened in the past, and they are important indicators of what will happen in the future. Many people outside the company carefully study these financial reports. The two most important groups are investors (including owners) and creditors. FOCUS ON BUSINESS PRACTICE What Do CFOs Do? According to a survey, the chief financial officer (CFO) is the involving international operations, and many of them are “new business partner of the chief executive officer” (CEO). becoming CEOs of their companies. Those who do become CFOs are increasingly required to take on responsibilities CEOs are finding that “a financial background is invaluable when

for strategic planning, mergers and acquisitions, and tasks they’re saddled with the responsibility of making big calls.”9 12 CHAPTER 1 Uses of Accounting Information and the Financial Statements Investors Those such as Lilian Jackson, owner of the Keep-Fit Center, and Study Note CCVS’s stockholders who may invest in a business and acquire a part ownership in The primary external users of iit are interested in its past success and its potential earnings. A thorough study of accounting information are aa company’s financial statements helps potential investors judge the prospects for investors and creditors. aa profitable investment. After investing, they must continually review their com- mmitment, again by examining the company’s financial statements. Creditors Most companies borrow money for both long- and short-term oper- ating needs. Creditors, those who lend money or deliver goods and services before being paid, are interested mainly in whether a company will have the cash to pay interest charges and to repay the debt at the appropriate time. They study a com- pany’s liquidity and cash flow as well as its profitability. Banks, finance companies, mortgage companies, securities firms, insurance firms, suppliers, and other lenders must analyze a company’s financial position before they make a loan. Users with an Indirect Financial Interest In recent years, society as a whole, through governmental and public groups, has become one of the largest and most important users of accounting informa- tion. Users who need accounting information to make decisions on public issues include tax authorities, regulatory agencies, and various other groups. Tax Authorities Government at every level is financed through the collection of taxes. Companies and individuals pay many kinds of taxes, including federal, state, and city income taxes; Social Security and other payroll taxes; excise taxes; and sales taxes. Each tax requires special tax returns and often a complex set of records as well. Proper reporting is generally a matter of law and can be very complicated. The Inter- nal Revenue Code, for instance, contains thousands of rules governing the prepara- tion of the accounting information used in computing federal income taxes. Regulatory Agencies Most companies must report periodically to one or more regulatory agencies at the federal, state, and local levels. For example, all publicly traded corporations must report periodically to the Securities and Exchange Commission (SEC). This body, set up by Congress to protect the public, regu- lates the issuing, buying, and selling of stocks in the United States. Companies listed on a stock exchange also must meet the special reporting requirements of their exchange. Other Groups Labor unions study the financial statements of corporations as part of preparing for contract negotiations; a company’s income and costs often play an important role in these negotiations. Those who advise investors and creditors—financial analysts, brokers, underwriters, lawyers, economists, and the financial press—also have an indirect interest in the financial performance and prospects of a business. Consumer groups, customers, and the general public have become more concerned about the financing and earnings of corporations as well as the effects that corporations have on inflation, the environment, social issues, and the quality of life. And economic planners, among them the President’s Council of Economic Advisers and the Federal Reserve Board, use aggregated accounting information to set and evaluate economic policies and programs. Governmental and Not-for-Profit Organizations More than 30 percent of the U.S. economy is generated by governmental and not-for-profit organizations (hospitals, universities, professional organizations, Accounting Measurement 13 and charities). The managers of these diverse entities perform the same functions as managers of businesses, and they therefore have the same need for accounting information and a knowledge of how to use it. Their functions include raising

funds from investors (including owners), creditors, taxpayers, and donors and deploying scarce resources. They must also plan how to pay for operations and to repay creditors on a timely basis. In addition, they have an obligation to report their financial performance to legislators, boards, and donors, as well as to deal with tax authorities, regulators, and labor unions. Although most of the examples in this text focus on business enterprises, the same basic principles apply to gov- ernmental and not-for-profit organizations. STOP & APPLY Match the terms below with the type of user of accounting information (some answers may be used more than once): _____ 1. Tax authorities a. Internal user _____ 2. Investors b. Direct external user _____ 3. Management c. Indirect user _____ 4. Creditors _____ 5. Regulatory agencies _____ 6. Labor unions and consumer groups SOLUTION 1. c; 2. b; 3. a; 4. b; 5. c; 6. c Accounting In this section, we begin the study of the measurement aspects of accounting— Measurement that is, what accounting actually measures. To make an accounting measurement, the accountant must answer four basic questions: LO3 Explain the importance 1. What is measured? of business transactions, money 2. When should the measurement be made? measure, and separate entity. 3. What value should be placed on what is measured? 4. How should what is measured be classified? Accountants in industry, professional associations, public accounting, govern- ment, and academic circles debate the answers to these questions constantly, and the answers change as new knowledge and practice require. But the basis of today’s accounting practice rests on a number of widely accepted concepts and conventions, which are described in this book. We begin by focusing on the first question: What is measured? We discuss the other three questions (recognition, valuation, and classification) in the next chapter. Every system must define what it measures, and accounting is no exception. Basically, financial accounting uses money to gauge the impact of business trans- actions on separate business entities. 14 CHAPTER 1 Uses of Accounting Information and the Financial Statements Business Transactions Business transactions are economic events that affect a business’s financial posi- tion. Businesses can have hundreds or even thousands of transactions every day. These transactions are the raw material of accounting reports. A transaction can be an exchange of value (a purchase, sale, payment, col- lection, or loan) between two or more parties. A transaction also can be an eco- nomic event that has the same effect as an exchange transaction but that does not involve an exchange. Some examples of “nonexchange” transactions are losses from fire, flood, explosion, and theft; physical wear and tear on machinery and equipment; and the day-by-day accumulation of interest. To be recorded, a transaction must relate directly to a business entity. Suppose a customer buys toothpaste from CVS but has to buy shampoo from a competing store because CVS is out of shampoo. The transaction in which the toothpaste was sold is entered in CVS’s records. However, the purchase of the shampoo from the competitor is not entered in CVS’s records because even though it indi- rectly affects CVS economically, it does not involve a direct exchange of value between CVS and the customer. Money Measure All business transactions are recorded in terms of money. This concept is called money measure. Of course, nonfinancial information may also be recorded, but it is through the recording of monetary amounts that a business’s transactions and activities are measured. Money is the only factor common to all business transactions, and thus it is the only unit of measure capable of producing financial data that can be compared. The monetary unit a business uses depends on the country in which the busi- Study Note ness resides. For example, in the United States, the basic unit of money is the dollar. In Japan, it is the yen; in Europe, the euro; and in the United Kingdom,

The common unit of measurement used in the the pound. In international transactions, exchange rates must be used to translate United States for financial from one currency to another. An exchange rate is the value of one currency in reporting purposes is the dollar. terms of another. For example, a British person purchasing goods from a U.S. company like CVS and paying in U.S. dollars must exchange British pounds for U.S. dollars before making payment. In effect, currencies are goods that can be bought and sold. Table 1-1 illustrates the exchange rates for several currencies in dollars. It shows the exchange rate for British pounds as $1.49 per pound on a particular date. Like the prices of many goods, currency prices change daily according to supply and demand. For example, a year earlier, the exchange rate for British pounds was $1.98. Although our discussion in this book focuses on dollars, some examples and assignments involve foreign currencies. TABLE 1-1 Price Price Examples of Foreign Exchange Rates Country in $U.S. Country in $U.S. Australia (dollar) 0.72 Hong Kong (dollar) 0.13 Brazil (real) 0.46 Japan (yen) 0.011 Britain (pound) 1.49 Mexico (peso) 0.07 Canada (dollar) 0.85 Russia (ruble) 0.03 Europe (euro) 1.35 Singapore (dollar) 0.68 Source: The Wall Street Journal, January 7, 2009. The Forms of Business Organization 15 Separate Entity For accounting purposes, a business is a separate entity, distinct not only from Study Note its creditors and customers but also from its owners. It should have its own set of For accounting purposes, a financial records, and its records and reports should refer only to its own affairs. business is always separate For example, Just Because Flowers Company should have a bank account and distinct from its owners, separate from the account of Holly Sapp, the owner. Holly Sapp may own a creditors, and customers. home, a car, and other property, and she may have personal debts, but these are not the resources or debts of Just Because Flowers. Holly Sapp may own another business, say a stationery shop. If she does, she should have a completely separate set of records for each business. STOP & APPLY Match the terms below with the type of user of accounting information: _____ 1. R equires an exchange of value a. Business transaction between two or more parties b. Money measure _____ 2. R equires a separate set of records for c. Separate entity a business _____ 3. A n amount associated with a business transaction SOLUTION 1. a; 2. c; 3. b The Forms The three basic forms of business organization are the sole proprietorship, the part- of Business nership, and the corporation. Accountants recognize each form as an economic unit separate from its owners. Legally, however, only the corporation is separate from Organization its owners. The characteristics of corporations make them very efficient in amassing capital, which enables them to grow extremely large. As Figure 1-4 shows, even LO4 Identify the three basic though corporations are fewer in number than sole proprietorships and partnerships, forms of business organization. they contribute much more to the U.S. economy in monetary terms. For example, in 2007, Exxon Mobil generated more revenues than all but 30 of the world’s coun- tries. Here, we point out the most important features of each form of business. Characteristics of Corporations, Sole Proprietorships, and Partnerships AA sole proprietorship is a business owned by one person.* The owner takes Study Note aall the profits or losses of the business and is liable for all its obligations. As A key disadvantage of a F Figure 1-4 shows, sole proprietorships represent the largest number of businesses partnership is the unlimited iin the United States, but typically they are the smallest in size. liability of its owners. Unlimited A partnership is like a sole proprietorship in most ways, but it has two or liability can be avoided by mmore owners. The partners share the profits and losses of the business accord- organizing the business as a iing to a prearranged formula. Generally, any partner can obligate the business

corporation or, in some states, by forming what is known as *Accounting for a sole proprietorship is simpler than accounting for a partnership or corpora- a limited liability partnership tion. For that reason, we focus on the sole proprietorship in the early part of this book. At (LLP). critical points, however, we call attention to the essential differences between accounting for a sole proprietorship and accounting for a partnership or corporation. 16 CHAPTER 1 Uses of Accounting Information and the Financial Statements FIGURE 1-4 Number and Receipts of U.S. Proprietorships, Partnerships, and Corporations NUMBER OF BUSINESSES Proprietorships 19,710 Partnerships 2,375 Corporations 5,401 0 2 4 6 8 10 12 14 16 18 20 22 Millions RECEIPTS OF BUSINESSES Proprietorships $ 1,050 Partnerships 2,923 Corporations 20,690 $0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 Billions Source: U.S. Treasury Department, Internal Revenue Service, Statistics of Income Bulletin, Winter 2006. to another party, and the personal resources of each partner can be called on to pay the obligations. A partnership must be dissolved if the ownership changes, as when a partner leaves or dies. If the business is to continue as a partnership after this occurs, a new partnership must be formed. Both the sole proprietorship and the partnership are convenient ways of separating the owners’ commercial activities from their personal activities. Legally, however, there is no economic separation between the owners and the businesses. A corporation, on the other hand, is a business unit chartered by the state and legally separate from its owners (the stockholders). The stockhold- ers, whose ownership is represented by shares of stock, do not directly control the corporation’s operations. Instead, they elect a board of directors to run the corporation for their benefit. In exchange for their limited involvement in the corporation’s operations, stockholders enjoy limited liability; that is, their risk of loss is limited to the amount they paid for their shares. Thus, stockholders are often willing to invest in risky, but potentially profitable, activities. Also, because stockholders can sell their shares without dissolving the corporation, the life of a corporation is unlimited and not subject to the whims or health of a proprietor or a partner. FOCUS ON BUSINESS PRACTICE Are Most Corporations Big or Small Businesses? Most people think of corporations as large national or only about 15,000 have stock that is publicly bought and global companies whose shares of stock are held by thou- sold. The vast majority of corporations are small businesses sands of people and institutions. Indeed, corporations can privately held by a few stockholders. Illinois alone has more be huge and have many stockholders. However, of the than 250,000 corporations. Thus, the study of corporations approximately 4 million corporations in the United States, is just as relevant to small businesses as it is to large ones. Financial Position and the Accounting Equation 17 STOP & APPLY Match the descriptions on the left with the forms of business enterprise on the right: _____ 1. Pays dividends _____ 5. M ost numerous but usually small in size _____ 2. Owned by only one person _____ 6. Biggest segment of the economy _____ 3. Multiple co-owners a. Sole proprietorship _____ 4. M anagement appointed by board of b. Partnership directors c. Corporation SOLUTION 1. c; 2. a; 3. b; 4. c; 5. a; 6. c Financial Financial position refers to a company’s economic resources, such as cash, inven- Position and tory, and buildings, and the claims against those resources at a particular time. Another term for claims is equities. the Accounting Every company has two types of equities: creditors’ equities, such as bank Equation loans, and owner’s equity. The sum of these equities equals a company’s resources: LO5 Define financial position, and state the accounting Economic Resources (cid:2) Creditors’ Equities (cid:3) Owner’s Equity equation. In accounting terminology, economic resources are called assets and creditors’

equities are called liabilities. So the equation can be written like this: Assets (cid:2) Liabilities (cid:3) Owner’s Equity This equation is known as the accounting equation. The two sides of the equa- tion must always be equal, or “in balance,” as shown in Figure 1-5. To evalu- ate the financial effects of business activities, it is important to understand their effects on this equation. FIGURE 1-5 The Accounting Equation Owner’s Assets Liabilities Equity A = L + OE 18 CHAPTER 1 Uses of Accounting Information and the Financial Statements Assets Assets are the economic resources of a company that are expected to benefit the company’s future operations. Certain kinds of assets—for example, cash and money that customers owe to the company (called accounts receivable)—are monetary items. Other assets—inventories (goods held for sale), land, buildings, and equipment—are nonmonetary, physical items. Still other assets—the rights granted by patents, trademarks, and copyrights—are nonphysical. Liabilities Liabilities are a business’s present obligations to pay cash, transfer assets, or provide services to other entities in the future. Among these obligations are amounts owed to suppliers for goods or services bought on credit (called accounts payable), borrowed money (e.g., money owed on bank loans), sala- ries and wages owed to employees, taxes owed to the government, and ser- vices to be performed. As debts, liabilities are claims recognized by law. That is, the law gives creditors the right to force the sale of a company’s assets if the company fails to pay its debts. Creditors have rights over owners and must be paid in full before the owners receive anything, even if payment of the debt uses up all the assets of the business. Owner’s Equity Owner’s equity represents the claims by the owner of a business to the assets of the business. Theoretically, owner’s equity is what would be left if all liabili- ties were paid, and it is sometimes said to equal net assets. By rearranging the accounting equation, we can define owner’s equity this way: Owner’s Equity (cid:2) Assets (cid:4) Liabilities Owner’s equity is affected by the owner’s investments in and withdrawals from the business and by the business’s revenues and expenses. Owner’s invest- ments are assets that the owner puts into the business (e.g., by transferring cash from a personal bank account to the business’s bank account). In this case, the assets (cash) of the business increase, and the owner’s equity in those assets also increases. Owner’s withdrawals are assets that the owner takes out of the business (e.g., by transferring cash from the business’s bank account to a personal bank account). In this case, the assets of the business decrease, as does the owner’s equity in the business. Simply stated, revenues and expenses are the increases and decreases in owner’s equity that result from operating a business. For example, the amount a customer pays (or agrees to pay in the future) to CVS for a product or service is a revenue for CVS. CVS’s assets (cash or accounts receivable) increase, as does its stockholders’ (owner’s) equity in those assets. On the other hand, the amount CVS must pay out (or agree to pay out) so that it can provide a product or service is an expense. In this case, the assets (cash) decrease or the liabilities (accounts payable) increase, and the owner’s equity decreases. Generally, a company is successful if its revenues exceed its expenses. When revenues exceed expenses, the difference is called net income. When expenses exceed revenues, the difference is called net loss. It is important not to confuse expenses and withdrawals, both of which reduce owner’s equity. In summary, owner’s equity is the accumulated net income (revenues (cid:4) expenses) less with- drawals over the life of the business. Financial Statements 19 STOP & APPLY Johnson Company had assets of $140,000 and liabilities of $60,000 at the beginning of the year, and assets of $200,000 and liabilities of $70,000 at the end of the year. During the year, $20,000

was invested in the business, and withdrawals of $24,000 were made. What amount of net income did the company earn during the year? Beginning of the year Assets (cid:2) Liabilities (cid:3) Owner’s Equity $140,000 (cid:2) $60,000 (cid:3) $ 80,000 During year Investment (cid:3) 20,000 Withdrawals (cid:4) 24,000 ? Net income End of year $200,000 (cid:2) $70,000 (cid:3) $130,000 SOLUTION Net income (cid:2) $54,000 Start by finding the owner’s equity at the beginning of the year. (Check: $140,000 (cid:4) $60,000 (cid:2) $80,000) Then find the owner’s equity at the end of the year. (Check: $200,000 (cid:4) $70,000 (cid:2) $130,000) Then determine net income by calculating how the transactions during the year led to the owner’s equity amount at the end of the year. (Check: $80,000 (cid:3) $20,000 (cid:4) $24,000 (cid:3) $54,000 (cid:2) $130,000) Financial Financial statements are the primary means of communicating important account- Statements ing information about a business to those who have an interest in the business. These statements are models of the business enterprise in that they show the business in financial terms. As is true of all models, however, financial statements LO6 Identify the four basic are not perfect pictures of the real thing. Rather, they are the accountant’s best financial statements. effort to represent what is real. Four major financial statements are used to com- municate accounting information about a business: the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows. Study Note Businesses use four basic Income Statement financial statements to communicate financial The income statement summarizes the revenues earned and expenses incurred by information to decision makers. a business over an accounting period (see Exhibit 1-1). Many people consider it the most important financial report because it shows whether a business achieved its profitability goal—that is, whether it earned an acceptable income. Exhibit 1-1 shows that Weiss Consultancy had revenues of $14,000 from consulting. From this amount, total expenses of $5,600 were deducted (equipment rental expense of $2,800, wages expense of $1,600, and utilities expense of $1,200) to arrive at net income of $8,400. To show the period to which the statement applies, it is dated “For the Month Ended December 31, 2011.” 20 CHAPTER 1 Uses of Accounting Information and the Financial Statements EXHIBIT 1-1 Income Statement for Weiss Consultancy Weiss Consultancy Income Statement For the Month Ended December 31, 2011 Revenues Consulting fees earned $14,000 Expenses Equipment rental expense $2,800 Wages expense 1,600 Utilities expense 1,200 Total expenses 5,600 Net income $ 8,400 Statement of Owner’s Equity The statement of owner’s equity shows the changes in owner’s equity over an accounting period. In Exhibit 1-2, beginning owner’s equity is zero because Weiss Consultancy began operations in this accounting period. During the month, the owner, James Weiss, invested $200,000 in the business, and the company earned an income (as shown on the income statement) of $8,400. Deducted from this amount are $2,400 of withdrawals that the owner made during the month, leav- ing an ending balance of $206,000 of capital in the business. The Balance Sheet The purpose of a balance sheet is to show the financial position of a business on Study Note a certain date, usually the end of the month or year (see Exhibit 1-3). For this rea- son, it often is called the statement of financial position and is dated as of a specific The date on the balance sheet is date. The balance sheet presents a view of the business as the holder of resources, a single date, whereas the dates or assets, that are equal to the claims against those assets. The claims consist of the on the other three statements cover a period of time, such as a company’s liabilities and the owner’s equity in the company. Exhibit 1-3 shows month, quarter, or year. that Weiss Consultancy has several categories of assets, which total $208,400. These assets equal the total liabilities of $2,400 (accounts payable) plus the ending

balance of owner’s equity of $206,000. Notice that the amount of the owner’s Capital account on the balance sheet comes from the ending balance on the state- ment of owner’s equity. EXHIBIT 1-2 Weiss Consultancy Statement of Owner’s Equity for Weiss Consultancy Statement of Owner’s Equity For the Month Ended December 31, 2011 J. Weiss, Capital, December 1, 2011 $ 0 Investment by J. Weiss 200,000 Net income for the month 8,400 Subtotal $208,400 Less withdrawals 2,400 J. Weiss, Capital, December 31, 2011 $206,000 Financial Statements 21 EXHIBIT 1-3 Balance Sheet for Weiss Consultancy Weiss Consultancy Balance Sheet December 31, 2011 Assets Liabilities Cash $ 62,400 Accounts payable $ 2,400 Accounts receivable 4,000 Total liabilities $ 2,400 Supplies 2,000 Owner’s Equity Land 40,000 Buildings 100,000 J. Weiss, Capital 206,000 Total assets $208,400 Total liabilities and owner’s equity $208,400 Statement of Cash Flows Whereas the income statement focuses on a company’s profitability, the state- Study Note ment of cash flows focuses on its liquidity (see Exhibit 1-4). Cash flows are the inflows and outflows of cash into and out of a business. Net cash flows are the The statement of cash flows explains the change in cash in difference between the inflows and outflows. terms of operating, investing, As you can see in Exhibit 1-4, the statement of cash flows is organized accord- and financing activities over an ing to the three major business activities described earlier in the chapter. accounting period. It provides (cid:2) Cash flows from operating activities: The first section of Exhibit 1-4 shows valuable information that cannot the cash produced by business operations. Weiss’s operating activities pro- be determined in an examination duced net cash flows of $4,800 (liquidity) compared to net income of $8,400 of the other financial statements. (profitability). The company used cash to increase accounts receivable and supplies. However, by borrowing funds, it increased accounts payable. This is not a good trend, which Weiss should try to reverse in future months. (cid:2) Cash flows from investing activities: Weiss used cash to expand by pur- Study Note chasing land and a building. (cid:2) Cash flows from financing activities: Weiss obtained most of its cash from Notice the sequence in which the owner, who then made a small cash withdrawal. these statements are prepared: Income statement, statement of Overall, Weiss had a net increase in cash of $62,400, due in large part to the owner’s equity, balance sheet, investment by the owner. In future months, Weiss must generate more cash and finally, the statement of through operations. cash flows. The statement of cash flows is related directly to the other three financial statements. Notice that net income comes from the income statement and that withdrawals come from the statement of owner’s equity. The other items in the state- ment r epresent changes in the balance sheet accounts: accounts receivable, supplies, accounts payable, land, and buildings. Here we focus on the importance and overall structure of the statement. Its construction and use are discussed in a later chapter. Relationships Among the Financial Statements Exhibit 1-5 illustrates the relationships among the four financial statements by showing how they would appear for Weiss Consultancy. The period covered is the month of December 2011. Notice the similarity of the headings at the top 22 CHAPTER 1 Uses of Accounting Information and the Financial Statements of each statement. Each identifies the company and the kind of statement. The income statement, the statement of owner’s equity, and the statement of cash flows indicate the period to which they apply; the balance sheet gives the specific date to which it applies. Much of this book deals with developing, using, and interpreting more complete versions of these statements. EXHIBIT 1-4 Statement of Cash Flows for Weiss Consultancy Weiss Consultancy Statement of Cash Flows For the Month Ended December 31, 2011 Cash flows from operating activities Net income $ 8,400

Adjustments to reconcile net income to net cash flows from operating activities (Increase) in accounts receivable ($ 4,000) (Increase) in supplies (2,000) Increase in accounts payable 2,400) (3,600) Net cash flows from operating activities $ 4,800 Cash flows from investing activities Purchase of land ($ 40,000) Purchase of building (100,000) Net cash flows from investing activities (140,000) Cash flows from financing activities Investments by owner $ 200,000 Withdrawals (2,400) Net cash flows from financing activities 197,600 Net increase (decrease) in cash $ 62,400 Cash at beginning of month 0 Cash at end of month $ 62,400 Note: Parentheses indicate a negative amount. Financial Statements 23 EXHIBIT 1-5 Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows for Weiss Consultancy Weiss Consultancy Weiss Consultancy Statement of Cash Flows Income Statement For the Month Ended December 31, 2011 For the Month Ended December 31, 2011 Cash flows from operating activities Revenues Net income $ 8,400 Consulting fees $14,000 Adjustments to reconcile Expenses net income to net cash Equipment rental expense $2,800 flows from operating Wages expense 1,600 activities Utilities expense 1,200 (Increase) in accounts ($ 4,000) Total expenses 5,600 receivable Net income $ 8,400 (Increase) in supplies (2,000) Weiss Consultancy Increase in accounts Statement of Owner’s Equity payable 2,400) (3,600) For the Month Ended December 31, 2011 Net cash flows from operating activities $ 4,800 J. Weiss, Capital, December 1, 2011 $ 0 Investment by J. Weiss 200,000 Cash flows from investing activities Net income for the month 8,400 Purchase of land ($ 40,000) Subtotal $208,400 Purchase of building (100,000) Less withdrawals 2,400 Net cash flows from J. Weiss, Capital, December 31, 2011 $206,000 investing activities (140,000) Cash flows from financing activities Investments Weiss Consultancy by owner $200,000 Balance Sheet Withdrawals (2,400) December 31, 2011 Net cash flows from Assets Liabilities financing activities 197,600 Net increase (decrease) Cash $ 62,400 Accounts payable $ 2,400 in cash $ 62,400 Accounts 4,000 Total liabilities $ 2,400 Cash at beginning of receivable month 0 Supplies 2,000 Owner’s Equity Cash at end of month $ 62,400 Land 40,000 Buildings 100,000 J. Weiss, Capital 206,000 Total liabilities and T otal assets $208,400 owner’s equity $208,400 24 CHAPTER 1 Uses of Accounting Information and the Financial Statements STOP & APPLY Complete the following financial statements by determining the amounts that correspond to the letters. (Assume no new investments by owners.) Income Statement Revenues $2,775 Expenses (a) Net income $ (b) Statement of Owner’s Equity Beginning balance $7,250 Net income (c) Less withdrawals 500 Ending balance $7,500 Balance Sheet Total assets $ (d) Liabilities $4,000 Owner’s equity L. Buckman, capital (e) Total liabilities and owner’s equity $ (f) SOLUTION Net income links the income statement and the statement of owner’s equity. The ending balance of owner’s equity links the statement of owner’s equity and the balance sheet. Thus, start with (c), which must equal $750 (check: $7,250 (cid:3) $750 (cid:4) $500 (cid:2) $7,500). Then, (b) equals (c), or $750. Thus, (a) must equal $2,025 (check: $2,775 – $2,025 (cid:2) $750). Because (e) equals $7,500 (ending balance from the statement of owner’s equity), (f) must equal $11,500 (check: $4,000 (cid:3) $7,500 (cid:2) $11,500). Now, (d) equals (f), or $11,500. Generally To ensure that financial statements are understandable to their users, a set Accepted of practices, called generally accepted accounting principles (GAAP), has been developed to provide guidelines for financial accounting. “Generally Accounting accepted accounting principles encompass the conventions, rules, and proce- Principles dures necessary to define accepted accounting practice at a particular time.”10 In other words, GAAP arise from wide agreement on the theory and prac- LO7 Explain how generally tice of accounting at a particular time. These “principles” are not like the

accepted accounting principles unchangeable laws of nature in chemistry or physics. They evolve to meet the (GAAP) and international finan- needs of decision makers, and they change as circumstances change or as bet- cial reporting standards (IFRS) ter methods are developed. relate to financial statements In this book, we present accounting practice, or GAAP, as it is today, and the independent CPA’s and we try to explain the reasons or theory on which the practice is based. report, and identify the organiza- Both theory and practice are important to the study of accounting. H owever, tions that influence GAAP. accounting is a discipline that is always growing, changing, and improv- ing. Just as years of research are necessary before a new surgical method or lifesaving drug can be introduced, it may take years for new accounting discoveries to be implemented. As a result, you may encounter practices that seem contradictory. In some cases, we point out new directions in accounting. Your instructor also may mention certain weaknesses in current theory or practice. Generally Accepted Accounting Principles 25 TABLE 1-2 Firm Home Office Some Major Clients Large International Certified Public Accounting Firms Deloitte & Touche New York General Motors, Procter & Gamble Ernst & Young New York Coca-Cola, McDonald’s KPMG New York General Electric, Xerox PricewaterhouseCoopers New York Exxon Mobil, IBM, Ford GAAP and the Independent CPA’s Report Because financial statements are prepared by management and could be falsi- fied for personal gain, all companies that sell shares of their stock to the public and many companies that apply for sizable loans have their financial statements audited by an independent certified public accountant (CPA). Independent means that the CPA is not an employee of the company being audited and has no financial or other compromising ties with it. CPAs are licensed by all states for the same reason that lawyers and doctors are—to protect the public by ensuring the quality of professional service. The firms listed in Table 1-2 employ about 25 percent of all CPAs. An audit is an examination of a company’s financial statements and the accounting systems, controls, and records that produced them. The purpose Study Note of the audit is to ascertain that the financial statements have been prepared in accordance with generally accepted accounting principles. If the independent The audit lends credibility to CPA is satisfied that this standard has been met, his or her report contains the a set of financial statements. following language: The auditor does not attest to the absolute accuracy of the In our opinion, the financial statements . . . present fairly, in all material published information or to respects . . . in conformity with generally accepted accounting principles . . . the value of the company as an investment. All he or she This wording emphasizes that accounting and auditing are not exact sciences. renders is an opinion, based on Because the framework of GAAP provides room for interpretation and the appropriate testing, about the application of GAAP necessitates the making of estimates, the auditor can render fairness of the presentation of only an opinion about whether the financial statements present fairly or conform the financial information. in all material respects to GAAP. The auditor’s report does not preclude minor or immaterial errors in the financial statements. However, a favorable report from FOCUS ON BUSINESS PRACTICE IFRS: The Arrival of International Financial Reporting Standards in the United States Over the next few years, international financial and Exchange Commission (SEC) recently voted to reporting standards (IFRS) will become much more allow foreign registrants in the United States. This important in the United States and globally. The is a major development because in the past, the International Accounting Standards Board (IASB) SEC required foreign registrants to explain how the has been working with the Financial Accounting standards used in their statements differed from

Standards Board (FASB) and similar boards in other U.S. standards. This change affects approximately 10 nations to achieve identical or nearly identical stan- percent of all public U.S. companies. In addition, the dards worldwide. IFRS are now required in many SEC may in the near future allow U.S. companies to parts of the world, including Europe. The Securities- use IFRS.11 26 CHAPTER 1 Uses of Accounting Information and the Financial Statements the auditor does imply that, on the whole, investors (owners) and creditors can rely on the financial statements. Historically, auditors have enjoyed a strong repu- tation for competence and independence. The independent audit has been an important factor in the worldwide growth of financial markets. Organizations That Issue Accounting Standards Two organizations issue accounting standards that are used in the United States: Study Note the FASB and the IASB. The Financial Accounting Standards Board (FASB) The FASB is the primary source is the most important body for developing rules on accounting practice. This of GAAP, but the IASB is independent body has been designated by the Securities and Exchange Commis- increasing in importance. sion (SEC) to issue Statements of Financial Accounting Standards. With the growth of financial markets throughout the world, global coop- eration in the development of accounting principles has become a priority. The International Accounting Standards Board (IASB) has approved more than 40 international financial reporting standards (IFRS). Foreign companies may use these standards in the United States rather than having to convert their statements to U.S. GAAP as called for by the FASB standards. Other Organizations That Influence GAAP Many organizations directly or indirectly influence GAAP and so influence much of what is in this book. The Public Company Accounting Oversight Board (PCAOB), a governmen- Study Note tal body created by the Sarbanes-Oxley Act, regulates the accounting profession The PCAOB regulates audits of and has wide powers to determine the standards that auditors must follow and to public companies registered discipline them if they do not. with the Securities and The American Institute of Certified Public Accountants (AICPA), the pro- Exchange Commission. fessional association of certified public accountants, influences accounting prac- tice through the activities of its senior technical committees.* The Securities and Exchange Commission (SEC) is an agency of the federal Study Note government that has the legal power to set and enforce accounting practices for companies whose securities are offered for sale to the general public. As such, it The AICPA is the primary has enormous influence on accounting practice. professional organization of certified public accountants. The Governmental Accounting Standards Board (GASB), which is under the same governing body as the FASB, issues accounting standards for state and local governments. U.S. tax laws that govern the assessment and collection of revenue for operat- ing the federal government also influence accounting practice. Because a major source of the government’s revenue is the income tax, the tax laws specify the rules for determining taxable income. The Internal Revenue Service (IRS) interprets and enforces these rules. In some cases, the rules conflict with good a ccounting *In May 2005, the AICPA passed a resolution to start working with the FASB to develop GAAP for privately held, for-profit companies, which would result in recognition, measure- ment, and disclosure differences, where appropriate, from current GAAP for public compa- nies. If and when this resolution is acted upon, two sets of GAAP will exist: one for private companies and one for public companies. Generally Accepted Accounting Principles 27 practice, but they are nonetheless an important influence on practice. Cases in which the tax laws affect accounting practice are noted throughout this book. Professional Conduct The code of professional ethics of the American Institute of Certified Public

Accountants (and adopted, with variations, by each state) governs the conduct of CPAs. Fundamental to this code is responsibility to clients, creditors, investors (owners), and anyone else who relies on the work of a CPA. The code requires CPAs to act with integrity, objectivity, and independence. (cid:2) Integrity means the accountant is honest and candid and subordinates per- sonal gain to service and the public trust. (cid:2) Objectivity means the accountant is impartial and intellectually honest. (cid:2) Independence means the accountant avoids all relationships that impair or even appear to impair his or her objectivity. The accountant must also exercise due care in all activities, carrying out pro- fessional responsibilities with competence and diligence. For example, an accoun- tant must not accept a job for which he or she is not qualified, even at the risk of losing a client to another firm, and careless work is unacceptable. These broad principles are supported by more specific rules that public accountants must fol- low; for instance, with certain exceptions, client information must be kept strictly confidential. Accountants who violate the rules can be disciplined or even sus- pended from practice. The Institute of Management Accountants (IMA) also has a code of profes- Study Note sional conduct. It emphasizes that management accountants have a responsibility The IMA is the primary to be competent in their jobs, to keep information confidential except when autho- professional association of rized or legally required to disclose it, to maintain integrity and avoid conflicts of management accountants. interest, and to communicate information objectively and without bias.12 Corporate Governance The financial scandals at Enron, WorldCom, and other companies highlighted the importance of corporate governance, which is the oversight of a corporation’s management and ethics by its board of directors. Corporate governance is grow- ing and is clearly in the best interests of a business. A survey of 124 corporations in 22 countries found that 78 percent of boards of directors had established ethi- cal standards, a fourfold increase over a 10-year period. In addition, research has shown that, over time, companies with codes of ethics tend to have higher stock prices than those that have not adopted such codes.13 To strengthen corporate governance, a provision of the Sarbanes-Oxley Act requires boards of directors to establish an audit committee made up of indepen- dent directors who have financial expertise. This provision is aimed at ensuring that boards of directors are objective in evaluating management’s performance. The audit committee is also responsible for engaging the corporation’s indepen- dent auditors and reviewing their work. Another of the committee’s functions is to ensure that adequate systems exist to safeguard the corporation’s resources and that accounting records are reliable. In short, the audit committee is the front line of defense against fraudulent financial reporting. 28 CHAPTER 1 Uses of Accounting Information and the Financial Statements STOP & APPLY Match the common acronym with its description: _____ 1. GAAP a. Sets U.S. accounting standards _____ 2. IFRS b. Audits financial statements _____ 3. CPA c. Established by the Sarbanes-Oxley Act _____ 4. FASB d. Sets international accounting standards _____ 5. IASB e. Established by the FASB _____ 6. PCAOB f. Established by the IASB _____ 7. AICPA g. Influences accounting standards through _____ 8. SEC member CPAs h. Receives audited financial statements of public companies SOLUTION 1. c; 2. f; 3. b; 4. a; 5. d; 6. c; 7. g; 8. h (cid:2) KEEP-FIT CENTER: REVIEW PROBLEM The Decision Point at the beginning of this chapter focused on Keep-Fit Center, an apparently successful new company. Although the firm generated commissions from sales of property, the owner, Lilian Jackson, had these questions: • Is Keep-Fit Center meeting its goal of profitability? • As owner of Keep-Fit Center, what financial knowledge does Lilian Jackson need

to measure progress toward the company’s goals? • In deciding whether to make a loan to Keep-Fit Center, what financial knowledge would a bank need to evaluate the company’s financial performance? As you’ve learned in this chapter, managers and others with an interest in a business measure its profitability in financial terms such as net sales, net income, total assets, and owner’s equity and liquidity in terms such as cash flows. Owners and managers report on the progress they have made toward their financial goals in their company’s financial statements. Preparation and Interpretation of Financial Statements LO6 Keep-Fit Center: Review Problem 29 The following financial statement accounts and amounts are from the records of Keep-Fit Center for the year ended December 31, 2010, the company’s first year of operations: Accounts payable $ 19,000 Accounts receivable 104,000 Cash 111,000 Equipment 47,000 Fees revenue 375,000 Investment by L. Jackson 100,000 Marketing expense 18,000 Salaries 172,000 Salaries payable 78,000 Studio and equipment rent expense 91,000 Supplies 2,000 Supplies expense 6,000 Utilities expense 11,000 Withdrawals 10,000 Required 1. Prepare an income statement, statement of owner’s equity, and balance sheet for Keep-Fit Center. For examples, refer to Exhibit 1-5. 2. User insight: From the income statement and balance sheet, does it appear that Keep-Fit Center is profitable? Why or why not? Answers to 1. Preparation of financial statements Review Problem 30 CHAPTER 1 Uses of Accounting Information and the Financial Statements 2. Keep-Fit Center is profitable. The income statement shows that it earned $77,000 after expenses were deducted from fees revenue. Further, it may be observed that this $77,000 of net income is very good when compared to total assets of $264,000 and owner’s equity on the balance sheet. Stop & Review 31 STOP & REVIEW LO1 Defi ne accounting and Accounting is an information system that measures, processes, and communicates describe its role in financial information about an economic entity. It provides the information nec- making informed deci- essary to make reasoned choices among alternative uses of scarce resources in the sions, identify business conduct of business and economic activities. A business is an economic entity that engages in operating, investing, and financing activities to achieve the goals of goals and activities, and profitability and liquidity. explain the importance Management accounting focuses on the preparation of information primarily of ethics in accounting. for internal use by management. Financial accounting is concerned with the devel- opment and use of reports that are communicated to those outside the business as well as to management. Ethical financial reporting is important to the well-being of a company; fraudulent financial reports can have serious consequences for many people. LO2 Identify the users of Accounting plays a significant role in society by providing information to man- accounting information. agers of all institutions and to individuals with a direct financial interest in those institutions, including present or potential investors (owners) and creditors. Accounting information is also important to those with an indirect financial interest in the business—for example, tax authorities, regulatory agencies, and economic planners. LO3 Explain the importance To make an accounting measurement, the accountant must determine what is of business transactions, measured, when the measurement should be made, what value should be placed on money measure, and what is measured, and how to classify what is measured. The objects of accounting separate entity. measurement are business transactions. Financial accounting uses money measure to gauge the impact of these transactions on a separate business entity. LO4 Identify the three basic The three basic forms of business organization are the sole proprietorship, the part- forms of business nership, and the corporation. Accountants recognize each form as an economic organization. unit separate from its owners, although legally only the corporation is separate from

its owners. A sole proprietorship is a business owned by one person. A partnership is like a sole proprietorship in most ways, but it has two or more owners. A corpora- tion, on the other hand, is a business unit chartered by the state and legally separate from its owners (the stockholders). LO5 Defi ne fi nancial position, Financial position refers to a company’s economic resources and the claims against and state the accounting those resources at a particular time. The accounting equation shows financial equation. position as Assets (cid:2) Liabilities (cid:3) Owner’s Equity. Business transactions affect financial position by decreasing or increasing assets, liabilities, and owner’s equity in such a way that the accounting equation is always in balance. LO6 Identify the four basic The four basic financial statements are the income statement, the statement of fi nancial statements. owner’s equity, the balance sheet, and the statement of cash flows. They are the primary means by which accountants communicate the financial condition and activities of a business to those who have an interest in the business. 32 CHAPTER 1 Uses of Accounting Information and the Financial Statements LO7 Explain how generally Acceptable accounting practice consists of the conventions, rules, and procedures accepted accounting that make up generally accepted accounting principles at a particular time. GAAP principles (GAAP) and are essential to the preparation and interpretation of financial statements and the international fi nancial independent CPA’s report. Foreign companies registered in the United States may use international financial reporting standards (IFRS). reporting standards Among the organizations that influence the formulation of GAAP are (IFRS) relate to fi nancial the Public Company Accounting Oversight Board, the Financial Accounting statements and the inde- Standards Board, the American Institute of Certified Public Accountants, the pendent CPA’s report, Securities and Exchange Commission, and the Internal Revenue Service. and identify the orga- All accountants are required to follow a code of professional ethics, the founda- nizations that infl uence tion of which is responsibility to the public. Accountants must act with integrity, GAAP. objectivity, and independence, and they must exercise due care in all their activities. The board of directors is responsible for determining corporate policies and appointing corporate officers. It is also responsible for corporate governance, the oversight of a corporation’s management and ethics. The audit committee, which is appointed by the board and made up of independent directors, is an important factor in corporate governance. REVIEW of Concepts and Terminology The following concepts and terms Financial analysis 6 (LO1) Management 10 (LO2) were introduced in this chapter: Financial position 17 (LO5) Management accounting 7 (LO1) Accounting 4 (LO1) Financial statements 7 (LO1) Management information system Accounting equation 17 (LO5) Financing activities 6 (LO1) (MIS) 8 (LO1) American Institute of Certified Fraudulent financial reporting Money measure 14 (LO3) Public Accountants (AICPA) 8 (LO1) Net assets 18 (LO5) 26 (LO7) Generally accepted accounting Net income 18 (LO5) Assets 18 (LO5) principles (GAAP) 24 (LO7) Net loss 18 (LO5) Audit 25 (LO7) Governmental Accounting Objectivity 27 (LO1) Audit committee 27 (LO7) Standards Board (GASB) Operating activities 5 (LO1) Balance sheet 20 (LO6) 26 (LO7) Owner’s equity 18 (LO5) Bookkeeping 7 (LO1) Income statement 19 (LO6) Partnership 15 (LO4) Business 4 (LO1) Independence 27 (LO7) Performance measures 6 (LO1) Business transactions 14 (LO3) Institute of Management Accountants (IMA) 27 (LO7) Profitability 5 (LO1) Cash flows 21 (LO6) Public Company Accounting Integrity 27 (LO7) Certified public accountant (CPA) Oversight Board (PCAOB) 25 (LO7) Internal Revenue Service (IRS) 26 (LO7) 26 (LO7) Corporate governance 27 (LO7) Revenues 18 (LO5) International Accounting Standards Corporation 16 (LO4) Board (IASB) 26 (LO7) Sarbanes-Oxley Act 9 (LO1)

Due care 27 (LO7) Securities and Exchange Commis- International financial reporting Ethics 8 (LO1) standards (IFRS) sion (SEC) 12, 26 (LO2 and LO7) Exchange rate 14 (LO3) 26 (LO7) Separate entity 15 (LO3) Expenses 18 (LO5) Investing activities 5 (LO1) Sole proprietorship 15 (LO4) Financial accounting 7 (LO1) Liabilities 18 (LO5) Statement of cash flows 21 (LO6) Financial Accounting Standards Liquidity 5 (LO1) Statement of owner’s equity Board (FASB) 26 (LO7) 20 (LO6) Chapter Assignments 33 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises Short exercises are simple applications of chapter material for one or more learn- ing objectives. If you need help locating the related text discussions, refer to the LO numbers in the margin. LO1 Accounting and Business Enterprises SE 1. Match the terms on the left with the definitions on the right: _____ 1. Accounting a. The process of producing account- _____ 2. Profitability ing information for the internal use of a company’s management. _____ 3. Liquidity b. Having enough cash available to _____ 4. Financing activities pay debts when they are due. _____ 5. Investing activities c. Activities management engages in to _____ 6. Operating activities obtain adequate funds for beginning and continuing to operate a business. _____ 7. Financial accounting d. The process of generating and _____ 8. Management accounting communicating accounting infor- _____ 9. Ethics mation in the form of financial _____ 10. F raudulent financial statements to decision makers reporting outside the organization. e. Activities management engages in to spend capital in ways that are productive and will help a business achieve its objectives. f. The ability to earn enough income to attract and hold investment capital. g. An information system that mea- sures, processes, and communi- cates financial information about an identifiable economic entity. h. The intentional preparation of mis- leading financial statements. i. Activities management engages in to operate the business. j. A code of conduct that addresses whether actions are right or wrong. LO3 LO4 Accounting Concepts SE 2. Indicate whether each of the following words or phrases relates most closely to (a) a business transaction, (b) a separate entity, or (c) a money measure: 1. Partnership 4. Sole proprietorship 2. U.S. dollar 5. Sale of an asset 3. Payment of an expense 34 CHAPTER 1 Uses of Accounting Information and the Financial Statements LO4 Forms of Business Organization SE 3. Match the descriptions on the left with the forms of business organization on the right: _____ 1. Most numerous a. Sole proprietorship b. Partnership _____ 2. Commands most revenues c. Corporation _____ 3. Has two or more co-owners _____ 4. Has stockholders _____ 5. Is owned by only one person _____ 6. Has a board of directors LO5 The Accounting Equation SE 4. Determine the amount missing from each accounting equation below. Assets (cid:2) Liabilities (cid:3) Owner’s Equity 1. ? $50,000 $ 70,000 2. $156,000 $84,000 ? 3. $292,000 ? $192,000 LO5 The Accounting Equation SE 5. Use the accounting equation to answer each question below. 1. The assets of Aaron Company are $240,000, and the liabilities are $90,000. What is the amount of the owner’s equity? 2. The liabilities of Oak Company equal one-fifth of the total assets. The own- er’s equity is $40,000. What is the amount of the liabilities? LO5 The Accounting Equation SE 6. U se the accounting equation to answer each question below. 1. At the beginning of the year, Fazio Company’s assets were $45,000, and its own- er’s equity was $25,000. During the year, assets increased by $30,000 and liabili- ties increased by $5,000. What was the owner’s equity at the end of the year? 2. At the beginning of the year, Gal Company had liabilities of $50,000 and owner’s equity of $96,000. If assets increased by $40,000 and liabilities decreased by $30,000, what was the owner’s equity at the end of the year? LO5 The Accounting Equation and Net Income SE 7. Carlton Company had assets of $280,000 and liabilities of $120,000 at the

beginning of the year, and assets of $400,000 and liabilities of $140,000 at the end of the year. During the year, the owner invested an additional $40,000 in the business, and the company made withdrawals of $48,000. What amount of net income did the company earn during the year? LO6 Preparation and Completion of a Balance Sheet SE 8. Use the following accounts and balances to prepare a balance sheet with the accounts in proper order for Global Company at June 30, 2010, using Exhibit 1-3 as a model: Accounts Receivable $ 1,600 Wages Payable 700 Owner’s Capital 28,700 Building 22,000 Cash ? Chapter Assignments 35 LO6 Preparation of Financial Statements SE 9. Tarech Company engaged in activities during the first year of its operations that resulted in the following: service revenue, $4,800; expenses, $2,450; and withdrawals, $410. In addition, the year-end balances of selected accounts were as follows: Cash, $1,890; Other Assets, $1,000; Accounts Payable, $450; and Owner’s Capital, $500. In proper format, prepare the income statement, state- ment of retained earnings, and balance sheet for Tarech Company (assume the year ends on December 31, 2010). (Hint: You must solve for the beginning and ending balances of Owner’s Equity for 2010.) Exercises Exercises are more complex applications of chapter concepts than short exercises. LO1 LO2 Discussion Questions LO3 LO4 E 1. Develop a brief answer to each of the following questions: 1. What makes accounting a valuable discipline? 2. Why do managers in governmental and not-for-profit organizations need to understand financial information as much as managers in profit-seeking businesses do? 3. Are all economic events business transactions? 4. Sole proprietorships, partnerships, and corporations differ legally; how and why does accounting treat them alike? LO1 LO5 Discussion Questions LO6 LO7 E 2. Develop a brief answer to each of the following questions: 1. How are expenses and withdrawals similar, and how are they different? 2. In what ways are CVS and Southwest Airlines comparable? Not comparable? 3. How do generally accepted accounting principles (GAAP) differ from the laws of science? 4. What are some unethical ways in which a business may do its accounting or prepare its financial statements? LO1 LO2 The Nature of Accounting LO3 LO7 E 3. Match the terms on the left with the descriptions on the right: _____ 1. Bookkeeping a. The recording of all business trans- actions in terms of money _____ 2. Creditors b. A process by which information _____ 3. Money measure is exchanged between individuals _____ 4. F inancial Accounting through a common system of Standards Board (FASB) symbols, signs, or behavior _____ 5. Business transactions c. The process of identifying and assign- _____ 6. Financial statements ing values to business transactions d. Legislation ordering CEOs and _____ 7. Communication CFOs to swear that any reports _____ 8. S ecurities and Exchange they file with the SEC are accurate Commission (SEC) and complete _____ 9. Investors e. Shows how well a company is _____ 10. Sarbanes-Oxley Act meeting the goals of profitability and liquidity _____ 11. Management f. Collectively, the people who have _____ 12. M anagement information overall responsibility for operating system a business and meeting its goals 36 CHAPTER 1 Uses of Accounting Information and the Financial Statements g. People who commit money to earn a financial return h. The interconnected subsystems that provide the information needed to run a business i. The most important body for developing and issuing rules on accounting practice, called Statements of Financial Accounting Standards j. An agency set up by Congress to protect the public by regulating the issuing, buying, and selling of stocks k. Economic events that affect a busi- ness’s financial position l. People to whom money is due LO2 LO4 Users of Accounting Information and Forms of Business Organization E 4. Gottlieb Pharmacy has recently been formed to develop a new type of drug treatment for cancer. Previously a partnership, Gottlieb has now become a cor-

poration. Describe the various groups that will have an interest in the financial statements of Gottlieb. What is the difference between a partnership and a corpo- ration? What advantages does the corporate form have over the partnership form of business organization? LO3 Business Transactions E 5. Velu owns and operates a minimart. Which of Velu’s actions described below are business transactions? Explain why any other actions are not considered trans- actions. 1. Velu reduces the price of a gallon of milk in order to match the price offered by a competitor. 2. Velu pays a high school student cash for cleaning up the driveway behind the market. 3. Velu fills his son’s car with gasoline in payment for his son’s restocking the vending machines and the snack food shelves. 4. Velu pays interest to himself on a loan he made to the business three years ago. LO3 LO4 Accounting Concepts E 6. Financial accounting uses money measures to gauge the impact of business transactions on a separate business entity. Indicate whether each of the following words or phrases relates most closely to (a) a business transaction, (b) a separate entity, or (c) a money measure: 1. Corporation 5. Sole proprietorship 9. Japanese yen 2. Euro 6. U.S. dollar 10. Purchase of supplies 3. Sales of products 7. Partnership 4. Receipt of cash 8. Owner’s investments LO3 Money Measure E 7. You have been asked to compare the sales and assets of four companies that make computer chips to determine which company is the largest in each category. You have gathered the following data, but they cannot be used for direct com- parison because each company’s sales and assets are in its own currency: Chapter Assignments 37 Company (Currency) Sales Assets U.S. Chip (U.S. dollar) 2,750,000 1,300,000 Nanhai (Hong Kong dollar) 5,000,000 2,800,000 Tova (Japanese yen) 350,000,000 290,000,000 Holstein (Euro) 3,500,000 3,900,000 Assuming that the exchange rates in Table 1-1 are current and appropriate, con- vert all the figures to U.S. dollars and determine which company is the largest in sales and which is the largest in assets. LO5 The Accounting Equation E 8. Use the accounting equation to answer each question that follows. Show any calculations you make. 1. The assets of Rasche Company are $380,000, and the owner’s equity is $155,000. What is the amount of the liabilities? 2. The liabilities and owner’s equity of Lee Company are $65,000 and $79,500, respectively. What is the amount of the assets? 3. The liabilities of Hurka Company equal one-third of the total assets, and owner’s equity is $180,000. What is the amount of the liabilities? 4. At the beginning of the year, Jahis Company’s assets were $310,000, and its owner’s equity was $150,000. During the year, assets increased $45,000 and liabilities decreased $22,500. What is the owner’s equity at the end of the year? LO5 LO6 Identification of Accounts E 9. 1. Indicate whether each of the following accounts is an asset (A), a liability (L), or a part of owner’s equity (OE): a. Cash d. Owner’s Capital g. Supplies b. Salaries Payable e. Land c. Accounts Receivable f. Accounts Payable 2. Indicate whether each account below would be shown on the income state- ment (IS), the statement of owner’s equity (OE), or the balance sheet (BS). a. Repair Revenue d. Cash g. Withdrawals b. Automobile e. Rent Expense c. Fuel Expense f. Accounts Payable LO6 Preparation of a Balance Sheet E 10. Listed in random order are some of the account balances for the Uptime Services Company as of December 31, 2011. Accounts Payable $ 25,000 Accounts Receivable $31,250 Building 56,250 Cash 12,500 Owner’s Capital 106,250 Equipment 25,000 Supplies 6,250 Place the balances in proper order and prepare a balance sheet similar to the one in Exhibit 1-3. LO6 Preparation and Integration of Financial Statements E 11. Proviso Company had the following accounts and balances during 2010: S ervice Revenue, $26,400; Rent Expense, $2,400; Wages Expense, $16,680; Advertising Expense, $2,700; Utilities Expense, $1,800; and With- drawals, $1,400. In addition, the year-end balances of selected accounts were

38 CHAPTER 1 Uses of Accounting Information and the Financial Statements as follows: Cash, $3,100; Accounts Receivable, $1,500; Supplies, $200; Land, $2,000; Accounts Payable, $900; Investment by Owner, $2,480; and begin- ning capital balance of $2,000. In proper format, prepare the income statement, statement of owner’s equity, and balance sheet for Proviso Company (assume the year ends on December 31, 2010). (Hint: You must solve for the beginning and ending balances of owner’s equity for 2010.) LO5 Owner’s Equity and the Accounting Equation E 12. The total assets and liabilities at the beginning and end of the year for Schu- pan Company are listed below. Assets Liabilities Beginning of the year $180,000 $ 68,750 End of the year 275,000 150,500 Determine Schupan Company’s net income or loss for the year under each of the following alternatives: 1. The owner made no investments in or withdrawals from the business during the year. 2. The owner made no investments in the business but withdrew $27,500 during the year. 3. The owner invested $16,250 in the business but made no withdrawals during the year. 4. The owner invested $12,500 in the business and withdrew of $29,000 during the year. LO6 Statement of Cash Flows E 13. Martin Service Company began the year 2010 with cash of $55,900. In addition to earning a net income of $38,000 and making cash withdrawals of $19,500, Martin Service borrowed $78,000 from the bank and purchased equip- ment with $125,000 of cash. Also, Accounts Receivable increased by $7,800, and Accounts Payable increased by $11,700. Determine the amount of cash on hand at December 31, 2010, by preparing a statement of cash flows similar to the one in Exhibit 1–4. LO4 LO5 Statement of Owner’s Equity LO6 E 14. Below is information from the statement of owner’s equity of Mrs. Kitty’s Cookies for a recent year. Withdrawals 0 Net income ? Owner’s Equity, January 31, 2010 $159,490 Owner’s Equity, January 31, 2009 $105,000 Prepare the statement of owner’s equity for Mrs. Kitty’s Cookies in good form. You will need to solve for the amount of net income. What is owner’s equity? Why might the owner decide not to make any withdrawals from the company? LO7 Accounting Abbreviations E 15. Identify the accounting meaning of each of the following abbreviations: AICPA, SEC, PCAOB, GAAP, FASB, IRS, GASB, IASB, IMA, and CPA. Chapter Assignments 39 Problems LO6 Preparation and Interpretation of Financial Statements P 1. B elow is a list of financial statement items. ____ Utilities expense ____ Equipment ____ Withdrawals ____ Building ____ Revenues ____ Fees earned ____ Owner’s capital ____ Accounts receivable ____ Cash ____ Net income ____ Accounts payable ____ Supplies ____ Land ____ Rent expense ____ Wages expense Required 1. Indicate whether each item is found on the income statement (IS), statement of owner’s equity (OE), and/or balance sheet (BS). User insight (cid:2) 2. Which statement is most closely associated with the goal of profitability? LO6 Integration of Financial Statements P 2. The following three independent sets of financial statements have several amounts missing: Income Statement Set A Set B Set C Revenues $5,320 $ 8,600 $ m Expenses a g 2,010 Net income $ 510 $ h $ n Statement of Owner’s Equity Beginning balance $1,780 $15,400 $ 200 Net income b i 450 Less withdrawals c 1,000 o Ending balance $ d $16,000 $ p Balance Sheet Total assets $ e $ j $1,900 Liabilities $ f $ 2,000 $1,300 Owner’s equity Owner’s capital 2,100 k q Total liabilities and owner’s equity $2,700 $ l $ r Required 1. Complete each set of financial statements by determining the amounts that correspond to the letters. User insight (cid:2) 2. Why is it necessary to prepare the income statement prior to the balance sheet? Curious if you got the right answer? Look at the Check Figures section that pre- cedes Chapter 1. LO1 LO6 Preparation and Interpretation of Financial Statements P 3. Below are the financial accounts of Special Assets. The company has just completed its 10th year of operations ended December 31, 2011. Accounts Payable $ 3,600

Accounts Receivable 4,500 Cash 71,700 Commission Sales Revenue 400,000 Commissions Expense 225,000 Commissions Payable 22,700 40 CHAPTER 1 Uses of Accounting Information and the Financial Statements Equipment $59,900 Marketing Expense 20,100 Office Rent Expense 36,000 Owner’s Capital, December 31, 2010 64,300 Supplies 700 Supplies Expense 2,600 Telephone and Computer Expenses 5,100 Wages Expense 32,000 Withdrawals 33,000 Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Special Assets. There were no investments by the owner during the year. User insight (cid:2) 2. The owner is considering expansion. What other statement would be useful to the owner in assessing whether the company’s operations are generating suffi- cient funds to support the expenses? Why would it be useful? LO4 LO6 Preparation and Interpretation of Financial Statements P 4. The following are the accounts of Unique Ad, an agency that develops mar- keting materials for print, radio, and television. The agency’s first year of opera- tions just ended on January 31, 2010. Accounts Payable $ 19,400 Accounts Receivable 24,900 Advertising Service Revenue 165,200 Cash 1,800 Equipment Rental Expense 37,200 Marketing Expense 6,800 Office Rent Expense 13,500 Owner’s Capital 5,000* Salaries Expense 86,000 Salaries Payable 1,300 Supplies 1,600 Supplies Expense 19,100 Withdrawals 0 *Represents the initial investment by the owner. Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Unique Ad. User insight (cid:2) 2. Review the financial statements and comment on the financial challenges Unique Ad faces. LO1 LO6 Use and Interpretation of Financial Statements LO7 P 5. The financial statements for the Oros Riding Club follow. Chapter Assignments 41 Oros Riding Club Income Statement For the Month Ended November 30, 2011 Revenues Riding lesson revenue $4,650 Locker rental revenue 1,450 Total revenues $6,100 Expenses Salaries expense $1,125 Feed expense 750 Utilities expense 450 Total expenses 2,325 Net income $3,775 Oros Riding Club Statement of Owner’s Equity For the Month Ended November 30, 2011 Owner’s capital, October 31, 2011 $35,475 Investment by owner 6,000 Net income for the month 3,775 Subtotal $45,250 Less withdrawals 2,400 Owner’s capital, November 30, 2011 $42,850 Oros Riding Club Balance Sheet November 30, 2011 Assets Liabilities Cash $ 6,700 Accounts payable $11,250 Accounts receivable 900 Owner’s Equity Supplies 750 Owner’s capital 42,850 Land 15,750 Building 22,500 Horses 7,500 Total liabilities and Total assets $54,100 owner’s equity $54,100 42 CHAPTER 1 Uses of Accounting Information and the Financial Statements Oros Riding Club Statement of Cash Flows For the Month Ended November 30, 2011 Cash flows from operating activities Net income $3,775 Adjustments to reconcile net income to net cash flows from operating activities Increase in accounts receivable $ (400) Increase in supplies (550) Increase in accounts payable 400 (550) Net cash flows from operating activities $3,225 Cash flows from investing activities Purchase of horses $2,000 Sale of horses (1,000) Net cash flows from financing activities 1,000 Cash flows from financing activities Investment by Owner $6,000 Cash withdrawals (2,400) Net cash flows from financing activities 3,600 Net increase in cash $7,825 Cash at beginning of month 475 Cash at end of month $8,300 Required User insight (cid:2) 1. Explain how the four statements for Oros Riding Club relate to each other. User insight (cid:2) 2. Which statements are most closely associated with the goals of liquidity and profitability? Why? User insight (cid:2) 3. If you were the owner of this business, how would you evaluate the com- pany’s performance? Give specific examples. User insight (cid:2) 4. If you were a banker considering Oros Riding Club for a loan, why might you want the company to be audited by an independent CPA? What would the audit tell you? Looking for more practice? Alternate problems have the same format and learn- ing objectives as problems that appear earlier. Alternate Problems

LO6 Integration of Financial Statements P 6. Below are three independent sets of financial statements with several amounts missing. Chapter Assignments 43 Income Statement Set A Set B Set C Revenues $ 1,200 $ g $ 240 Expenses a 5,000 m Net income $ b $ h $ 148 Statement of Owner’s Equity Beginning balance $ 2,900 $24,400 $ 340 Net income c 1,600 n Less withdrawals 200 i o Ending balance $ 3,090 $ j $ p Balance Sheet Total assets $ d $30,000 $ q Liabilities $1,600 $ 5,000 $ r Owner’s equity Owner’s capital e k 380 Total liabilities and owner’s equity $ f $ l $ 580 Required 1. Complete each set of financial statements by determining the amounts that correspond to the letters. User insight (cid:2) 2. In what order is it necessary to prepare the financial statements and why? LO1 LO6 Preparation and Interpretation of Financial Statements P 7. Below are the financial accounts of Metro Labs. The company has just com- pleted its third year of operations ended November 30, 2011. Accounts Payable $ 7,400 Accounts Receivable 51,900 Cash 115,750 Design Service Revenue 300,000 Marketing Expense 19,700 Office Rent Expense 50,000 Owner’s Capital, November 30, 2010 70,400 Salaries Expense 96,000 Salaries Payable 2,700 Supplies 800 Supplies Expense 6,350 Withdrawals 40,000 Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Metro Labs. There were no investments by the owner during the year. User insight (cid:2) 2. Evaluate the company’s ability to meet its bills when they come due. LO4 LO6 Preparation and Interpretation of Financial Statements P 8. Below are the accounts of Giordano’s Pizza. The company has just com- pleted its first year of operations ended September 30, 2010. Accounts Payable $10,500 Accounts Receivable 13,200 Cash 2,600 Delivery Truck Rent Expense 7,200 44 CHAPTER 1 Uses of Accounting Information and the Financial Statements Equipment $ 6,300 Equipment Rental Expense 2,900 Marketing Expense 1,500 Owner’s Capital 2,000* Pizza Revenue 82,000 Salaries Expense 56,000 Salaries Payable 700 Supplies 400 Supplies Expense 4,100 Withdrawals 1,000 *Represents the initial investment by the owner Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Giordano’s Pizza. User insight (cid:2) 2. Why would the owner of Giordano’s Pizza set his business up as a sole pro- prietorship and not a partnership? Discuss the advantages of the two forms of business organizations. LO6 Integration of Financial Statements P 9. Below are three independent sets of financial statements with several amounts missing. Income Statement Set X Set Y Set Z Revenues $1,100 $ g $240 Expenses a 5,200 m Net income $ b $ h $ 80 Statement of Owner’s Equity Beginning balance $2,900 $24,400 $240 Net income c 1,600 n Less withdrawals 200 i o Ending balance $3,000 $ j $ p Balance Sheetz Total assets $ d $31,000 $ q Liabilities $1,600 $ 5,000 $ r Owner’s equity Owner’s capital e k 280 Total liabilities and owner’s equity $ f $ l $580 Required 1. Complete each set of financial statements by determining the amounts that correspond to the letters. User insight (cid:2) 2. In what order is it necessary to prepare the financial statements and why? LO6 Preparation and Interpretation of Financial Statements P 10. Below are the financial accounts of Brad Realty. The company has just com- pleted its 10th year of operations ended December 31, 2011. Accounts Payable $ 3,600 Accounts Receivable 4,500 Cash 91,600 Commission Sales Revenue 450,000 Commissions Expense 225,000 Commissions Payable 22,700 Chapter Assignments 45 Equipment $59,000 Marketing Expense 29,200 Office Rent Expense 36,000 Owner’s Capital, December 31, 2010 50,300 Supplies 700 Supplies Expense 2,600 Telephone and Computer Expenses 5,100 Wages Expense 32,000 Withdrawals 40,000 Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Brad Realty. There were no investments by the owner during the year. User insight (cid:2) 2. The owner is considering expansion. What other statement would be useful to the owner in assessing whether the company’s operations are generating suffi-

cient funds to support expenses? Why would it be useful? ENHANCING Your Knowledge, Skills, and Critical Thinking LO1 LO2 Business Activities and Management Functions C 1. Costco Wholesale Corporation is America’s largest membership retail company. According to its letter to stockholders: Our mission is to bring quality goods and services to our members at the lowest possible price in every market where we do business. . . . A hallmark of Costco warehouses has been the extraordinary sales volume we achieve.14 To achieve its business goals, Costco must organize its management by functions that relate to the principal activities of a business. Discuss the three basic activities Costco will engage in to achieve its goals, and suggest some examples of each. What is the role of Costco’s management? What functions must its management perform to carry out these activities? LO5 Concept of an Asset C 2. Southwest Airlines Co. is one of the most successful airlines in the United States. Its annual report contains this statement: “We are a company of People, not Planes. That is what distinguishes us from other airlines and other com- panies. At Southwest Airlines, People are our most important asset.”15 Are employees considered assets in the financial statements? Why or why not? Dis- cuss in what sense Southwest considers its employees to be assets. LO7 Generally Accepted Accounting Principles C 3. Fidelity Investments Company is a well-known mutual fund investment company. It makes investments worth billions of dollars in companies listed on the New York Stock Exchange and other stock markets. Generally accepted accounting principles (GAAP) are very important for Fidelity’s investment ana- lysts. What are generally accepted accounting principles? Why are financial state- ments that have been prepared in accordance with GAAP and audited by an independent CPA useful for Fidelity’s investment analysts? What organizations influence GAAP? Explain how they do so. 46 CHAPTER 1 Uses of Accounting Information and the Financial Statements LO7 Professional Ethics C 4. Discuss the ethical choices in the situations below. In each instance, describe the ethical dilemma, determine the alternative courses of action, and tell what you would do. 1. You are the payroll accountant for a small business. A friend asks you how much another employee is paid per hour. 2. As an accountant for the branch office of a wholesale supplier, you discover that several of the receipts the branch manager has submitted for reimburse- ment as selling expenses actually stem from nights out with his spouse. 3. You are an accountant in the purchasing department of a construction com- pany. When you arrive home from work on December 22, you find a large ham in a box marked “Happy Holidays—It’s a pleasure to work with you.” The gift is from a supplier who has bid on a contract your employer plans to award next week. 4. As an auditor with one year’s experience at a local CPA firm, you are expected to complete a certain part of an audit in 20 hours. Because of your lack of experience, you know you cannot finish the job within that time. Rather than admit this, you are thinking about working late to finish the job and not telling anyone. 5. You are a tax accountant at a local CPA firm. You help your neighbor fill out her tax return, and she pays you $200 in cash. Because there is no record of this transaction, you are considering not reporting it on your tax return. 6. The accounting firm for which you work as a CPA has just won a new client, a firm in which you own 200 shares of stock that you received as an inheri- tance from your grandmother. Because it is only a small number of shares and you think the company will be very successful, you are considering not disclosing the investment. LO6 LO7 Analysis of Four Basic Financial Statements C 5. Refer to the CVS annual report in the Supplement to Chapter 5 to answer the questions below. Keep in mind that every company, while following basic principles, adapts financial statements and terminology to its own special needs.

Therefore, the complexity of CVS’s financial statements and the terminology in them will differ somewhat from the financial statements in the text. 1. What titles does CVS give to its four basic financial statements? (Note that the word consolidated in the titles of the financial statements means that these statements combine those of several companies owned by CVS.) 2. Prove that the accounting equation works for CVS on December 31, 2008, by finding the amounts for the following equation: Assets (cid:2) Liabilities (cid:3) Shareholders’ (Owner’s) Equity. 3. What were the total revenues of CVS for the year ended December 31, 2008? 4. Was CVS profitable in the year ended December 31, 2008? How much was net income (loss) in that year, and did it increase or decrease from the year ended December 29, 2007? 5. Did the company’s cash and cash equivalents increase from December 29, 2007, to December 31, 2008? If so, by how much? In what two places in the statements can this number be found or computed? 6. Did cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities increase or decrease from 2007 to 2008? 7. Who is the auditor for the company? Why is the auditor’s report that accom- panies the financial statements important? Chapter Assignments 47 LO1 LO5 Performance Measures and Financial Statements C 6. Refer to the CVS annual report and the financial statements of Southwest Airlines Co. in the Supplement to Chapter 5 to answer these questions: 1. Which company is larger in terms of assets and in terms of revenues? What do you think is the best way to measure the size of a company? 2. Which company is more profitable in terms of net income? What is the trend of profitability over the past three years for both companies? 3. Which company has more cash? Which increased its cash the most in the last year? Which has more liquidity as measured by cash flows from operating activities? C H A P T E R 2 Analyzing Business Transactions A ll business transactions require the application of three basic Making a Statement accounting concepts: recording a transaction at the right time, placing the right value on it, and calling it by the right name. INCOME STATEMENT Most accounting frauds and mistakes violate one or more of these Revenues basic accounting concepts. What you learn in this chapter will help – Expenses you avoid making such mistakes. It will also help you recognize correct accounting practices. = Net Income STATEMENT OF LEARNING OBJECTIVES OWNER’S EQUITY Beginning Balance LO1 Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are + Net Income important factors in ethical financial reporting. (pp. 50–53) – Withdrawals = Ending Balance LO2 Explain the double-entry system and the usefulness of T accounts in analyzing business transactions. (pp. 54–57) BALANCE SHEET LO3 Demonstrate how the double-entry system is applied to Assets Liabilities common business transactions. (pp. 58–65) Owner’s LO4 Prepare a trial balance, and describe its value and Equity limitations. (pp. 65–67) A = L + OE LO5 Show how the timing of transactions affects cash flows and liquidity. (pp. 68–69) STATEMENT OF CASH FLOWS Operating activities + Investing activities + Financing activities SUPPLEMENTAL OBJECTIVE = Change in Cash + Beginning Balance SO6 Define the chart of accounts, record transactions in the general = Ending Cash Balance journal, and post transactions to the ledger. (pp. 70–75) Business transactions can affect all the financial statements. 48 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Is there a difference between an economic event and a business PAWS AND HOOFS CLINIC transaction that should be recorded in the accounting records? After graduating from veterinary school, Larry Cox started the Paws and Hoofs Clinic. On his second day of business, he received a stand- (cid:2) Can a business transaction benefit a business even though ing order from Quarter Horse Stables to examine its horses on a no cash is received when the

monthly basis for one year. The fee for the service was to be $500 transaction takes place? per visit, or $6,000 for the year. Confident that his agreement with (cid:2) What is the difference between Quarter Horse Stables will work out, Larry is thinking of including the an asset and an expense? $6,000 in his financial statements. He believes that doing so would be a good advertisement for his business, but he must answer the questions at right to determine if this is acceptable practice. 4499 50 CHAPTER 2 Analyzing Business Transactions Measurement Business transactions are economic events that affect a company’s financial posi- Issues tion. As shown in Figure 2-1, to measure a business transaction, you must decide when the transaction occurred (the recognition issue), what value to place on LO1 Explain how the concepts the transaction (the valuation issue), and how the components of the transaction should be categorized (the classification issue). of recognition, valuation, and These three issues—recognition, valuation, and classification—underlie almost classification apply to business every major decision in financial accounting today. They are at the heart of account- transactions and why they are ing for pension plans, mergers of giant companies, and international transactions. important factors in ethical In discussing these issues, we follow generally accepted accounting principles and financial reporting. use an approach that promotes an understanding of basic accounting concepts. Keep in mind, however, that measurement issues can be controversial and resolu- tions to them are not always as cut-and-dried as the ones presented here. Recognition The recognition issue refers to the difficulty of deciding when a business transac- Study Note tion should be recorded. The resolution of this issue is important because the date In accounting, recognize means on which a transaction is recorded affects amounts in the financial statements. to record a transaction or event. To illustrate some of the factors involved in the recognition issue, suppose a company wants to purchase an office desk. The following events take place: 1. An employee sends a purchase requisition for the desk to the purchasing department. 2. The purchasing department sends a purchase order to the supplier. 3. The supplier ships the desk. 4. The company receives the desk. Study Note 5. The company receives the bill from the supplier. A purchase should usually not be recognized (recorded) before 6. The company pays the bill. title is transferred, because According to accounting tradition, a transaction should be recorded when until that point, the vendor title to merchandise passes from the supplier to the purchaser and creates an obli- has not fulfilled its contractual gation to pay. Thus, depending on the details of the shipping agreement for the obligation and the buyer has no desk, the transaction should be recognized (recorded) at the time of either event liability. 3 or 4. This is the guideline we generally use in this book. However, many small FIGURE 2-1 The Role of Measurement Issues ECONOMIC EVENTS RECOGNITION VALUATION CLASSIFICATION BUSINESS TRANSACTIONS THAT AFFECT FINANCIAL POSITION Measurement Issues 51 FOCUS ON BUSINESS PRACTICE Accounting Policies: Where Do You Find Them? The Boeing Company, one of the world’s makers of air- this question and others about companies’ accounting poli- liners, takes orders for planes years in advance. Although cies can be found in the Summary of Significant Accounting it is an important economic event to both Boeing and the Policies in their annual reports. For example, in that section buyer, neither the buyer nor the seller would record the of its annual report, Boeing states: “We recognize sales for event as a transaction. So, how do you know when compa- commercial airplane deliveries as each unit is completed nies record sales or purchase transactions? The answer to and accepted by the customer.”1 businesses that have simple accounting systems do not record a transaction until they receive a bill (event 5) or pay it (event 6), because these are the implied

points of title transfer. The predetermined time at which a transaction should be recorded is the recognition point. Although purchase requisitions and purchase orders (events 1 and 2) are eco- nomic events, they do not affect a company’s financial position, and they are not recognized in the accounting records. Even the most important economic events may not be recognized in the accounting records. Here are some more examples of economic events that should and should not be recorded as business transactions: Events That Are Not Recorded Events That Are Recorded as Transactions as Transactions A customer inquires about the A customer buys a service. availability of a service. A company hires a new employee. A company pays an employee for work performed. A company signs a contract to A company performs a service. provide a service in the future. The recognition issue can be difficult to resolve. Consider an advertising agency that is planning a major advertising campaign for a client. Employees may work on the plan several hours a day for a number of weeks. They add value to the plan as they develop it. Should this added value be recognized as the plan is being developed or at the time it is completed? Usually, the increase in value is recorded at the time the plan is finished and the client is billed for it. However, if a plan is going to take a long time to develop, the agency and the client may agree that the client will be billed at key points during its development. In that case, a transaction is recorded at each billing. Valuation Study Note The valuation issue focuses on assigning a monetary value to a business trans- action and accounting for the assets and liabilities that result from the business The value of a transaction transactions. Generally accepted accounting principles state that all business usually is based on a business document—a canceled check transactions should be valued at fair value when they occur. Fair value is defined or an invoice. as the exchange price of an actual or potential business transaction between mar- ket participants.2 This practice of recording transactions at exchange price at the 52 CHAPTER 2 Analyzing Business Transactions FOCUS ON BUSINESS PRACTICE The Challenge of Fair Value Accounting The measurement of fair value is a major challenge in merg- h ypothetical transaction that in many cases is difficult to ing international financial reporting standards (IFRS) with measure: It represents the selling price of an asset or the U.S. GAAP. Both the International Accounting Standards payment price of a liability. It does not represent the price Board (IASB) and the Financial Accounting Standards Board of acquiring the asset or assuming the liability. In practice, (FASB) are committed to this effort. Fair value is the price the potential selling price of equipment used in a factory to sell an asset or transfer a liability in an orderly market or an investment in a private company for which no ready by an arm’s-length transaction. Fair value represents a market exists may not be easy to determine. point of recognition is commonly referred to as the cost principle. It is used because the cost, or exchange price, is verifiable. For example, when Larry Cox performs the service for Quarter Horse Stables described in the Decision Point at the beginning of this chapter, he and Quarter Horse Stables will record the trans- action in their respective records at the price they have agreed on. Normally, the value of an asset is held at its initial fair value or cost until the asset is sold, expires, or is consumed. However, if there is evidence that the fair value of the asset or liability has changed, an adjustment to the initial value may be required. There are different rules for the application of fair value to different classes of assets. For example, a building or equipment remains at cost unless there is convincing evidence that the fair value is less than cost. In this case, a loss should be recorded to reduce the value from its cost to fair value. Investments,

on the other hand, are often accounted for at fair value, regardless of whether fair value is greater or less than cost. Because these investments are available for sale, the fair value is the best measure of the potential benefit to the company. In its annual report, Intel Corporation states: “Investments designated as available-for- sale on the balance sheet date are reported at fair value.”3 FOCUS ON BUSINESS PRACTICE No Dollar Amount: How Can That Be? Determining the value of a sale or purchase transaction (cid:2) An office supply company provides a year’s sup- isn’t difficult when the value equals the amount of cash ply of computer paper to a local weekly newspaper that changes hands. However, barter transactions, in which in exchange for an advertisement in 52 issues of the exchanges are made but no cash changes hands, can make newspaper. valuation more complicated. Barter transactions are quite (cid:2) Two Internet companies each provide an advertisement common in business today. Here are some examples: and link to the other’s website on their own websites. (cid:2) A consulting company provides its services to an auto Determining the value of these transactions is a matter of dealer in exchange for the loan of a car for a year. determining the fair value of the items being traded. Measurement Issues 53 Classification The classification issue has to do with assigning all the transactions in which a Study Note business engages to appropriate categories, or accounts. Classification of debts can affect a company’s ability to borrow money, and classification of purchases If CVS buys paper towels to can affect its income. One of the most important classification issues in account- resell to customers, the cost ing is the difference between an expense and an asset, both represented by debits would be recorded as an asset in the accounts. To use the Decision Point case again as an example, if Larry Cox in the Inventory account. If buys medicines that are used immediately, their cost is classified as an expense. If the paper towels are used for the medicines will be used in the future, they are classified as assets. cleaning in the store, the cost is an expense. As we explain later in the chapter, proper classification depends not only on correctly analyzing the effect of each transaction on a business but also on main- taining a system of accounts that reflects that effect. Ethics and Measurement Issues Recognition, valuation, and classification are important factors in ethical financial reporting, and generally accepted accounting principles provide direction about their treatment. These guidelines are intended to help managers meet their obligation to their company’s owners and to the public. Many of the worst financial reporting frauds over the past several years have resulted from violations of these guidelines. (cid:2) Computer Associates violated the guidelines for recognition when it kept its books open a few days after the end of a reporting period so revenues could be counted a quarter earlier than they should have been. In all, the company prematurely reported $3.3 billion in revenues from 363 software contracts. When the SEC ordered the company to stop the practice, Computer Associ- ates’ stock price dropped by 43 percent in a single day. (cid:2) Among its many other transgressions, Enron Corporation violated the guide- lines for valuation when it valued assets that it transferred to related compa- nies at far more than their actual value. (cid:2) By a simple violation of the guidelines for classification, WorldCom (now MCI) perpetrated the largest financial fraud in history, which resulted in the largest bankruptcy in history. Over a period of several years, the company recorded expenditures as expenses that should have been classified as assets; this had the effect of understating the company’s expenses and overstating its income by more than $10 billion. STOP & APPLY Four major issues underlie every accounting transaction: recognition, valuation, classification, and ethics. Match each of these issues to the statements below that are most closely associated with the

issue. A company: 1. R ecords a piece of equipment at the price 3. R ecords the equipment as an expense in paid for it. order to show lower earnings. 2. R ecords the purchase of the equipment on 4. R ecords the equipment as an asset because the day on which it takes ownership. it will benefit future periods. SOLUTION 1. valuation; 2. recognition; 3. ethics; 4. classification 54 CHAPTER 2 Analyzing Business Transactions Double-Entry The double-entry system, the backbone of accounting, evolved during the Renais- System sance. The first systematic description of double-entry bookkeeping appeared in 1494, two years after Columbus discovered America, in a mathematics book by LO2 Explain the double-entry Fra Luca Pacioli. Goethe, the famous German poet and dramatist, referred to double-entry bookkeeping as “one of the finest discoveries of the human intellect.” system and the usefulness of Werner Sombart, an eminent economist-sociologist, believed that “double-entry T accounts in analyzing business bookkeeping is born of the same spirit as the system of Galileo and Newton.” transactions. What is the significance of the double-entry system? The system is based on the principle of duality, which means that every economic event has two aspects— Study Note effort and reward, sacrifice and benefit, source and use—that offset, or balance, each other. In the double-entry system, each transaction must be recorded with Each transaction must include at least one debit and one credit, and the total amount of the debits must equal at least one debit and one the total amount of the credits. Because of the way it is designed, the whole sys- credit, and the debit totals must tem is always in balance. All accounting systems, no matter how sophisticated, are equal the credit totals. based on the principle of duality. Accounts Accounts are the basic storage units for accounting data and are used to accumulate amounts from similar transactions. An accounting system has a separate account for each asset, each liability, and each component of owner’s equity, including rev- enues and expenses. Whether a company keeps records by hand or by computer, managers must be able to refer to accounts so that they can study their company’s financial history and plan for the future. A very small company may need only a few dozen accounts; a multinational corporation may need thousands. An account title should describe what is recorded in the account. How- ever, account titles can be rather confusing. For example, Fixed Assets, Plant and Equipment, Capital Assets, and Long-Lived Assets are all titles for long- term assets. Moreover, many account titles change over time as preferences and practices change. When you come across an account title that you don’t recognize, examine the context of the name—whether it is classified in the financial statements as an asset, liability, or component of owner’s equity—and look for the kind of transac- tion that gave rise to the account. The T Account The T account is a good place to begin the study of the double-entry system. Study Note Such an account has three parts: a title, which identifies the asset, liability, or owner’s equity account; a left side, which is called the debit side; and a right side, Many students have which is called the credit side. The T account, so called because it resembles the preconceived ideas about what debit and credit mean. They letter T, is used to analyze transactions and is not part of the accounting records. think debit means “decrease” It looks like this: (or implies something bad) and credit means “increase” (or implies something good). It is TITLE OF ACCOUNT important to realize that debit Debit Credit simply means “left side” and (left) side (right) side credit simply means “right side.” Any entry made on the left side of the account is a debit, and any entry made on the right side is a credit. The terms debit (abbreviated Dr., from the Latin debere) and credit (abbreviated Cr., from the Latin credere) are simply the Double-Entry System 55 accountant’s words for “left” and “right” (not for “increase” or “decrease”). We

present a more formal version of the T account, the ledger account form, later in this chapter. The T Account Illustrated Suppose a company had several transactions during the month that involved the receipt or payment of cash. These transactions can be summarized in the Cash account by recording receipts on the left (debit) side of a T account and pay- ments on the right (credit) side. CASH Dr. Cr. 100,000 70,000 3,000 400 1,200 103,000 71,600 Bal. 31,400 The cash receipts on the left total $103,000. (The total is written in smaller, bold figures so that it cannot be confused with an actual debit entry.) The cash payments on the right side total $71,600. These totals are simply working totals, or footings. Footings, which are calculated at the end of each month, are an easy way to determine cash on hand. The difference in dollars between the total debit footing and the total credit footing is called the balance, or account balance. If the balance is a debit, it is written on the left side. If it is a credit, it is written on the right side. Notice that the Cash account has a debit balance of $31,400 ($103,000 (cid:4) $71,600). This is the amount of cash the business has on hand at the end of the month. Rules of Double-Entry Accounting The two rules of the double-entry system are that every transaction affects at least two accounts and that total debits must equal total credits. In other words, for every transaction, one or more accounts must be debited, or entered on the left side of the T account, and one or more accounts must be credited, or entered on the right side of the T account, and the total dollar amount of the debits must equal the total dollar amount of the credits. Look again at the accounting equation: Assets (cid:2) Liabilities (cid:3) Owner’s Equity You can see that if a debit increases assets, then a credit must be used to increase liabilities or owner’s equity because they are on opposite sides of the equal sign. Likewise, if a credit decreases assets, then a debit must be used to decrease liabili- ties or owner’s equity. These rules can be shown as follows: ASSETS (cid:2) LIABILITIES (cid:3) OWNER’S EQUITY Debit Credit Debit Credit Debit Credit for for for for for for increases decreases decreases increases decreases increases ((cid:3)) ((cid:4)) ((cid:4)) ((cid:3)) ((cid:4)) ((cid:3)) 56 CHAPTER 2 Analyzing Business Transactions 1. Debit increases in assets to asset accounts. Credit decreases in assets to asset Study Note accounts. Although withdrawals are a 2. Credit increases in liabilities and owner’s equity to liability and owner’s component of owner’s equity, equity accounts. Debit decreases in liabilities and owner’s equity to liability they normally appear only and owner’s equity accounts. in the statement of owner’s equity. They do not appear One of the more difficult points to understand is the application of double- in the owner’s equity section entry rules to the components of owner’s equity. The key is to remember that of the balance sheet or as withdrawals and expenses are deductions from owner’s equity. Thus, transac- an expense on the income tions that increase withdrawals or expenses decrease owner’s equity. Consider this statement. expanded version of the accounting equation: Owner’s Equity Assets (cid:2) Liabilities (cid:3) Owner’s (cid:4) Withdrawals (cid:3) Revenues (cid:4) Expenses Capital ASSETS LIABILITIES OWNER’S CAPITAL WITHDRAWALS REVENUES EXPENSES (cid:3) (cid:4) (cid:4) (cid:3) (cid:4) (cid:3) (cid:3) (cid:4) (cid:4) (cid:3) (cid:3) (cid:4) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) (Dr.) (Cr.) Normal Balance The normal balance of an account is its usual balance and is the side (debit or credit) that increases the account. Table 2-1 summarizes the normal account bal- ances of the major account categories. If you have difficulty remembering the normal balances and the rules of debit and credit, try using the acronym AWE: Asset accounts, Withdrawals, and Expenses are always increased by debits. All other normal accounts are increased by credits.

Owner’s Equity Accounts Figure 2-2 illustrates how owner’s equity accounts relate to each other and to the financial statements. The distinctions among these accounts are important for both legal purposes and financial reporting. TABLE 2-1 Increases Recorded by Normal Balance Normal Account Balances of Major Account Categories Account Category Debit Credit Debit Credit Assets x x Liabilities x x Owner’s equity: Owner’s Capital x x Withdrawals x x Revenues x x Expenses x x Double-Entry System 57 FIGURE 2-2 Relationships of Owner’s Equity BALANCE SHEET Accounts ASSETS = LIABILITIES + OWNER’S EQUITY Study Note Although revenues and expenses are components of OWNER’S WITHDRAWALS REVENUES EXPENSES owner’s equity, they appear CAPITAL on the income statement, not SHOWN ON in the owner’s equity section INCOME STATEMENT of the balance sheet. Figure 2-2 illustrates this point. SHOWN ON STATEMENT OF OWNER’S EQUITY STOP & APPLY You are given the following list of accounts with dollar amounts: J. Morgan, Withdrawals $ 75 Cash $625 Accounts Payable 200 J. Morgan, Capital 400 Wages Expense 150 Fees Revenue 250 Insert the account title at the top of the corresponding T account that follows and enter the dollar amount as a normal balance in the account. Then show that the accounting equation is in balance. OWNER’S EQUITY J. MORGAN, J. MORGAN, ASSETS (cid:2) LIABILITIES (cid:3) CAPITAL (cid:4) WITHDRAWALS (cid:3) REVENUES (cid:4) EXPENSES SOLUTION ACCOUNTS J. MORGAN, J. MORGAN, FEES WAGES CASH PAYABLE CAPITAL WITHDRAWALS REVENUE EXPENSE 625 200 400 75 250 150 Assets (cid:2) Liabilities (cid:3) Owner’s Equity $625 (cid:2) $200 (cid:3) ($400 (cid:2) $75 (cid:3) $250 (cid:2) $150) $625 (cid:2) $200 (cid:3) $425 $625 (cid:2) $625 58 CHAPTER 2 Analyzing Business Transactions Business In the pages that follow, we show how to apply the double-entry system to some Transaction common business transactions. Source documents—invoices, receipts, checks, or contracts—usually support the details of a transaction. We focus on the transactions Analysis of a small firm, Miller Design Studio. For each transaction, we follow these steps: LO3 Demonstrate how 1. State the transaction. the double-entry system is 2. Analyze the transaction to determine which accounts are affected. applied to common business 3. Apply the rules of double-entry accounting by using T accounts to show how the transactions. transaction affects the accounting equation. It is important to note that this step is not part of the accounting records but is undertaken before recording a transaction in order to understand the effects of the transaction on the accounts. 4. Show the transaction in journal form. The journal form is a way of record- Study Note ing a transaction with the date, debit account, and debit amount shown on T accounts are used to one line, and the credit account (indented) and credit amount on the next understand and visualize line. The amounts are shown in their respective debit and credit columns. the double-entry effects of a This step represents the initial recording of a transaction in the records and takes transaction on the accounting the following form: equation. They help in then recording the journal entry in Dr. Cr. the general journal. Date Debit Account Name Amount Credit Account Name Amount A series of transactions in this form results in a chronological record of the transactions called a general journal. Periodically, each debit and credit in an entry is transferred to its appropriate account in a list of accounts called the general ledger. We discuss the relationship of the general journal to the general ledger later in this chapter. 5. Provide a comment that will help you apply the rules of double entry. The formal process of recording and posting of transactions in the records is illus- trated under SO 6 at the end of this chapter. Chapters 3 and 4 cover other steps necessary to produce financial statements. Owner’s Investment to Form the Business July 1: Joan Miller invests $40,000 in cash to form Miller Design Studio. Analysis: An owner’s investment in the business increases the asset account Cash with

a debit and increases the owner’s equity account J. Miller, Capital with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH J. MILLER, CAPITAL Dr. Cr. Dr. Cr. July 1 40,000 July 1 40,000 Entry in Journal Form: Dr. Cr. July 1 Cash 40,000 J. Miller, Capital 40,000 Comment: If Joan Miller had invested assets other than cash in the business, the appropriate asset accounts would be increased with a debit. Business Transaction Analysis 59 Economic Event That Is Not a Business Transaction July 2: Orders office supplies, $5,200. Comment: When an economic event does not constitute a business transaction, no entry is made. In this case, there is no confirmation that the supplies have been shipped or that title has passed. Prepayment of Expenses in Cash July 3: Rents an office; pays two months’ rent in advance, $3,200. Analysis: The prepayment of office rent in cash increases the asset account Pre- paid Rent with a debit and decreases the asset account Cash with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH Dr. Cr. July 1 40,000 July 3 3,200 PREPAID RENT Dr. Cr. July 3 3,200 Entry in Journal Form: Dr. Cr. July 3 Prepaid Rent 3,200 Cash 3,200 Comment: A prepaid expense is an asset because the expenditure will benefit future operations. This transaction does not affect the totals of assets or liabili- ties and owner’s equity because it simply trades one asset for another asset. If the company had paid only July’s rent, the owner’s equity account Rent Expense would be debited because the total benefit of the expenditure would be used up in the current month. Purchase of an Asset on Credit July 5: Receives office supplies ordered on July 2 and an invoice for $5,200. Analysis: The purchase of office supplies on credit increases the asset account Office Supplies with a debit and increases the liability account Accounts Payable with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity OFFICE SUPPLIES ACCOUNT PAYABLE Dr. Cr. Dr. Cr. July 5 5,200 July 5 5,200 Entry in Journal Form: Dr. Cr. July 5 Office Supplies 5,200 Accounts Payable 5,200 60 CHAPTER 2 Analyzing Business Transactions Comment: Office supplies are considered an asset (prepaid expense) because they will not be used up in the current month and thus will benefit future periods. Accounts Payable is used when there is a delay between the time of the purchase and the time of payment. Purchase of an Asset Partly in Cash and Partly on Credit July 6: Purchases office equipment, $16,320; pays $13,320 in cash and agrees to pay the rest next month. Analysis: The purchase of office equipment in cash and on credit increases the asset account Office Equipment with a debit, decreases the asset account Cash with a credit, and increases the liability account Accounts Payable with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH ACCOUNT PAYABLE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 5 5,200 6 13,320 6 3,000 OFFICE EQUIPMENT July 6 16,320 Entry in Journal Form: Dr. Cr. July 6 Office Equipment 16,320 Cash 13,320 Accounts Payable 3,000 Comment: As this transaction illustrates, assets may be paid for partly in cash and partly on credit. When more than two accounts are involved in a journal entry, as they are in this one, it is called a compound entry. Payment of a Liability July 9: Makes a partial payment of the amount owed for the office supplies received on July 5, $2,600. Analysis: A payment of a liability decreases the liability account Accounts Payable with a debit and decreases the asset account Cash with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH ACCOUNT PAYABLE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 9 2,600 July 5 5,200 6 13,320 6 3,000 9 2,600 Entry in Journal Form: Dr. Cr. July 9 Accounts Payable 2,600 Cash 2,600 Business Transaction Analysis 61 Comment: Note that the office supplies were recorded when they were purchased on July 5. Revenue in Cash July 10: Performs a service for an investment advisor by designing a series of bro-

chures and collects a fee in cash, $2,800. Analysis: Revenue received in cash increases the asset account Cash with a debit and increases the owner’s equity account Design Revenue with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH DESIGN REVENUE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 10 2,800 10 2,800 6 13,320 9 2,600 Entry in Journal Form: Dr. Cr. July 10 Cash 2,800 Design Revenue 2,800 Comment: For this transaction, revenue is recognized when the service is pro- vided and the cash is received. Revenue on Credit July 15: Performs a service for a department store by designing a TV commercial; bills for the fee now but will collect the fee later, $9,600. Analysis: A revenue billed to a customer increases the asset account Accounts Receivable with a debit and increases the owner’s equity account Design Revenue with a credit. Accounts Receivable is used to indicate the company’s right to col- lect the money in the future. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ACCOUNTS RECEIVABLE DESIGN REVENUE Dr. Cr. Dr. Cr. July 15 9,600 July 10 2,800 15 9,600 Entry in Journal Form: Dr. Cr. July 15 Accounts Receivable 9,600 Design Revenue 9,600 Comment: In this case, there is a delay between the time revenue is earned and the time the cash is received. Revenues are recorded at the time they are earned and billed regardless of when cash is received. Revenue Collected in Advance July 19: Accepts an advance fee as a deposit on a series of brochures to be designed, $1,400. 62 CHAPTER 2 Analyzing Business Transactions Analysis: Revenue received in advance increases the asset account Cash with a debit and increases the liability account Unearned Design Revenue with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH UNEARNED DESIGN REVENUE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 19 1,400 10 2,800 6 13,320 19 1,400 9 2,600 Entry in Journal Form: Dr. Cr. July 19 Cash 1,400 Unearned Design Revenue 1,400 Comment: In this case, cash is received before the fees are earned. Unearned Design Revenue is a liability because the firm must provide the service or return the deposit. Collection on Account July 22: Receives cash from customer previously billed on July 15, $5,000. Analysis: Collection of an account receivable from a customer previously billed increases the asset account Cash with a debit and decreases the asset account Accounts Receivable with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH Dr. Cr. July 1 40,000 July 3 3,200 10 2,800 6 13,320 19 1,400 9 2,600 22 5,000 ACCOUNTS RECEIVABLE Dr. Cr. July 15 9,600 July 22 5,000 Entry in Journal Form: Dr. Cr. July 22 Cash 5,000 Accounts Receivable 5,000 Comment: Note that the revenue related to this transaction was recorded on July 15. Thus, no revenue is recorded at this time. Expense Paid in Cash July 26: Pays employees four weeks’ wages, $4,800. Business Transaction Analysis 63 Analysis: This cash expense increases the owner’s equity account Wages Expense with a debit and decreases the asset account Cash with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH WAGES EXPENSE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 26 4,800 10 2,800 6 13,320 19 1,400 9 2,600 22 5,000 26 4,800 Entry in Journal Form: Dr. Cr. July 26 Wages Expense 4,800 Cash 4,800 Comment: Note that the increase in Wages Expense will decrease owner’s equity. Expense to Be Paid Later July 30: Receives, but does not pay, the utility bill that is due next month, $680. Analysis: This cash expense increases the owner’s equity account Utilities Expense with a debit and increases the liability account Accounts Payable with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ACCOUNTS PAYABLE UTILITIES EXPENSE Dr. Cr. Dr. Cr. July 9 2,600 July 5 5,200 July 30 680 6 3,000 30 680 Entry in Journal Form: Dr. Cr. July 30 Utilities Expense 680 Accounts Payable 680 Comment: The expense is recorded if the benefit has been received and the

amount is owed, even if the cash is not to be paid until later. Note that the increase in Utilities Expense will decrease owner’s equity. Withdrawals July 31: Withdraws $2,800 in cash. Analysis: A cash withdrawal increases the owner’s equity account Withdrawals with a debit and decreases the asset account Cash with a credit. 64 CHAPTER 2 Analyzing Business Transactions Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH J. MILLER, WITHDRAWALS Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 31 2,800 10 2,800 6 13,320 19 1,400 9 2,600 22 5,000 26 4,800 31 2,800 Entry in Journal Form: Dr. Cr. July 31 J. Miller, Withdrawals 2,800 Cash 2,800 Comment: Note that the increase in Withdrawals will decrease owner’s equity. EXHIBIT 2-1 Summary of Transactions of Miller Design Studio Assets (cid:3) Liabilities (cid:4) Owner’s Equity Cash Accounts Payable J. Miller, Capital Dr. Cr. Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 9 2,600 July 5 5,200 July 1 40,000 10 2,800 6 13,320 6 3,000 19 1,400 9 2,600 30 680 J. Miller, Withdrawals 22 5,000 26 4,800 2,600 8,880 July 31 2,800 31 2,800 Bal. 6,280 49,200 26,720 This account links to the statement of cash flows. Bal. 22,480 Accounts Receivable Unearned Design Revenue Design Revenue Dr. Cr. Dr. Cr. Dr. Cr. July 15 9,600 July 22 5,000 July 19 1,400 July 10 2,800 15 9,600 Bal. 4,600 Bal. 12,400 Office Supplies Wages Expense Dr. Cr. Dr. Cr. July 5 5,200 July 26 4,800 Prepaid Rent Utilities Expense Dr. Cr. Dr. Cr. July 3 3,200 July 30 680 Office Equipment These accounts link to the income statement. Dr. Cr. July 6 16,320 Assets (cid:2) Liabilities (cid:3) Owner’s Equity $51,800 (cid:2) $7,680 (cid:3) $44,120 The Trial Balance 65 Summary of Transactions Exhibit 2-1 uses the accounting equation to summarize the transactions of Miller Design Studio. Note that the income statement accounts appear under owner’s equity and that the transactions in the Cash account will be reflected on the statement of cash flows. STOP & APPLY The following accounts are applicable to Leona’s Nail Salon, a company that provides manicures and pedicures: 1. Cash 5. Accounts Payable 2. Accounts Receivable 6. Services Revenue 3. Supplies 7. Wages Expense 4. Equipment 8. Rent Expense For Leona’s Nail Salon, enter the number corresponding to the proper account for each debit and credit for the following transactions: Debit Credit a. Made a rent payment for the current month. 8 1 b. Received cash from customers for current services. c. Agreed to accept payment next month from a client for current services. d. Purchased supplies on credit. e. Purchased a new chair and table for cash. f. Made a payment on accounts payable. SOLUTION Debit Credit a. Made a rent payment for the current month. 8 1 b. Received cash from customers for current services. 1 6 c. Agreed to accept payment next month from a client 2 6 for current services. d. Purchased supplies on credit. 3 5 e. Purchased a new chair and table for cash. 4 1 f. Made a payment on accounts payable. 5 1 The Trial For every amount debited, an equal amount must be credited. This means that Balance the total of debits and credits in the T accounts must be equal. To test this, the accountant periodically prepares a trial balance. Exhibit 2-2 shows a trial balance LO4 Prepare a trial balance, for Miller Design Studio. It was prepared from the accounts in Exhibit 2-1. and describe its value and limitations. Preparation and Use of a Trial Balance Although a trial balance may be prepared at any time, it is usually prepared on the last day of the accounting period. The preparation involves these steps: 66 CHAPTER 2 Analyzing Business Transactions EXHIBIT 2-2 Miller Design Studio Trial Balance Trial Balance July 31, 2011 Cash $22,480 Accounts Receivable 4,600 Office Supplies 5,200 Prepaid Rent 3,200 Office Equipment 16,320 Accounts Payable $ 6,280 Unearned Design Revenue 1,400 J. Miller, Capital 40,000 J. Miller, Withdrawals 2,800 Design Revenue 12,400 Wages Expense 4,800 680 Utilities Expense $60,080 $60,080 1. List each account that has a balance, with debit balances in the left column

Study Note and credit balances in the right column. Accounts are listed in the order in The trial balance is usually which they appear in the financial statements. prepared at the end of an 2. Add each column. accounting period. It is an initial check that the accounts are in 3. Compare the totals of the columns. balance. Once in a while, a transaction leaves an account with a balance that isn’t “normal.” For example, when a company overdraws its bank account, its Cash account (an asset) will show a credit balance instead of a debit balance. The “abnormal” balance should be copied into the trial balance columns as it stands, as a debit or a credit. The trial balance proves whether the accounts are in balance. In balance means that the total of all debits recorded equals the total of all credits recorded. But the trial balance does not prove that the transactions were analyzed correctly or recorded in the proper accounts. For example, there is no way of determining from the trial balance that a debit should have been made in the Office Sup- plies account rather than in the Office Equipment account. And the trial balance does not detect whether transactions have been omitted, because equal debits and credits will have been omitted. Also, if an error of the same amount is made in both a debit and a credit, it will not be evident in the trial balance. The trial balance proves only that the debits and credits in the accounts are in balance. FOCUS ON BUSINESS PRACTICE Are All Trial Balances Created Equal? In computerized accounting systems, posting is done software packages for small businesses list the trial balance automatically, and the trial balance can be easily prepared amounts in a single column and show credit balances as as often as needed. Any accounts with abnormal balances minuses. In such cases, the trial balance is in balance if the are highlighted for investigation. Some general ledger total is zero. The Trial Balance 67 Finding Trial Balance Errors If the debit and credit balances in a trial balance are not equal, look for one or more of the following errors: 1. A debit was entered in an account as a credit, or vice versa. 2. The balance of an account was computed incorrectly. 3. An error was made in carrying the account balance to the trial balance. 4. The trial balance was summed incorrectly. Other than simply adding the columns incorrectly, the two most common mistakes in preparing a trial balance are 1. Recording an account as a credit when it usually carries a debit balance, or vice versa. This mistake causes the trial balance to be out of balance by an amount divisible by 2. 2. Transposing two digits when transferring an amount to the trial balance (for example, entering $23,459 as $23,549). This error causes the trial balance to be out of balance by an amount divisible by 9. So, if a trial balance is out of balance and the addition of the columns is correct, determine the amount by which the trial balance is out of balance and divide it first by 2 and then by 9. If the amount is divisible by 2, look in the trial balance for an amount that is equal to the quotient. If you find such an amount, chances are it’s in the wrong column. If the amount is divisible by 9, trace each amount back to the T account balance, checking carefully for a transposition error. If neither of these techniques is successful in identifying the error, first recompute the balance of each T account. Then, if you still have not found the error, retrace each posting to the journal or the T account. STOP & APPLY Prepare a trial balance from the following list of accounts (in alphabetical order) of the Jasoni Company as of March 31, 2011. Compute the balance of cash. Accounts Payable $ 9 Jasoni, Capital $16 Accounts Receivable 5 Equipment 2 Building 10 Land 1 Cash ? Inventory 3 SOLUTION Jasoni Company Trial Balance March 31, 2011 Cash $ 4 Accounts Receivable 5 Inventory 3 Land 1 Building 10 Equipment 2 Accounts Payable $ 9 Jasoni, Capital 16 Totals $25 $25 68 CHAPTER 2 Analyzing Business Transactions Cash Flows To avoid financial distress, a company must be able to pay its bills on time. Because

and the Timing the timing of cash flows is critical to maintaining adequate liquidity to pay bills, managers and other users of financial information must understand the difference of Transactions between transactions that generate immediate cash and those that do not. Con- sider the transactions of Miller Design Studio shown in Figure 2-3. Most of them LO5 Show how the timing involve either an inflow or outflow of cash. of transactions affects cash As you can see in Figure 2-3, Miller’s Cash account has more transactions flows and liquidity. than any of its other accounts. Look at the transactions of July 10, 15, and 22: (cid:2) July 10: Miller received a cash payment of $2,800. (cid:2) July 15: The firm billed a customer $9,600 for a service it had already per- formed. (cid:2) July 22: The firm received a partial payment of $5,000 from the customer, but it had not received the remaining $4,600 by the end of the month. Because Miller incurred expenses in providing this service, it must pay careful Study Note attention to its cash flows and liquidity. Recording revenues and One way Miller can manage its expenditures is to rely on its creditors to give expenses when they occur will it time to pay. Compare the transactions of July 3, 5, and 9 in Figure 2-3. provide a clearer picture of a (cid:2) July 3: Miller prepaid rent of $3,200. That immediate cash outlay may have company’s profitability on the caused a strain on the business. income statement. The change in cash flows will provide a (cid:2) July 5: The firm received an invoice for office supplies in the amount of clearer picture of a company’s $5,200. In this case, it took advantage of the opportunity to defer payment. liquidity on the statement of (cid:2) July 9: The firm paid $2,600, but it deferred paying the remaining $2,600 cash flows. until after the end of the month. Large companies face the same challenge, but often on a much greater scale. For example, it can take Boeing a number of years to plan and make the aircraft that customers order. At the end of 2008, Boeing had orders totaling $352 b illion.4 Think of the cash outlays Boeing must make before it delivers the planes and collects payment for them. To maintain liquidity so that Boeing can eventually reap the rewards of delivering the planes, Boeing’s management must carefully plan the company’s needs for cash. FIGURE 2-3 Transactions of Miller Design Studio Design Revenue Cash Cash Cash Prepaid Rent Office Supplies Sale Purchase July 10 2,800 July 10 2,800 Ju ly 3 3,200 Ju ly 3 3,200 July 5 5,200 15 9,600 22 5,000 9 2,600 Credit Collection Payment on Credit Sale on Account Account Purchase Accounts Receivable Accounts Payable July 15 9,600 July 22 5,000 Ju ly 9 2,600 Ju ly 5 5,200 Cash Flows and the Timing of Transactions 69 FOCUS ON BUSINESS PRACTICE Should Earnings Be Aligned with Cash Flows? Electronic Data Systems Corporation (EDS), the large 40 percent of EDS’s revenue had been recognized well before computer services company, announced that it was reducing the cash was to be received. Analysts’ response to the change past earnings by $2.24 billion to implement a new accounting in EDS’s accounting was very positive. “Finally, maybe, we’ll rule that would more closely align its earnings with cash see cash flows moving in line with earnings,” said one.5 flows. Analysts had been critical of EDS for recording rev- Although there are natural and unavoidable differences enue from its long-term contracts when the contracts were between earnings and cash flows, it is best if accounting signed rather than when the cash was received. In fact, about rules are not used to exaggerate these differences. STOP & APPLY A company engaged in the following transactions: Oct. 1 Performed services for cash, Oct. 4 Performed services on credit, $900. $1,050. 5 Paid on account, $350. 2 Paid expenses in cash, $550. 6 Collected on account, $600. 3 Incurred expenses on credit, $650. Enter the correct titles in the following T accounts, and enter the transactions above in the accounts. Determine the cash balance after these transactions, the amount still to be received, and

the amount still to be paid. Cash Sale Cash Purchase Credit Purchase Credit Collection on Payment on Sale Account Account SOLUTION Design Fees Earned Cash Expenses Cash Sale Cash Purchase Oct. 1 1,050 Oct. 1 1,050 Oct. 2 550 Oct. 2 550 4 900 6 600 5 350 3 650 Credit Purchase Credit Collection on Payment on Sale Account Account Accounts Receivable Accounts Payable Oct. 4 900 Oct. 6 600 Oct. 5 350 Oct. 3 650 Cash balance after transactions: $1,050 (cid:3) $600 (cid:4) $550 (cid:4) $350 (cid:2) $750 Amount still to be received: $900 (cid:4) $600 (cid:2) $300 Amount still to be paid: $650 (cid:4) $350 (cid:2) $300 70 CHAPTER 2 Analyzing Business Transactions Recording Earlier in the chapter, we described how transactions are analyzed according to and Posting the rules of double entry and how a trial balance is prepared. As Figure 2-4 shows, transaction analysis and preparation of a trial balance are the first and last steps Transactions in a four-step process. The two intermediate steps are recording the entry in the general journal and posting the entry to the ledger. In this section, we demon- SO6 Define the chart of strate how these steps are accomplished in a manual accounting system. accounts, record transactions in the general journal, and post Chart of Accounts transactions to the ledger. In a manual accounting system, each account is kept on a separate page or card. These pages or cards are placed together in a book or file called the general ledger. In the computerized systems that most companies have today, accounts are maintained electronically. However, as a matter of convenience, accountants Study Note still refer to the group of company accounts as the general ledger, or simply the ledger. A chart of accounts is a table To help identify accounts in the ledger and make them easy to find, the of contents for the ledger. accountant often numbers them. A list of these numbers with the correspond- Typically, it lists accounts in the ing account titles is called a chart of accounts. A very simple chart of accounts order in which they appear in appears in Exhibit 2-3. The first digit in the account number identifies the major the ledger, which is usually the financial statement classification—that is, an account number that begins with order in which they appear in the digit 1 means that the account is an asset account, an account number that the financial statements. The begins with a 2 means that the account is a liability account, and so forth. The numbering scheme allows for some flexibility. second and third digits identify individual accounts. The gaps in the sequence of numbers allow the accountant to expand the number of accounts. General Journal Although transactions can be entered directly into the ledger accounts, this Study Note method makes identifying individual transactions or finding errors very diffi- The journal is a chronological cult because the debit is recorded in one account and the credit in another. The record of events. solution is to record all transactions chronologically in a journal. The journal is sometimes called the book of original entry because it is where transactions first enter the accounting records. Later, the debit and credit portions of each transac- tion are transferred to the appropriate accounts in the ledger. A separate journal entry is used to record each transaction; the process of recording transactions is called journalizing. Most businesses have more than one kind of journal. The simplest and most flexible kind is the general journal, the one we focus on here. Businesses will also have several special-purpose journals, each for recording a common transaction, FIGURE 2-4 such as credit sales, credit purchases, cash receipts, and cash disbursements. At this Analyzing and Processing Transactions STEP 1 STEP 2 STEP 3 STEP 4 Analyze the trans- Record the entry. Post the entry. Prepare the action according trial balance. to the rules of General Ledger General Journal Page 1 Office Supplies Account No. 116 double entry. Date Description P Ro es ft .. Debit Credit Date Item P Ro es ft .. Debit Credit DeB ba itlan Cc re edit Acct Name Debit Credit 20xx 20xx

SALES INVOICE July 5 O ff Aic ce c oS uu np tp sl i Pe as yable 1 21 16 2 5,200 5,200 July 5 J1 5,200 5,200 Cash 36,800 P ofu fir cc eh a ss ue p po lf ies Office Supplies 5,200 on credit General Ledger Prepaid Rent 3,200 Accounts Payable Account No. 212 Accts Payable 5,200 Date Item P Ro es ft .. Debit Credit DeB ba itlan Cc re edit Owner’s Capital 40,000 2 Ju0 lx yx 5 J1 5,200 5,200 45,200 45,200 $5,200 Recording and Posting Transactions 71 EXHIBIT 2-3 Chart of Accounts for a Small Business Account Account Number Name Description Assets 111 Cash Money and any medium of exchange (coins, currency, checks, money orders, and money on deposit in a bank) 112 Notes Receivable Promissory notes (written promises to pay defi nite sums of money at fi xed future dates) due from others 113 Accounts Receivable Amounts due from others for revenues or sales on credit (sales on account) 116 Offi ce Supplies Prepaid expense; offi ce supplies purchased and not used 117 Prepaid Rent Prepaid expense; rent paid in advance and not used 118 Prepaid Insurance Prepaid expense; insurance purchased and not expired 141 Land Property owned for use in the business 142 Buildings Structures owned for use in the business 143 Accumulated Periodic allocation of the cost of buildings to expense; deducted from Depreciation–Buildings buildings 146 Offi ce Equipment Offi ce equipment owned for use in the business 147 Accumulated Periodic allocation of the cost of offi ce equipment to expense; deducted Depreciation–Offi ce from Offi ce Equipment Equipment Liabilities 211 Notes Payable Promissory notes due to others 212 Accounts Payable Amounts due to others for purchases on credit 213 Unearned Design Revenue Unearned revenue; advance deposits for design services to be provided in the future 214 Wages Payable Amounts due to employees for wages earned and not paid Owner’s Equity 311 Owner’s Capital Owner’s investments in a company and claims against company assets derived from profi table operations 313 Withdrawals Distributions of assets (usually cash) that reduce owner’s capital 314 Income Summary Temporary account used at the end of the accounting period to summarize the revenues and expenses for the period Revenues 411 Design Revenue Revenues derived from design services Expenses 511 Wages Expense Amounts earned by employees 512 Utilities Expense Amounts for utilities, such as water, electricity, and gas, used 513 Telephone Expense Amounts of telephone services used 514 Rent Expense Amounts of rent on property and buildings used 515 Insurance Expense Amounts for insurance expired 517 Offi ce Supplies Expense Amounts for offi ce supplies used 518 Depreciation Amount of buildings’ cost allocated to expense Expense–Buildings 520 Depreciation Amount of offi ce equipment cost allocated to expense Expense–Offi ce Equipment 72 CHAPTER 2 Analyzing Business Transactions EXHIBIT 2-4 General Journal Page 1 The General Journal Post. Date Description Ref. Debit Credit 2010 July 3 Prepaid Rent 3,200 A (cid:3) L (cid:4) OE (cid:3) 3,200 Cash 3,200 (cid:4) 3,200 Paid two months’ rent in advance 5 Office Supplies 5,200 A (cid:3) L (cid:4) OE (cid:3) 5,200 (cid:3) 5,200 Accounts Payable 5,200 Purchase of office supplies on credit point, we cover only the general journal. Exhibit 2-4, which displays two of the transactions of Miller Design Studio that we discussed earlier, shows the format for recording entries in a general journal. As you can see in Exhibit 2-4, the entries in a general journal include the following information about each transaction: 1. The date. The year appears on the first line of the first column, the month on the next line of the first column, and the day in the second column opposite the month. For subsequent entries on the same page for the same month and year, the month and year can be omitted. 2. The names of the accounts debited and credited, which appear in the Descrip- tion column. The names of the accounts that are debited are placed next to the left margin opposite the dates; on the line below, the names of the accounts credited are indented.

3. The debit amounts, which appear in the Debit column opposite the accounts that are debited, and the credit amounts, which appear in the Credit column opposite the accounts credited. 4. An explanation of each transaction, which appears in the Description column below the account names. An explanation should be brief but sufficient to explain and identify the transaction. 5. The account numbers in the Post. Ref. column, if they apply. At the time the transactions are recorded, nothing is placed in the Post. Ref. (posting reference) column. (This column is sometimes called LP or Folio.) Later, if the company uses account numbers to identify accounts in the ledger, the account numbers are filled in. They provide a convenient cross-reference from the general journal to the ledger and indicate that the entry has been posted to the ledger. If the accounts are not numbered, the accountant uses a checkmark (✓) to signify that the entry has been posted. General Ledger The general journal is used to record the details of each transaction. The general ledger is used to update each account. The Ledger Account Form The ledger account form, which contains four columns for dollar amounts, is illustrated in Exhibit 2-5. The account title and number appear at the top of the account form. As in the journal, the transaction date appears in the first two columns. The Item column Recording and Posting Transactions 73 EXHIBIT 2-5 General Ledger Accounts Payable in the General Ledger Accounts Payable Account No. 212 Balance Post. Date Item Ref. Debit Credit Debit Credit 2010 July 5 J1 5,200 5,200 6 J1 3,000 8,200 9 J1 2,600 5,600 30 J2 680 6,280 is rarely used to identify transactions because explanations already appear in the Study Note journal. The Post. Ref. column is used to note the journal page on which the original entry for the transaction can be found. The dollar amount is entered in A T account is a means of the appropriate Debit or Credit column, and a new account balance is computed quickly analyzing a set of in the last two columns opposite each entry. The advantage of this account form transactions. It is simply over the T account is that the current balance of the account is readily available. an abbreviated version of a ledger account. Ledger accounts, which provide more Posting After transactions have been entered in the journal, they must be trans- information, are used in the ferred to the ledger. The process of transferring journal entry information from accounting records. the journal to the ledger is called posting. Posting is usually done after several entries have been made—for example, at the end of each day or less frequently, depending on the number of transactions. As Exhibit 2-6 shows, in posting, each amount in the Debit column of the journal is transferred to the Debit column of the appropriate account in the ledger, and each amount in the Credit column of the journal is transferred to the Credit column of the appropriate account in the ledger. The steps in the posting process are as follows: 1. In the ledger, locate the debit account named in the journal entry. 2. Enter the date of the transaction in the ledger and, in the Post. Ref. column, the journal page number from which the entry comes. 3. In the Debit column of the ledger account, enter the amount of the debit as it appears in the journal. 4. Calculate the account balance and enter it in the appropriate Balance column. 5. Enter in the Post. Ref. column of the journal the account number to which the amount has been posted. 6. Repeat the same five steps for the credit side of the journal entry. Notice that Step 5 is the last step in the posting process for each debit and credit. As noted earlier, in addition to serving as an easy reference between the journal entry and the ledger account, this entry in the Post. Ref. column of the journal indicates that the entry has been posted to the ledger. Some Notes on Presentation A ruled line appears in financial reports before each subtotal or total to indicate that the amounts above are added or subtracted. It is common practice to use a

double line under a final total to show that it has been verified. 74 CHAPTER 2 Analyzing Business Transactions EXHIBIT 2-6 General Journal Page 2 Posting from the General Journal to the Ledger Post. Date Description Ref. Debit Credit 2010 A (cid:3) L (cid:4) OE July 30 Utilities Expense 512 680 (cid:3)680 (cid:4)680 Accounts Payable 212 680 Received bill from utility company General Ledger Accounts Payable Account No. 212 Balance Post. Date Item Ref. Debit Credit Debit Credit 2010 July 5 J1 5,200 5,200 6 J1 3,000 8,200 9 J1 2,600 5,600 30 J2 680 6,280 General Ledger Utilities Expense Account No. 512 Balance Post. Date Item Ref. Debit Credit Debit Credit 2010 July 30 J2 680 680 Dollar signs ($) are required in all financial statements and on the trial bal- ance and other schedules. On these reports, a dollar sign should be placed before the first amount in each column and before the first amount in a column follow- ing a ruled line. Dollar signs in the same column are aligned. Dollar signs are not used in journals and ledgers. On normal, unruled paper, commas and decimal points are used when record- ing dollar amounts. On the paper used in journals and ledgers, commas and deci- mal points are unnecessary because ruled columns are provided to properly align dollars and cents. Commas, dollar signs, and decimal points are also unnecessary in electronic spreadsheets. In this book, because most problems and illustrations are in whole dollar amounts, the cents column usually is omitted. When accoun- tants deal with whole dollars, they often use a dash in the cents column to indi- cate whole dollars rather than taking the time to write zeros. Account names are capitalized when referenced in text or listed in work doc- uments like the journal or ledger. In financial statements, however, only the first word of an account name is capitalized. Paws and Hoofs Clinic: Review Problem 75 STOP & APPLY Record the following transactions in proper journal form and use the following account num- bers—Cash, 111; Supplies 114; and Accounts Payable, 212—to show in the Post Ref. columns that the entries have been posted: June 4 Purchased supplies for $40 on credit, 8 Paid for the supplies purchased on June 4 SOLUTION Post. Date Description Ref. Debit Credit June 4 Supplies 114 40 Accounts Payable 212 40 Purchased supplies on credit 8 Accounts Payable 212 40 Cash 114 40 Paid amount due for supplies (cid:2) PAWS AND HOOFS CLINIC: REVIEW PROBLEM In the Decision Point at the beginning of the chapter, we described the standing order for monthly service that Quarter Horse Stables placed with Paws and Hoofs Clinic. We noted that Larry Cox, the owner of the clinic, was confident of receiving $6,000 in fees over the course of the year and that he was thinking of including the fees in his financial statements. We asked these questions: • Is there a difference between an economic event and a business transaction that should be recorded in the accounting records? • Can a business transaction benefit a business even though no cash is received when the transaction takes place? • What is the difference between an asset and an expense? Paws and Hoofs Clinic engaged in the following economic events during May 2010: Transaction Analysis, T Accounts, Journalizing, May 1 Larry Cox invested $20,000 in cash to form Paws and Hoofs Clinic. and the Trial Balance 2 Made an agreement to provide $6,000 in services over the next year to Quarter Horse Stables. LO1 LO3 3 Paid $600 in advance for two months’ rent of an offi ce. LO4 SO6 9 Purchased medical supplies for $400 in cash. 12 Purchased $4,000 of equipment on credit; made a 25 percent down payment. 15 Delivered a calf for a fee of $350 on credit. 18 Made a payment of $500 on the equipment purchased on May 12. 27 Paid a utility bill of $140. 76 CHAPTER 2 Analyzing Business Transactions Required 1. Identify the company’s business transactions, and record them in journal form. 2. Post the transactions to the following T accounts: Cash, Accounts Receivable, Medical Supplies, Prepaid Rent, Equipment, Accounts Payable, L. Cox, Capital;

Veterinary Fees Earned, and Utilities Expense. 3. Prepare a trial balance for the month of May. 4. User insight: Answer the following questions: a. How does the event on May 2 illustrate the difference between an economic event and a business transaction? b. How does the business transaction of May 15 benefit the business even though no cash was received? c. How do the transactions of May 9 and May 27 illustrate the difference between an asset and an expense? Answers to 1. Transactions recorded in journal form: Review Problem Paws and Hoofs Clinic: Review Problem 77 2. Transactions posted to T accounts: 3. Trial balance: 4. User insight: a. Despite its importance as an economic event, the standing order on May 2 did not constitute a business transaction. Neither the buyer nor the seller should have recognized it in their accounting records. At the time of the 78 CHAPTER 2 Analyzing Business Transactions agreement, Larry Cox had provided no services. Even “firm” orders like this one may be changed or canceled sometime during the year. b. Cox provided a service on May 15 and thus earned a revenue and added an asset to accounts receivable, which will provide cash for the business when the client pays the bill. c. Although closely related and recorded by debits, assets and expenses are different in how they affect future operations. The supplies purchased on May 9 are classified as an asset because they will benefit future accounting periods. The payment for utilities is classified as an expense because it is used up and will not benefit future periods. Stop & Review 79 STOP & REVIEW LO1 Explain how the concepts To measure a business transaction, you must determine when the transaction of recognition, valuation, occurred (the recognition issue), what value to place on the transaction (the val- and classifi cation apply uation issue), and how the components of the transaction should be categorized to business transactions (the classification issue). In general, recognition occurs when title passes, and and why they are impor- a transaction is valued at the exchange price—the fair value or cost at the time tant factors in ethical the transaction is recognized. Classification refers to assigning transactions to fi nancial reporting. the appropriate accounts. GAAP provide guidance about the treatment of these three basic measurement issues. Failure to follow these guidelines is a major rea- son some companies issue unethical financial statements. LO2 Explain the double- In the double-entry system, each transaction must be recorded with at least one entry system and the debit and one credit, and the total amount of the debits must equal the total usefulness of T accounts amount of the credits. Each asset, liability, and component of owner’s equity, in analyzing business including revenues and expenses, has a separate account, which is a device for transactions. storing transaction data. The T account is a useful tool for quickly analyzing the effects of transactions. It shows how increases and decreases in assets, liabilities, and owner’s equity are debited and credited to the appropriate accounts. LO3 Demonstrate how the The double-entry system is applied by analyzing transactions to determine which double-entry system is accounts are affected and by using T accounts to show how the transactions affect applied to common busi- the accounting equation. The transactions may be recorded in journal form with ness transactions. the date, debit account, and debit amount shown on one line, and the credit account (indented) and credit amount on the next line. The amounts are shown in their respective debit and credit columns. LO4 Prepare a trial balance, A trial balance is used to check that the debit and credit balances are equal. It and describe its value is prepared by listing each account balance in the appropriate Debit or Credit and limitations. column. The two columns are then added, and the totals are compared. The major limitation of a trial balance is that even when it shows that debit and credit

balances are equal, it does not guarantee that the transactions were analyzed cor- rectly or recorded in the proper accounts. LO5 Show how the timing of Some transactions generate immediate cash. For those that do not, there is a transactions aff ects cash holding period in either Accounts Receivable or Accounts Payable before the fl ows and liquidity. cash is received or paid. The timing of cash flows is critical to a company’s ability to maintain adequate liquidity so that it can pay its bills on time. Supplemental Objective SO6 Defi ne the chart of The chart of accounts is a list of account numbers and titles; it serves as a table accounts, record trans- of contents for the ledger. The general journal is a chronological record of all actions in the general transactions; it contains the date of each transaction, the titles of the accounts journal, and post trans- involved, the amounts debited and credited, and an explanation of each entry. actions to the ledger. After transactions have been entered in the general journal, they are posted to the 80 CHAPTER 2 Analyzing Business Transactions ledger. Posting is done by transferring the amounts in the Debit and Credit col- umns of the general journal to the Debit and Credit columns of the correspond- ing account in the ledger. After each entry is posted, a new balance is entered in the appropriate Balance column. REVIEW of Concepts and Terminology The following concepts and terms Double-entry system 54 (LO2) Normal balance 56 (LO2) were introduced in this chapter: Fair value 51 (LO1) Posting 73 (SO6) Accounts 54 (LO2) Footings 55 (LO2) Recognition 50 (LO1) Balance 55 (LO2) General journal 70 (SO6) Recognition point 51 (LO1) Chart of accounts 70 (SO6) General ledger 70 (SO6) Source documents 58 (LO3) Classification 53 (LO1) Journal 70 (SO6) T account 54 (LO2) Compound entry 60 (LO3) Journal entry 70 (SO6) Trial balance 65 (LO4) Cost principle 52 (LO1) Journal form 58 (LO3) Valuation 51 (LO1) Credit 54 (LO2) Journalizing 70 (SO6) Debit 54 (LO2) Ledger account form 72 (SO6) Chapter Assignments 81 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises Short exercises are simple applications of chapter material for one or more learn- ing objectives. If you need help locating the related text discussions, refer to the LO numbers in the margin. LO1 Recognition SE 1. Which of the following events would be recognized and entered in the accounting records of Kazuo Company? Why? Jan. 10 Kazuo Company places an order for office supplies. Feb. 15 Kazuo Company receives the office supplies and a bill for them. Mar. 1 Kazuo Company pays for the office supplies. LO1 LO3 Recognition, Valuation, and Classification SE 2. Tell how the concepts of recognition, valuation, and classification apply to this transaction: CASH SUPPLIES Dr. Cr. Dr. Cr. June 1 1,000 June 1 1,000 LO1 Classification of Accounts SE 3. Tell whether each of the following accounts is an asset, a liability, a revenue, an expense, or none of these: a. Accounts Payable b. Supplies c. Withdrawals d. Fees Earned e. Supplies Expense f. Accounts Receivable g. Unearned Revenue h. Equipment LO2 Normal Balances SE 4. Tell whether the normal balance of each account in SE 3 is a debit or a credit. LO3 Transaction Analysis SE 5. Leon Bear started a computer programming business, Bear’s Programming Service. For each transaction that follows, indicate which account is debited and which account is credited. May 2 Leon Bear invested $5,000. 5 Purchased a computer for $2,500 in cash. 7 Purchased supplies on credit for $300. 19 Received cash for programming services performed, $500. 22 Received cash for programming services to be performed, $600. 25 Paid the rent for May, $650. 31 Billed a customer for programming services performed, $250. 82 CHAPTER 2 Analyzing Business Transactions LO3 Recording Transactions in T Accounts SE 6. Set up T accounts and record each transaction in SE 5. Determine the balance of each account. LO4 Preparing a Trial Balance SE 7. From the T accounts created in SE 6, prepare a trial balance dated

May 31, 2010. LO5 Timing and Cash Flows SE 8. Use the T account for Cash below to record the portion of each of the fol- lowing transactions, if any, that affect cash. How do these transactions affect the company’s liquidity? CASH Jan. 2 Provided services for cash, $1,200 4 Paid expenses in cash, $700 8 Provided services on credit, $1,100 9 Incurred expenses on credit, $800 SO6 Recording Transactions in the General Journal SE 9. Prepare a general journal form like the one in Exhibit 2-4 and label it Page 4. Record the following transactions in the journal: Sept. 6 Billed a customer for services performed, $3,800. 16 R eceived partial payment from the customer billed on Sept. 6, $1,800. SO6 Posting to the Ledger Accounts SE 10. Prepare ledger account forms like the ones in Exhibit 2-5 for the fol- lowing accounts: Cash (111), Accounts Receivable (113), and Service Revenue (411). Post the transactions that are recorded in SE 9 to the ledger accounts for 2011, at the same time making the proper posting references. Also prepare a trial balance. SO6 Recording Transactions in the General Journal SE 11. Record the transactions in SE 5 in the general journal for 2011. Exercises LO1 LO2 Discussion Questions LO3 E 1. Develop a brief answer to each of the following questions. 1. Which is the most important issue in recording a transaction: recognition, valuation, or classification? 2. What is an example of how a company could make false financial statements through a violation of the recognition concept? 3. How are assets and expenses related, and why are the debit and credit effects for assets and expenses the same? 4. In what way are unearned revenues the opposite of prepaid expenses? LO4 LO5 Discussion Questions SO6 E 2. Develop a brief answer to each of the following questions. 1. Which account would be most likely to have an account balance that is not normal? Chapter Assignments 83 2. A company incurs a cost for a part that is needed to repair a piece of equip- ment. Is the cost an asset or an expense? Explain. 3. If a company’s cash flows for expenses temporarily exceed its cash flows from revenues, how might it make up the difference so that it can maintain liquidity? 4. How would the asset accounts in the chart of accounts for Miller Design Stu- dio differ if it were a retail company that sold promotional products instead of a service company? LO1 Recognition E 3. Which of the following events would be recognized and recorded in the accounting records of Villa Company on the date indicated? Jan. 15 Villa Company offers to purchase a tract of land for $140,000. There is a high likelihood that the offer will be accepted. Feb. 2 Villa Company receives notice that its rent will increase from $500 to $600 per month effective March 1. Mar.2 9 Villa Company receives its utility bill for the month of March. The bill is not due until April 9. June 10 Villa Company places an order for new office equipment costing $21,000. July 6 The office equipment Villa Company ordered on June 10 arrives. Payment is not due until August 1. LO1 Application of Recognition Point E 4. Torez Flower Shop uses a large amount of supplies in its business. The fol- lowing table summarizes selected transaction data for supplies that Torez Flower Shop purchased: Order Date Shipped Date Received Amount a June 26 July 5 $300 b July 10 15 750 c 16 22 400 d 23 30 600 e 27 Aug. 1 750 f Aug. 3 7 500 Determine the total purchases of supplies for July alone under each of the follow- ing assumptions: 1. Torez Flower Shop recognizes purchases when orders are shipped. 2. Torez Flower Shop recognizes purchases when orders are received. LO2 T Accounts, Normal Balance, and the Accounting Equation E 5. You are given the following list of accounts with dollar amounts: Rent Expense $ 450 Cash 1,725 Service Revenue 750 M. Powell, Withdrawals 375 Accounts Payable 600 M. Powell, Capital 1,200 Insert each account name at the top of its corresponding T account and enter the dollar amount as a normal balance in the account. Then show that the accounting equation is in balance.

84 CHAPTER 2 Analyzing Business Transactions Owner’s Equity Assets Liabilities M. Powell, M. Powell, Revenues Expenses Capital Withdrawals LO2 Classification of Accounts E 6. The following ledger accounts are for the Tuner Service Company: a. Cash m. Fees Earned b. Wages Expense n. R. Shuckman, Withdrawals c. Accounts Receivable o. Wages Payable d. R. Shuckman, Capital p. Unearned Revenue e. Service Revenue q. Office Equipment f. Prepaid Rent r. Rent Payable g. Accounts Payable s. Notes Receivable h. Investments in Securities t. Interest Expense i. Land u. Notes Payable j. Supplies Expense v. Supplies k. Prepaid Insurance w. Interest Receivable l. Utilities Expense x. Rent Expense Complete the following table, using X’s to indicate each account’s classification and normal balance (whether a debit or a credit increases the account). Type of Account Normal Balance Owner’s Equity (increases balance) R. Shuckman, R. Shuckman, Item Asset Liability Capital W ithdrawals Revenue Expense Debit Credit a. X X LO3 Transaction Analysis E 7. Analyze transactions a–g, following the example below. a. Sarah Lopez invested $2,500 in cash to establish Sarah’s Beauty Parlor. b. Paid two months’ rent in advance, $1,680. c. Purchased supplies on credit, $120. d. Received cash for barbering services, $700. e. Paid for supplies purchased in c. f. Paid utility bill, $72. g. Withdrew $100 in cash. Example a. The asset account Cash was increased. Increases in assets are recorded by debits. Debit Cash $2,500. A component of owner’s equity, S. Lopez, Capi- tal, was increased. Increases in owner’s capital are recorded by credits. Credit S. Lopez, Capital $2,500. Chapter Assignments 85 LO3 Transaction Analysis E 8. The following accounts are applicable to Dale’s Lawn Service, a company that maintains condominium grounds: 1. Cash 2. Accounts Receivable 3. Supplies 4. Equipment 5. Accounts Payable 6. Lawn Services Revenue 7. Wages Expense 8. Rent Expense Dale’s Lawn Service completed the following transactions: Debit Credit a. Paid for supplies purchased on credit last month. 5 1 b. Received cash from customers billed last month. c. Made a payment on accounts payable. d. Purchased supplies on credit. e. Billed a client for lawn services. f. Made a rent payment for the current month. g. Received cash from customers for lawn services. h. Paid employee wages. i. Ordered equipment. j. Received and paid for the equipment ordered in i. Analyze each transaction and show the accounts affected by entering the corre- sponding numbers in the appropriate debit or credit columns as shown in trans- action a. Indicate no entry, if appropriate. LO3 Recording Transactions in T Accounts E 9. Open the following T accounts: Cash; Repair Supplies; Repair Equipment; Accounts Payable; T. Ornega, Capital; Withdrawals; Repair Fees Earned; Sala- ries Expense; and Rent Expense. Record the following transactions for the month of June directly in the T accounts; use the letters to identify the trans- actions in your T accounts. Determine the balance in each account. a. Tony Ornega opened Ornega Repair Service by investing $4,300 in cash and $1,600 in repair equipment. b. Paid $800 for the current month’s rent. c. Purchased repair supplies on credit, $1,100. d. Purchased additional repair equipment for cash, $600. e. Paid salary to a helper, $900. f. Paid $400 of amount purchased on credit in c. g. Accepted cash for repairs completed, $3,720. h. Withdrew $1,000 in cash. LO4 Trial Balance E 10. After recording the transactions in E 9, prepare a trial balance in proper sequence for Ornega Repair Service as of June 30, 2011. 86 CHAPTER 2 Analyzing Business Transactions LO3 Analysis of Transactions E 11. Explain each transaction (a–h) entered in the following T accounts: CASH ACCOUNTS RECEIVABLE EQUIPMENT a. 20,000 b. 7,500 c. 4,000 g. 750 b. 7,500 h. 450 g. 750 e. 1,800 d. 4,500 h. 450 f. 2,250 ACCOUNTS PAYABLE B. CALDWELL, CAPITAL SERVICE REVENUE f. 2,250 d. 4,500 a. 20,000 c. 4,000 WAGES EXPENSE e. 1,800 LO4 Preparing a Trial Balance E 12. The list that follows presents the accounts (in alphabetical order) of the

Dymarski Company as of March 31, 2011. The list does not include the amount of Accounts Payable. Accounts Payable ? Accounts Receivable $ 2,800 Building 20,400 Cash 5,400 K. Dymarski, Capital 18,870 Equipment 7,200 Land 3,120 Notes Payable 10,000 Prepaid Insurance 660 Prepare a trial balance with the proper heading (see Exhibit 2-2) and with the accounts listed in the chart of accounts sequence (see Exhibit 2-3). Compute the balance of Accounts Payable. LO4 Effects of Errors on a Trial Balance E 13. Which of the following errors would cause a trial balance to have unequal totals? Explain your answers. a. A payment to a creditor was recorded as a debit to Accounts Payable for $129 and as a credit to Cash for $102. b. A payment of $150 to a creditor for an account payable was debited to Accounts Receivable and credited to Cash. c. A purchase of office supplies of $420 was recorded as a debit to Office Sup- plies for $42 and as a credit to Cash for $42. d. A purchase of equipment for $450 was recorded as a debit to Supplies for $450 and as a credit to Cash for $450. LO4 Correcting Errors in a Trial Balance E 14. The trial balance for Marek Services at the end of July 2011 appears at the top of the opposite page. It does not balance because of a number of errors. Marek’s accountant compared the amounts in the trial balance with the ledger, recomputed the account balances, and compared the postings. He found the fol- lowing errors: a. The balance of Cash was understated by $800. b. A cash payment of $420 was credited to Cash for $240. c. A debit of $120 to Accounts Receivable was not posted. d. Supplies purchased for $60 were posted as a credit to Supplies. e. A debit of $180 to Prepaid Insurance was not posted. Chapter Assignments 87 Marek Services Trial Balance July 31, 2011 Cash $ 3,440 Accounts Receivable 5,660 Supplies 120 Prepaid Insurance 180 Equipment 7,400 Accounts Payable $ 4,540 T. Marek, Capital 10,560 T. Marek, Withdrawals 700 Revenues 5,920 Salaries Expense 2,600 Rent Expense 600 Advertising Expense 340 Utilities Expense 26 $20,366 $21,720 f. The Accounts Payable account had debits of $5,320 and credits of $9,180. g. The Notes Payable account, with a credit balance of $2,400, was not included on the trial balance. h. The debit balance of T. Marek, Withdrawals was listed in the trial balance as a credit. i. A $200 debit to T. Marek, Withdrawals was posted as a credit. j. The actual balance of Utilities Expense, $260, was listed as $26 in the trial balance. Prepare a corrected trial balance. LO5 Cash Flow Analysis E 15. A company engaged in the following transactions: Dec. 1 Performed services for cash, $750. 1 Paid expenses in cash, $550. 2 Performed services on credit, $900. 3 Collected on account, $600. 4 Incurred expenses on credit, $650. 5 Paid on account, $350. Enter the correct titles on the following T accounts and enter the above transac- tions in the accounts. Determine the cash balance after these transactions, the amount still to be received, and the amount still to be paid. Cash Sale Cash Purchase Credit Purchase Credit Collection on Payment on Sale Account Account SO6 Recording Transactions in the General Journal E 16. Record the transactions in E 9 in the general journal. 88 CHAPTER 2 Analyzing Business Transactions LO3 SO6 Analysis of Unfamiliar Transactions E 17. Managers and accountants often encounter transactions with which they are unfamiliar. Use your analytical skills to analyze and record in journal form the following transactions, which have not yet been discussed in the text. May 1 Purchased merchandise inventory on account, $1,200. 2 Purchased marketable securities for cash, $3,000. 3 Returned part of merchandise inventory purchased for full credit, $250. 4 Sold merchandise inventory on account, $800 (record sale only). 5 Purchased land and a building for $300,000. Payment is $60,000 cash, and there is a 30-year mortgage for the remainder. The purchase price is allocated as follows: $100,000 to the land and $200,000 to the building. 6 Received an order for $12,000 in services to be provided. With

the order was a deposit of $3,500. SO6 Recording Transactions in the General Journal and Posting to the Ledger Accounts E 18. Open a general journal form like the one in Exhibit 2-4, and label it Page 10. After opening the form, record the following transactions in the journal: Dec. 14 P urchased equipment for $6,000, paying $2,000 as a cash down payment. 28 Paid $3,000 of the amount owed on the equipment. Prepare three ledger account forms like the one shown in Exhibit 2-5. Use the following account numbers: Cash, 111; Office Equipment, 146; and Accounts Payable, 212. Then post the two transactions from the general journal to the ledger accounts, being sure to make proper posting references. Assume that the Cash account has a debit balance of $8,000 on the day prior to the first transaction. Problems LO2 T Accounts, Normal Balance, and The Accounting Equation P 1. Delux Design Company creates radio and television advertising for local businesses in the twin cities. The following alphabetical list shows Delux Design’s account balances as of January 31, 2011: Accounts Payable $ 3,210 Accounts Receivable 39,000 Cash 9,200 Design Revenue 105,000 Equipment ? J. Smith, Capital 37,000 J. Smith, Withdrawals 18,000 Loans Payable 5,000 Rent Expense 5,940 Telephone Expense 480 Unearned Revenue 9,000 Wages Expense 62,000 Chapter Assignments 89 Required Insert the account title at the top of its corresponding T account and enter the dollar amount as a normal balance in the account. Determine the balance of Equipment and then show that the accounting equation is in balance. Owner’s Equity Assets (cid:2) Liabilities (cid:3) J. Smith, (cid:4) J. Smith, (cid:3) Revenues (cid:4) Expenses Capital Withdrawals LO3 Transaction Analysis P 2. The following accounts are applicable to Tom’s Warehouse Sweeps: 1. Cash 7. Accounts Payable 2. Accounts Receivable 8. T. Henzel, Capital 3. Supplies 9. T. Henzel, Withdrawals 4. Prepaid Insurance 10. Service Revenue 5. Equipment 11. Rent Expense 6. Notes Payable 12. Repair Expense Tom’s Warehouse Sweeps completed the following transactions: Debit Credit 7 1 a. Paid for supplies purchased on credit last month. b. Billed customers for services performed. c. Paid the current month’s rent. d. Purchased supplies on credit. e. Received cash from customers for services performed but not yet billed. f. Purchased equipment on account. g. Received a bill for repairs. h. Returned part of the equipment purchased in f for a credit. i. Received payments from customers previously billed. j. Paid the bill received in g. k. Received an order for services to be performed. l. Paid for repairs with cash. m. Made a payment to reduce the principal of the note payable. n. Made a cash withdrawal. 90 CHAPTER 2 Analyzing Business Transactions Required Analyze each transaction and show the accounts affected by entering the corresponding numbers in the appropriate debit or credit column as shown in transaction a. Indicate no entry, if appropriate. LO3 LO4 Transaction Analysis, T Accounts, and Trial Balance LO5 P 3. C armen Dahlen opened a secretarial school called Star Office Training. a. Dahlen contributed the following assets to the business: Cash $5,700 Computers 5,000 Office Equipment 3,600 b. Found a location for her business and paid the first month’s rent, $260. c. Paid for an advertisement announcing the opening of the school, $190. d. Received applications from three students for a four-week secretarial pro- gram and two students for a ten-day keyboarding course. The students will be billed a total of $1,300. e. Purchased supplies on credit, $330. f. Billed the enrolled students, $2,040. g. Purchased a second-hand computer, $480, and office equipment, $380, on credit. h. Paid for the supplies purchased on credit in e, $330. i. Paid cash to repair a broken computer, $40. j. Received partial payment from students previously billed, $1,380. k. Paid the utility bill for the current month, $90. l. Paid an assistant one week’s salary, $440. m. Made a cash withdrawal of $300. Required 1. Set up the following T accounts: Cash; Accounts Receivable; Supplies; Com-

puters; Office Equipment; Accounts Payable; C. Dahlen, Capital; C. Dahlen, Withdrawals; Tuition Revenue; Salaries Expense; Utilities Expense; Rent Expense; Repair Expense; and Advertising Expense. 2. Record the transactions directly in the T accounts, using the transaction let- ter to identify each debit and credit. 3. Prepare a trial balance using today’s date. User insight (cid:2) 4. Examine transactions f and j. What were the revenues, and how much cash was received from the revenues? What business issues might you see arising from the differences in these numbers? LO1 LO3 Transaction Analysis, Journal Form, T Accounts, and Trial Balance LO4 P 4. Melvin Patel bid for and won a concession to rent bicycles in the local park during the summer. During the month of June, Patel completed the following transactions for his bicycle rental business: June 2 Began business by placing $7,200 in a business checking account in the name of the company. 3 Purchased supplies on account for $150. 4 Purchased 10 bicycles for $2,500, paying $1,200 down and agreeing to pay the rest in 30 days. Chapter Assignments 91 June 5 Paid $2,900 in cash for a small shed to store the bicycles and to use for other operations. 8 Paid $400 in cash for shipping and installation costs (considered an addition to the cost of the shed) to place the shed at the park entrance. 9 Hired a part-time assistant to help out on weekends at $7 per hour. 10 Paid a maintenance person $75 to clean the grounds. 13 Received $970 in cash for rentals. 17 Paid $150 for the supplies purchased on June 3. 18 Paid a $55 repair bill on bicycles. 23 Billed a company $110 for bicycle rentals for an employee outing. 25 Paid the $100 fee for June to the Park District for the right to operate the bicycle concession. 27 Received $960 in cash for rentals. 29 Paid the assistant $240. 30 Made a cash withdrawal of $500. Required 1. Prepare entries to record these transactions in journal form. 2. Set up the following T accounts and post all the journal entries: Cash; Accounts Receivable; Supplies; Shed; Bicycles; Accounts Payable; M. Patel, Capital; M. Patel, Withdrawals; Rental Revenue; Wages Expense; Mainte- nance Expense; Repair Expense; and Concession Fee Expense. 3. Prepare a trial balance for Patel Rentals as of June 30, 2011. User insight (cid:2) 4. Compare and contrast how the issues of recognition, valuation, and classifi- cation are settled in the transactions of June 3 and 10. LO3 LO4 Transaction Analysis, General Journal, Ledger Accounts, and Trial Balance LO5 SO6 P 5. Alpha Pro Company is a marketing firm. The company’s trial balance on July 31, 2011, appears below. Alpha Pro Company Trial Balance July 31, 2011 Cash (111) $10,590 Accounts Receivable (113) 5,500 Office Supplies (116) 610 Office Equipment (146) 4,200 Accounts Payable (212) $ 2,600 K. Yating, Capital (311) 18,300 $20,900 $20,900 During the month of August, the company completed the following transactions: 92 CHAPTER 2 Analyzing Business Transactions Aug. 2 Paid rent for August, $650. 3 Received cash from customers on account, $2,300. 7 Ordered supplies, $380. 10 Billed customers for services provided, $2,800. 12 Made a payment on accounts payable, $1,300. 14 Received the supplies ordered on August 7 and agreed to pay for them in 30 days, $380. 17 Discovered some of the supplies were not as ordered and returned them for full credit, $80. 19 Received cash from a customer for services provided, $4,800. 24 Paid the utility bill for August, $250. 26 Received a bill, to be paid in September, for advertisements placed in the local newspaper during the month of August to promote Alpha Pro Company, $700. 29 Billed a customer for services provided, $2,700. 30 Paid salaries for August, $3,800. 31 Made a cash withdrawal of $1,200. Required 1. Open accounts in the ledger for the accounts in the trial balance plus the following accounts: K. Yating, Withdrawals (313); Marketing Fees (411); Salaries Expense (511); Rent Expense (514); Utilities Expense (512); and Advertising Expense (516). 2. Enter the July 31, 2011, account balances from the trial balance.

3. Enter the August transactions in the general journal (Pages 22 and 23). 4. Post the journal entries to the ledger accounts. Be sure to make the appropri- ate posting references in the journal and ledger as you post. 5. Prepare a trial balance as of August 31, 2011. User insight (cid:2) 6. Examine the transactions for August 3, 10, 19, and 29. What were the rev- enues, and how much cash was received from the revenues? What business issues might you see arising from the differences in these numbers? Alternate Problems LO2 T Accounts, Normal Balance, and the Accounting Equation P 6. The Stewart Construction Company builds foundations for buildings and parking lots. The following alphabetical list shows Stewart Construction’s account balances as of April 30, 2011: A. Stewart, Capital $20,000 A. Stewart, Withdrawals 3,500 Accounts Payable 1,950 Accounts Receivable 5,060 Cash ? Equipment 13,750 Notes Payable 10,000 Revenue Earned 8,700 Supplies 3,250 Supplies Expense 3,600 Utilities Expense 210 Wages Expense 4,400 Chapter Assignments 93 Required Insert the account at the top of its corresponding T account, and enter the dollar amount as a normal balance in the account. Determine the balance of cash and then show that the accounting equation is in balance. Owner’s Equity Assets (cid:2) Liabilities (cid:3) A. Stewart, (cid:4) A. Stewart, (cid:3) Revenues (cid:4) Expenses Capital Withdrawals LO1 LO3 Transaction Analysis, T Accounts, and Trial Balances LO4 P 7. Brad Cupello began an upholstery cleaning business on October 1 and engaged in the following transactions during the month: Oct. 1 Began business by depositing $15,000 in a bank account in the name of the company. 2 Ordered cleaning supplies, $3,000. 3 Purchased cleaning equipment for cash, $2,800. 4 Made two months’ van lease payment in advance, $1,200. 7 Received the cleaning supplies ordered on October 2 and agreed to pay half the amount in 10 days and the rest in 30 days. 9 Paid for repairs on the van with cash, $1,080. 12 Received cash for cleaning upholstery, $960. 17 Paid half the amount owed on supplies purchased on October 7, $1,500. 21 Billed customers for cleaning upholstery, $1,340. 24 Paid cash for additional repairs on the van, $80. 27 Received $600 from the customers billed on October 21. 31 Made a cash withdrawal of $700. Required 1. Set up the following T accounts: Cash; Accounts Receivable; Cleaning Sup- plies; Prepaid Lease; Cleaning Equipment; Accounts Payable; B. Cupello, Capital; B. Cupello, Withdrawals; Cleaning Revenue; and Repair Expense. 2. Record transactions directly in the T accounts. Identify each entry by date. 3. Prepare a trial balance for Cupello Upholstery Cleaning as of October 31, 2011. User insight (cid:2) 4. Compare and contrast how the issues of recognition, valuation, and classifi- cation are settled in the transactions of October 7 and 9. 94 CHAPTER 2 Analyzing Business Transactions LO3 LO4 Transaction Analysis, General Journal, Ledger Accounts, and Trial Balance LO5 SO6 P 8. The Golden Nursery School Company provides baby-sitting and child-care programs. On January 31, 2011, the company had the following trial balance: Golden Nursery School Company Trial Balance January 31, 2011 Cash (111) $ 2,070 Accounts Receivable (113) 1,700 Equipment (146) 1,040 Buses (148) 17,400 Notes Payable (211) $15,000 Accounts Payable (212) 1,640 T. Kuo, Capital (311) 5,570 $22,210 $22,210 During the month of February, the company completed the following transactions: Feb. 2 Paid this month’s rent, $400. 3 Received fees for this month’s services, $650. 4 Purchased supplies on account, $85. 5 Reimbursed the bus driver for gas expenses, $40. 6 Ordered playground equipment, $1,000. 8 Made a payment on account, $170. 9 Received payments from customers on account, $1,200. 10 Billed customers who had not yet paid for this month’s services, $700. 11 Paid for the supplies purchased on February 4. 13 Purchased and received playground equipment ordered on February 6 for cash, $1,000. 17 Purchased equipment on account, $290. 19 Paid this month’s utility bill, $145.

22 Received payment for one month’s services from customers previously billed, $500. 26 Paid part-time assistants for services, $460. 27 Purchased gas and oil for the bus on account, $325. 28 Made a cash withdrawal of $200. Required 1. Open accounts in the ledger for the accounts in the trial balance plus the fol- lowing ones: Supplies (116); T. Kuo, Withdrawals (313); Service Revenue (411); Rent Expense (514); Gas and Oil Expense (510); Wages Expense (511); and Utilities Expense (512). 2. Enter the January 31, 2011, account balances from the trial balance. 3. Enter the above transactions in the general journal (Pages 17 and 18). 4. Post the entries to the ledger accounts. Be sure to make the appropriate post- ing references in the journal and ledger as you post. 5. Prepare a trial balance as of February 28, 2011. User insight (cid:2) 6. Examine the transactions for February 3, 9, 10, and 22. What were the rev- enues, and how much cash was received from the revenues? What business issue might you see arising from the differences in these numbers? Chapter Assignments 95 LO3 Transaction Analysis P 9. The following accounts are applicable to Walter’s Chimney Sweeps: 1. Cash 2. Accounts Receivable 3. Supplies 4. Prepaid Insurance 5. Equipment 6. Notes Payable 7. Accounts Payable 8. W. Norman, Capital 9. W. Norman, Withdrawals 10. Service Revenue 11. Rent Expense 12. Repair Expense Walter’s Chimney Sweeps completed the following transactions: Debit Credit a. Paid for supplies purchased on credit last month. 7 1 b. Billed customers for services performed. c. Paid the current month’s rent. d. Purchased supplies on credit. e. Received cash from customers for services performed but not yet billed. f. Purchased equipment on account. g. Received a bill for repairs. h. Returned part of the equipment purchased in f for a credit. i. Received payments from customers previously billed. j. Paid the bill received in g. k. Received an order for services to be performed. l. Paid for repairs with cash. m. M ade a payment to reduce the principal of the note payable. n. Made a cash withdrawal. Required Analyze each transaction and show the accounts affected by entering the corre- sponding numbers in the appropriate debit or credit column as shown in transac- tion a. Indicate no entry, if appropriate. LO3 LO4 Transaction Analysis, T Accounts, and Trial Balance LO5 P 10. Bob Lutz opened a secretarial school called Best Secretarial Training. a. Lutz contributed the following assets to the business: Cash $5,700 Computers 4,300 Office Equipment 3,600 b. Found a location for his business and paid the first month’s rent, $260. c. Paid for an advertisement announcing the opening of the school, $190. d. Received applications from three students for a four-week secretarial program and two students for a ten-day keyboarding course. The students will be billed a total of $1,300. e. Purchased supplies on credit, $330. f. Billed the enrolled students, $1,740. 96 CHAPTER 2 Analyzing Business Transactions g. Purchased a second-hand computer, $480, and office equipment, $380, on credit. h. Paid for the supplies purchased on credit in e, $330. i. Paid cash to repair a broken computer, $40. j. Received partial payment from students previously billed, $1,080. k. Paid the utility bill for the current month, $90. l. Paid an assistant one week’s salary, $440. m. Made a cash withdrawal of $300. Required 1. Set up the following T accounts: Cash; Accounts Receivable; Supplies; Com- puters; Office Equipment; Accounts Payable; B. Lutz, Capital; B. Lutz, Withdrawals; Tuition Revenue; Salaries Expense; Utilities Expense; Rent Expense; Repair Expense; and Advertising Expense. 2. Record the transactions directly in the T accounts, using the transaction let- ter to identify each debit and credit. 3. Prepare a trial balance using today’s date. User insight (cid:2) 4. Examine transactions f and j. What were the revenues and how much cash was received from the revenues? What business issues might you see arising from the differences in these numbers? ENHANCING Your Knowledge, Skills, and Critical Thinking

LO1 Valuation Issue C 1. Nike, Inc. manufactures athletic shoes and related products. In one of its annual reports, Nike made this statement: “Property, plant, and equipment are recorded at cost.”6 Given that the property, plant, and equipment undoubtedly were purchased over several years and that the current value of those assets is likely to be very different from their original cost, what authoritative basis is there for carrying the assets at cost? Does accounting generally recognize changes in value after the purchase of property, plant, and equipment? Assume you are an accountant for Nike. Write a memo to management explaining the rationale underlying Nike’s approach. LO5 Cash Flows C 2. You have been promoted recently and now have access to the firm’s monthly financial statements. Business is good. Revenues are increasing rapidly, and income is at an all-time high. The balance sheet shows growth in receivables, and accounts payable have declined. However, the chief financial officer is concerned about the firm’s cash flows from operating activities because they are decreasing. What are some reasons why a company with a positive net income may fall short of cash from its operating activities? What could be done to improve this situa- tion? LO1 Recognition Point and Ethical Considerations C 3. Jerry Hasbrow, a sales representative for Penn Office Supplies Company, is compensated on a commission basis and receives a substantial bonus if he Chapter Assignments 97 meets his annual sales goal. The company’s recognition point for sales is the day of shipment. On December 31, Hasbrow realizes he needs sales of $2,000 to reach his sales goal and receive the bonus. He calls a purchaser for a local insurance company, whom he knows well, and asks him to buy $2,000 worth of copier paper today. The purchaser says, “But Jerry, that’s more than a year’s supply for us.” Hasbrow says, “Buy it today. If you decide it’s too much, you can return however much you want for full credit next month.” The purchaser says, “Okay, ship it.” The paper is shipped on December 31 and recorded as a sale. On January 15, the purchaser returns $1,750 worth of paper for full credit (approved by H asbrow) against the bill. Should the shipment on December 31 be recorded as a sale? Discuss the ethics of Hasbrow’s action. LO1 LO3 Valuation and Classification Issues for Dot-Coms C 4. The dot-com business has raised many issues about accounting practices, some of which are of great concern to both the SEC and the FASB. Important ones relate to the valuation and classification of revenue transactions. Many dot-com companies seek to report as much revenue as possible because revenue growth is seen as a key performance measure for these companies. Amazon.com is a good example. Consider the following situations: a. An Amazon.com customer orders and pays $28 for a video game on the Internet. Amazon sends an email to the company that makes the product, which sends the video game to the customer. Amazon collects $28 from the customer and pays $24 to the other company. Amazon never owns the video game. b. Amazon agrees to place a banner advertisement on its website for another dot-com company. Instead of paying cash for the advertisement, the other company agrees to let Amazon advertise on its website. c. Assume the same facts as in situation b except that Amazon agrees to accept the other company’s common stock in this barter transaction. Over the next six months, the price of that stock declines. Divide the class into three groups. Assign each group one of the above situations. Each group should discuss the valuation and classification issues that arise in the assigned situation, including how Amazon should account for each transaction. LO1 Recognition, Valuation, and Classification C 5. Refer to the Summary of Significant Accounting Policies in the notes to the financial statements in the CVS Corporation annual report at the end of Chapter 5 to answer these questions: 1. How does the concept of recognition apply to advertising costs?

2. How does the concept of valuation apply to inventories? 3. How does the concept of classification apply to cash and cash equivalents? Revenue Recognition C 6. Refer to the financial statements of CVS and Southwest Airlines Co. in the Supplement to Chapter 5. What is the total revenue for CVS and Southwest on the respective income statements? How do you think the nature of each business will affect revenue recognition for prescriptions filled for CVS versus airline tick- ets for Southwest? When do you think cash is received and revenues are earned for each company? C H A P T E R 3 Measuring Business Income Making a I ncome, or earnings, is the most important measure of a com- Statement pany’s success or failure. Thus, the incentive to manage, or mis- state, earnings by manipulating the numbers can be powerful, and INCOME STATEMENT because earnings are based on estimates, manipulation can be easy. Revenues For these reasons, ethical behavior is extremely important when – Expenses measuring business income. = Net Income LEARNING OBJECTIVES STATEMENT OF OWNER’S EQUITY LO1 Define net income, and explain the assumptions underlying income measurement and their ethical application. (pp. 100–104) Beginning Balance + Net Income LO2 Define accrual accounting, and explain how it is – Withdrawals accomplished. (pp. 104–106) = Ending Balance LO3 Identify four situations that require adjusting entries, and illustrate typical adjusting entries. (pp. 107–116) BALANCE SHEET LO4 Prepare financial statements from an adjusted trial Assets Liabilities balance. (pp. 116–119) Owner’s LO5 Use accrual-based information to analyze cash flows. Equity (pp. 119–120) A = L + OE STATEMENT OF CASH FLOWS Operating activities + Investing activities + Financing activities = Change in Cash + Beginning Balance = Ending Cash Balance Adjusting entries affect the balance sheet and income statement but not the statement of cash flows. 98 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What assumptions must Reliable RELIABLE ANSWERING Answering Service make to SERVICE account for transactions that span accounting periods? Reliable Answering Service takes telephone messages for doctors, (cid:2) How does Reliable assign its revenues and expenses to the lawyers, and other professionals and relays them immediately when proper accounting period so they involve an emergency. At the end of any accounting period, that net income is properly Reliable has many transactions that will affect future periods. Exam- measured? ples appear in the company’s trial balance on the following page. (cid:2) Why are the adjustments that They include office supplies and prepaid expenses, which, though paid these transactions require in the period just ended, will benefit future periods and are there- important to Reliable’s financial fore recorded as assets. Another example is unearned revenue, which performance? represents receipts for services the company will not perform and earn until a future period. If prepaid expenses and unearned revenue are not accounted for properly at the end of a period, the company’s income will be misstated. Similar misstatements can occur when a company fails to record (accrue) expenses that it incurred or revenue that it has earned but not yet received. Knowing the answers to the questions at right will help prevent such misstatements. 9999 100 CHAPTER 3 Measuring Business Income Profitability As you know, profitability and liquidity are the two major goals of a business. For Measurement: a business to succeed, or even to survive, it must earn a profit. Profit, however, means different things to different people. Accountants prefer to use the term net Issues and Ethics income because it can be precisely defined from an accounting point of view as the net increase in owner’s equity that results from a company’s operations. LO1 Define net income, and Net income is reported on the income statement, and management, owners, explain the assumptions under- and others use it to measure a company’s progress in meeting the goal of profitabil- lying income measurement and ity. Readers of income statements need to understand what net income means and

their ethical application. be aware of its strengths and weaknesses as a measure of a company’s performance. Net Income Net income is accumulated in the owner’s Capital account. In its simplest form, it is measured as the difference between revenues and expenses when revenues exceed expenses: Net Income (cid:2) Revenues (cid:4) Expenses Study Note WWhen expenses exceed revenues, a net loss occurs. The essence of revenue is that Revenues are increases in owner’s equity resulting from selling goods, render- something has been earned iing services, or performing other business activities. When a business delivers a through the sale of goods pproduct or provides a service to a customer, it usually receives cash or is prom- or services. That is why cash iised that it will receive cash in the near future. The amount of cash promised is received through a loan does rrecorded in either Accounts Receivable or Notes Receivable. The total of these not constitute revenue. aaccounts and the total cash received from customers in an accounting period are tthe company’s revenues for that period. Profitability Measurement: Issues and Ethics 101 Expenses are decreases in owner’s equity resulting from the cost of selling Study Note ggoods or rendering services and the cost of the activities necessary to carry on a bbusiness, such as attracting and serving customers. In other words, expenses are The primary purpose of an tthe cost of the goods and services used in the course of earning revenues. Exam- expense is to generate revenue. pples include salaries expense, rent expense, advertising expense, utilities expense, aand depreciation (allocation of cost) of a building or office equipment. These expenses are often called the cost of doing business or expired costs. Not all increases in owner’s equity arise from revenues, nor do all decreases in owner’s equity arise from expenses. Owner’s investments increase owner’s equity but are not revenues, and withdrawals decrease owner’s equity but are not expenses. Income Measurement Assumptions Users of financial reports should be aware that estimates and assumptions play a major role in the measurement of net income and other key indicators of perfor- mance. The management of Netflix, the online movie rental company, acknowl- edges this in its annual report, as follows: The preparation of . . . financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, . . . and the reported amount of revenues and expenses.1 The major assumptions made in measuring business income have to do with con- tinuity, periodicity, and matching. Continuity Measuring business income requires that certain expense and reve- nue transactions be allocated over several accounting periods. Choosing the num- ber of accounting periods raises the issue of continuity. What is the expected life of the business? Many businesses last less than five years, and in any given year, thousands of businesses go bankrupt. The majority of companies present annual financial statements on the assumption that the business will continue to oper- ate indefinitely—that is, that the company is a going concern. The continuity assumption is as follows: Unless there is evidence to the contrary, the accountant assumes that the business will continue to operate indefinitely. Justification for all the techniques of income measurement rests on the assumption of continuity. Consider, for example, the value of assets on the bal- ance sheet. The continuity assumption allows the cost of certain assets to be held on the balance sheet until a future accounting period, when the cost will become an expense on the income statement. When a firm is facing bankruptcy, the accountant may set aside the assump- tion of continuity and prepare financial statements based on the assumption that the firm will go out of business and sell all of its assets at liquidation value—that is, for what they will bring in cash.

Periodicity Measuring business income requires assigning revenues and expenses to a specific accounting period. However, not all transactions can be eas- ily assigned to specific periods. For example, when a company purchases a build- ing, it must estimate the number of years the building will be in use. The portion of the cost of the building that is assigned to each period depends on this estimate and requires an assumption about periodicity. The assumption is as follows: Although the lifetime of a business is uncertain, it is nonetheless useful to estimate the business’s net income in terms of accounting periods. 102 CHAPTER 3 Measuring Business Income FOCUS ON BUSINESS PRACTICE Fiscal Years Vary The fiscal years of many schools and governmental agen- Company Last Month of Fiscal Year cies end on June 30 or September 30. The table at the right Apple Computer September shows the last month of the fiscal year of some well-known Caesars World July companies. Fleetwood Enterprises April H.J. Heinz March Kelly Services December MGM-UA Communications August Toys “R” Us January Financial statements may be prepared for any time period, but generally, to Study Note make comparisons easier, the periods are of equal length. A 12-month account- Accounting periods are of equal ing period is called a fiscal year; accounting periods of less than a year are called length so that one period can interim periods. The fiscal year of many organizations is the calendar year, Janu- be compared with the next. ary 1 to December 31. However, retailers often end their fiscal years during a slack season, and in this case, the fiscal year corresponds to the yearly cycle of business activity. Matching To measure net income adequately, revenues and expenses must be assigned to the accounting period in which they occur, regardless of when cash is received or paid. This is an application of the matching rule: Revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the account- ing period in which they are used to produce revenue. In other words, expenses should be recognized in the same accounting period as the revenues to which they are related. However, a direct cause-and-effect rela- tionship between expenses and revenues is often difficult to identify. When there is no direct means of connecting expenses and revenues, costs are allocated in a sys- tematic way among the accounting periods that benefit from the costs. For example, a building’s cost is expensed over the building’s expected useful life, and interest on investments is recorded as income even though it may not have been received. The cash basis of accounting differs from the matching rule in that it is the practice of accounting for revenues in the period in which cash is received and for expenses in the period in which cash is paid. Some individuals and businesses use this method to account for income taxes. With this method, taxable income is calculated as the difference between cash receipts from revenues and cash pay- ments for expenses. Although the cash basis of accounting works well for some small businesses and many individuals, it does not meet the needs of most businesses. Ethics and the Matching Rule As shown in Figure 3-1, applying the matching rule involves making assumptions. It also involves exercising judgment. Consider the assumptions and judgment involved in estimating the useful life of a building. The estimate should be based Profitability Measurement: Issues and Ethics 103 FIGURE 3-1 Assumptions and the Matching Rule NET INCOME Revenues minus Expenses MATCHING RULE ASSUMPTIONS Periodicity Going Concern on realistic assumptions, but management has latitude in making that estimate, and its judgment will affect the final net income that is reported. The manipulation of revenues and expenses to achieve a specific outcome is called earnings management. Research has shown that companies that manage their earnings are much more likely to exceed projected earnings targets by a little

than to fall short by a little. Why would management want to manage earnings to keep them from falling short? It may want to (cid:2) Meet a previously announced goal and thus meet the expectations of the m arket. (cid:2) Keep the company’s stock price from dropping. (cid:2) Meet a goal that will enable it to earn bonuses. (cid:2) Avoid embarrassment. Earnings management, though not the best practice, is not illegal. However, when the estimates involved in earnings management begin moving outside a reasonable range, the financial statements become misleading. For instance, net income is misleading when revenue is overstated or expenses are understated by significant amounts. As noted earlier in the text, the preparation of financial state- ments that are intentionally misleading constitutes fraudulent financial reporting. Most of the enforcement actions that the Securities and Exchange Com- mission has brought against companies in recent years involve misapplications of the matching rule resulting from improper accrual accounting. For example, FOCUS ON BUSINESS PRACTICE Are Misstatements of Earnings Always Overstatements? Not all misstatements of earnings are overstatements. For for understating its income. Microsoft, a very successful instance, privately held companies, which do not have to company, accomplished this by overstating its unearned be concerned about the effect of their earnings announce- revenue on the balance sheet. The company’s motive in ments on owners or investors, may understate income to trying to appear less successful than it actually was may reduce or avoid income taxes. In an unusual case involv- have been that it was facing government charges of being ing a public company, the SEC cited and fined Microsoft a monopoly.2 104 CHAPTER 3 Measuring Business Income Dell Computer had to restate four years of its financial results because senior executives improperly applied accrual accounting to give the impression that the company was meeting quarterly earnings targets. After the SEC action, the com- pany conducted an internal investigation that resulted in many changes in its accounting controls.3 In the rest of this chapter, we focus on accrual accounting and its proper application. STOP & APPLY Match the assumptions or actions with the concepts below: _____ 1. I ncreases in owner’s equity resulting _____ 3. I ncrease in owner’s equity that from selling goods, rendering ser- results from a company’s operations. vices, or performing other business _____ 4. D ecreases in owner’s equity result- activities ing from the cost of selling goods, _____ 2. M anipulation of revenues and rendering services, and other busi- expenses to achieve a specific ness activities. change in owner’s equity a. Net income b. Revenues c. Expenses d. Earnings management SOLUTION 1. b; 2. d; 3. a; 4. c Accrual Accrual accounting encompasses all the techniques accountants use to apply the matching rule. In accrual accounting, revenues and expenses are recorded in the peri- Accounting ods in which they occur rather than in the periods in which they are received or paid. Accrual accounting is accomplished in the following ways: LO2 Define accrual account- ing, and explain how it is 1. Recording revenues when they are earned. accomplished. 2. Recording expenses when they are incurred. 3. Adjusting the accounts. Recognizing Revenues As you may recall, the process of determining when revenue should be recorded is called revenue recognition. The Securities and Exchange Commission requires that all the following conditions be met before revenue is recognized:4 (cid:2) Persuasive evidence of an arrangement exists. (cid:2) A product or service has been delivered. (cid:2) The seller’s price to the buyer is fixed or determinable. (cid:2) Collectibility is reasonably assured. For example, suppose Miller Design Studio has created a brochure for a cus- tomer and that the transaction meets the SEC’s four criteria: Miller and the Accrual Accounting 105 FOCUS ON BUSINESS PRACTICE Revenue Recognition: Principles Versus Rules

Revenue recognition highlights the differences between the other hand, has one broad IFRS for revenue recognition international and U.S. accounting standards. Although U.S. and leaves it to companies and their auditors to determine standards are referred to as generally accepted accounting how to apply the broad principle. As a result, revenue recog- principles, the FASB has issued extensive rules for revenue nition is an issue that will provide a challenge to achieving recognition in various situations and industries. The IASB, on international convergence of accounting practices. customer agree that the customer owes for the service, the service has been rendered, both parties understand the price, and there is a reasonable expec- tation that the customer will pay the bill. When Miller bills the customer, it records the transaction as revenue by debiting Accounts Receivable and credit- ing Design Revenue. Note that revenue can be recorded even though cash has not been collected; all that is required is a reasonable expectation that cash will be received. Recognizing Expenses Expenses are recorded when there is an agreement to purchase goods or ser- vices, the goods have been delivered or the services rendered, a price has been established or can be determined, and the goods or services have been used to produce revenue. For example, when Miller Design Studio receives its utility bill, it recognizes the expense as having been incurred and as having helped pro- duce revenue. Miller records this transaction by debiting Utilities Expense and crediting Accounts Payable. Until the bill is paid, Accounts Payable serves as a holding account. Note that recognition of the expense does not depend on the payment of cash. Adjusting the Accounts Accrual accounting also involves adjusting the accounts. Adjustments are neces- Study Note sary because the accounting period, by definition, ends on a particular day. The balance sheet must list all assets and liabilities as of the end of that day, and the Even though certain revenues income statement must contain all revenues and expenses applicable to the period and expenses theoretically ending on that day. Although operating a business is a continuous process, there change during the period, must be a cutoff point for the periodic reports. Some transactions invariably span there usually is no need to the cutoff point, and some accounts therefore need adjustment. adjust them until the end of the period, when the financial As you can see in Exhibit 3-1, some of the accounts in Miller Design Studio’s statements are prepared. trial balance as of July 31 do not show the correct balances for preparing the financial statements. The trial balance lists prepaid rent of $3,200. At $1,600 per month, this represents rent for the months of July and August. So, on July 31, one-half of the $3,200 represents rent expense for July, and the remaining $1,600 represents an asset that will be used in August. An adjustment is needed to reflect the $1,600 balance in the Prepaid Rent account on the balance sheet and the $1,600 rent expense on the income statement. As you will see, several other accounts in Miller Design Studio’s trial balance do not reflect their correct balances. Like the Prepaid Rent account, they need to be adjusted. 106 CHAPTER 3 Measuring Business Income EXHIBIT 3-1 Trial Balance Miller Design Studio Trial Balance July 31, 2011 Cash $22,480 Accounts Receivable 4,600 Office Supplies 5,200 Prepaid Rent 3,200 Office Equipment 16,320 Accounts Payable $ 6,280 Unearned Design Revenue 1,400 J. Miller, Capital 40,000 J. Miller, Withdrawals 2,800 Design Revenue 12,400 Wages Expense 4,800 Utilities Expense 680 $60,080 $60,080 Adjustments and Ethics Accrual accounting can be difficult to understand. The account adjustments take time to calculate and enter in the records. Also, adjusting entries do not affect cash flows in the current period because they never involve the Cash account. You might ask, “Why go to all the trouble of making them? Why worry about them?” For one thing,

the SEC has identified issues related to accrual accounting and adjustments as an area of utmost importance because of the potential for abuse and misrepresentation.5 All adjustments are important because of their effect on performance measures of profitability and liquidity. Adjusting entries affect net income on the income statement, and they affect profitability comparisons from one accounting period to the next. They also affect assets and liabilities on the balance sheet and thus provide information about a company’s future cash inflows and outflows. This information is needed to assess management’s performance in achieving sufficient liquidity to meet the need for cash to pay ongoing obligations. The potential for abuse arises because considerable judgment underlies the application of adjusting entries. When this judgment is misused, performance measures can be misleading. STOP & APPLY Four conditions must be met before revenue can be recognized. Identify which of these conditions applies to the following actions: a. Determines that the firm has a good credit rating. c. Performs services. b. Agrees to a price for services before it p erforms d. Signs a contract to perform them. services. SOLUTION a. Collectibility is reasonably assured. c. A product or service has been delivered. b. The seller’s price to the buyer is fixed or determinable. d. Persuasive evidence of an arrangement exists. The Adjustment Process 107 The Adjustment When transactions span more than one accounting period, accrual accounting requires the use of adjusting entries. Figure 3-2 shows the four situations in Process which adjusting entries must be made. Each adjusting entry affects one balance sheet account and one income statement account. As we have already noted, LO3 Identify four situations adjusting entries never affect the Cash account. that require adjusting entries, The four types of adjusting entries are as follows: and illustrate typical adjusting entries. Type 1. Allocating recorded costs between two or more accounting periods. Examples of these costs are prepayments of rent, insurance, and supplies and the depreciation of plant and equipment. The adjusting entry in this case involves an asset account and an expense account. Type 2. Recognizing unrecorded, incurred expenses. Examples of these expenses are wages and interest that have been incurred but are not recorded during an accounting period. The adjusting entry involves an expense account and a liabil- ity account. Type 3. Allocating recorded, unearned revenues between two or more account- ing periods. Examples include cash received in advance and deposits made on goods or services. The adjusting entry involves a liability account and a revenue account. Type 4. Recognizing unrecorded, earned revenues. An example is revenue that a company has earned for providing a service but for which it has not billed or col- lected a fee by the end of the accounting period. The adjusting entry involves an asset account and a revenue account. Adjusting entries are either deferrals or accruals. Study Note (cid:2) A deferral is the postponement of the recognition of an expense already paid Adjusting entries provide (Type 1 adjustment) or of revenue received in advance (Type 3 adjustment). information about past or future The cash payment or receipt is recorded before the adjusting entry is made. cash flows but never involve an entry to the Cash account. (cid:2) An accrual is the recognition of a revenue (Type 4 adjustment) or expense (Type 2 adjustment) that has arisen but not been recorded during the accounting period. The cash receipt or payment occurs in a future account- ing period, after the adjusting entry has been made. Type 1 Adjustment: Allocating Recorded Costs (Deferred Expenses) Companies often make expenditures that benefit more than one period. These costs are debited to an asset account. At the end of an accounting period, the FIGURE 3-2 BALANCE SHEET The Four Types of Adjustments Asset Liability I N C 1. Allocating recorded 2. Recognizing O costs between two unrecorded, incurred M Expense

or more accounting expenses. E periods. S T A 4. Recognizing 3. Allocating recorded, T unrecorded, unearned revenues E Revenue M earned revenues. between two or more E accounting periods. N T 108 CHAPTER 3 Measuring Business Income When transactions span more than one accounting period, an adjusting entry is necessary. Depreciation of plant and equipment, such as that found in this warehouse, is a type of transaction that requires an adjusting entry. In this case, the adjusting entry involves an asset account and an expense account. Courtesy of Timothy Babasade/ istockphoto.com. amount of the asset that has been used is transferred from the asset account to an expense account. Two important adjustments of this type are for prepaid expenses and the depreciation of plant and equipment. Prepaid Expenses Companies customarily pay some expenses, including Study Note those for rent, supplies, and insurance, in advance. These costs are called pre- The expired portion of a paid expenses. By the end of an accounting period, a portion or all of prepaid prepayment is converted to an services or goods will have been used or have expired. The required adjust- expense; the unexpired portion ing entry reduces the asset and increases the expense, as shown in Figure 3-3. remains an asset. The amount of the adjustment equals the cost of the goods or services used or expired. FIGURE 3-3 Adjustment for Prepaid (Deferred) Expenses BALANCE SHEET Asset 1. Allocating recorded costs between two or more accounting periods. I Asset Account Expense Account N C O Adjusting Adjusting Liability M Expense Entry Entry E Credit Debit 2. Recognizing S Amount equals cost unrecorded, incurred T of goods or services expenses. A used up or expired. T E M E 4. Recognizing 3. Allocating recorded, N unrecorded, unearned revenues T Revenue earned revenues. between two or more accounting periods. The Adjustment Process 109 If adjusting entries for prepaid expenses are not made at the end of an accounting period, both the balance sheet and the income statement will present incorrect information. The company’s assets will be overstated, and its expenses will be understated. Thus, owner’s equity on the balance sheet and net income on the income statement will be overstated. To illustrate this type of adjusting entry and the others discussed below, we refer again to the transactions of Miller Design Studio. At the beginning of July, Miller Design Studio paid two months’ rent in advance. The advance payment resulted in an asset consisting of the right to occupy the office for two months. As each day in the month passed, part of the asset’s cost expired and became an expense. By July 31, one-half of the asset’s cost had expired and had to be treated as an expense. The adjustment is as follows: Adjustment for Prepaid Rent July 31: Expiration of one month’s rent, $1,600. Analysis: Expiration of prepaid rent decreases the asset account Prepaid Rent with a credit and increases the owner’s equity account Rent Expense with a debit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity PREPAID RENT RENT EXPENSE Dr. Cr. Dr. Cr. July 3 3,200 July 31 1,600 July 31 1,600 Bal. 1,600 Entry in Journal Form: Dr. Cr. July 31 Rent Expense 1,600 Prepaid Rent 1,600 Comment: The Prepaid Rent account now has a balance of $1,600, which rep- resents one month’s rent that will be expensed during August. The logic in this analysis applies to all prepaid expenses. Miller Design Studio purchased $5,200 of office supplies in early July. A care- ful inventory of the supplies is made at the end of the month. It records the number and cost of supplies that have not yet been consumed and are thus still assets of the company. Suppose the inventory shows that office supplies costing $3,660 are still on hand. This means that of the $5,200 of supplies originally purchased, $1,540 worth were used (became an expense) in July. The adjustment is as follows: Adjustment for Supplies July 31: Consumption of supplies, $1,540 Analysis: Consumption of office supplies decreases the asset account Office Supplies

with a credit and increases the expense account Office Supplies Expense with a debit. 110 CHAPTER 3 Measuring Business Income Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity OFFICE SUPPLIES OFFICE SUPPLIES EXPENSE Dr. Cr. Dr. Cr. July 5 5,200 July 31 1,540 July 31 1,540 Bal. 3,660 Entry in Journal Form: Dr. Cr. July 31 Office Supplies Expense 1,540 Office Supplies 1,540 Comment: The asset account Office Supplies now reflects the correct balance of $3,660 of supplies yet to be consumed. The logic in this example applies to all kinds of supplies. Depreciation of Plant and Equipment When a company buys a long-term Study Note asset—such as a building, truck, computer, or store fixture—it is, in effect, In accounting, depreciation prepaying for the usefulness of that asset for as long as it benefits the com- refers only to the allocation pany. Because a long-term asset is a deferral of an expense, the accountant must of an asset’s cost, not to any allocate the cost of the asset over its estimated useful life. The amount allocated decline in the asset’s value. to any one accounting period is called depreciation, or depreciation expense. Depreciation, like other expenses, is incurred during an accounting period to produce revenue. It is often impossible to tell exactly how long an asset will last or how much Study Note of the asset has been used in any one period. For this reason, depreciation must be estimated. Accountants have developed a number of methods for estimat- The difficulty in estimating ing depreciation and for dealing with the related complex problems. (In the an asset’s useful life is further evidence that the net income discussion that follows, we assume that the amount of depreciation has been figure is, at best, an estimate. established.) To maintain historical cost in specific long-term asset accounts, separate accounts—called Accumulated Depreciation accounts—are used to accu- mulate the depreciation on each long-term asset. These accounts, which are deducted from their related asset accounts on the balance sheet, are called con- tra accounts. A contra account is a separate account that is paired with a related account—in this case, an asset account. The balance of a contra account is shown on a financial statement as a deduction from its related account. The net amount is called the carrying value, or book value, of the asset. As the months pass, the amount of the accumulated depreciation grows, and the carrying value of the asset declines. Adjustment for Plant and Equipment July 31: Depreciation of office equipment, $300 Analysis: Depreciation decreases the asset account Office Equipment by increas- ing the contra account Accumulated Depreciation–Office Equipment with a credit and increasing the owner’s equity account Depreciation Expense–Office Equip- ment with a debit. The Adjustment Process 111 Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity OFFICE EQUIPMENT DEPRECIATION EXPENSE– Dr. Cr. OFFICE EQUIPMENT July 6 16,320 Dr. Cr. July 31 300 ACCUMULATED DEPRECIATION– OFFICE EQUIPMENT Dr. Cr. July 31 300 Entry in Journal Form: Dr. Cr. July 31 Depreciation Expense–Office Equipment 300 Accumulated Depreciation– Office Equipment 300 Comment: The carrying value of Office Equipment is $16,020 ($16,320 (cid:4) $300) and is presented on the balance sheet as follows: PROPERTY, PLANT, AND EQUIPMENT Office equipment $16,320 Less accumulated depreciation 300 $16,020 Application to Netflix, Inc. Netflix has prepaid expenses and property and equipment similar to those in the examples we have presented. Among Netflix’s prepaid expenses are payments made in advance to movie companies for rights to DVDs. By paying in advance, Netflix is able to negotiate lower prices. These fixed payments are debited to Prepaid Expense. When the movies produce reve- nue, the prepaid amounts are transferred to expense through adjusting entries.6 Type 2 Adjustment: Recognizing Unrecorded, Incurred Expenses (Accrued Expenses) Usually, at the end of an accounting period, some expenses incurred during the

Study Note period have not been recorded in the accounts. These expenses require adjust- ing entries. One such expense is interest on borrowed money. Each day, interest Remember that in accrual accumulates on the debt. As shown in Figure 3-4, at the end of the account- accounting, an expense must be ing period, an adjusting entry is made to record the accumulated interest, which recorded in the period in which is an expense of the period, and the corresponding liability to pay the interest. it is incurred regardless of when Other common unrecorded expenses are wages and utilities. As the expense and payment is made. the corresponding liability accumulate, they are said to accrue—hence, the term accrued expenses. To illustrate how adjustments are made for unrecorded, incurred wages, sup- pose Miller Design Studio has two pay periods a month rather than one. In July, its pay periods end on the 12th and the 26th, as indicated in the calendar on the next page. 112 CHAPTER 3 Measuring Business Income FIGURE 3-4 BALANCE SHEET Adjustment for Unrecorded Liability (Accrued) Expenses 2. Recognizing unrecorded, incurred expenses. Liability Account Expense Account Asset Adjusting Adjusting I Entry Entry N Credit Debit C 1. Allocating recorded MO Expense costs between two Amount equals cost or more accounting E of expense incurred. periods. S T A 4. Recognizing 3. Allocating recorded, T unrecorded, unearned revenues E Revenue M earned revenues. between two or more E accounting periods. N T JULY SUN M T W TH F SAT 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 By the end of business on July 31, Miller’s assistant will have worked three days (Monday, Tuesday, and Wednesday) beyond the last pay period. The employee has earned the wages for those days but will not be paid until the first payday in August. The wages for these three days are rightfully an expense for July, and the liabilities should reflect that the company owes the assistant for those days. Because the assistant’s wage rate is $2,400 every two weeks, or $240 per day ($2,400(cid:5)10 working days), the expense is $720 ($240 (cid:6) 3 days). Adjustment for Unrecorded Wages July 31: Accrual of unrecorded wages, $720 Analysis: Accrual of wages increases the owner’s equity account Wages Expense with a debit and increases the liability account Wages Payable with a credit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity WAGES PAYABLE WAGES EXPENSE Dr. Cr. Dr. Cr. July 31 720 July 26 4,800 31 720 Bal. 5,520 Entry in Journal Form: Dr. Cr. July 31 Wages Expense 720 Wages Payable 720 The Adjustment Process 113 Comment: Note that the increase in Wages Expense will decrease owner’s equity and that total wages for the month are $5,520, of which $720 will be paid next month. Application to Netflix, Inc. In 2008, Netflix had accrued expenses of $31,394,000.7 If the expenses had not been accrued, Netflix’s liabilities would be significantly understated, as would the corresponding expenses on Netflix’s income statement. The end result would be an overstatement of the company’s earnings. Type 3 Adjustment: Allocating Recorded, Unearned Revenues (Deferred Revenues) Just as expenses can be paid before they are used, revenues can be received before Study Note they are earned. When a company receives revenues in advance, it has an obli- gation to deliver goods or perform services. Unearned revenues are therefore Unearned revenue is a liability shown in a liability account. because there is an obligation For example, publishing companies usually receive cash in advance for maga- to deliver goods or perform zine subscriptions. These receipts are recorded in a liability account, Unearned a service, or to return the Subscriptions. If the company fails to deliver the magazines, subscribers are enti- payment. Once the goods have tled to their money back. As the company delivers each issue of the magazine, it been delivered or the service performed, the liability is earns a part of the advance receipts. This earned portion must be transferred from

transferred to revenue. the Unearned Subscriptions account to the Subscription Revenue account, as shown in Figure 3-5. During July, Miller Design Studio received $1,400 from another firm as advance payment for a series of brochures. By the end of the month, it had com- pleted $800 of work on the brochures, and the other firm had accepted the work. Adjustment for Unearned Revenue July 31: Performance of services for which cash was received in advance, $800 Analysis: Performing the services for which cash was received in advance increases the owner’s equity account Design Revenue with a credit and decreases the liability account Unearned Design Revenue with a debit. FIGURE 3-5 Adjustment for Unearned (Deferred) Revenues BALANCE SHEET Asset Liability I N C 1. Allocating recorded 2. Recognizing O Expense costs between two unrecorded, incurred M or more accounting expenses. E periods. S T A 4. Recognizing T 3. Allocating recorded, unearned revenues between two or more unrecorded, E Revenue accounting periods. M earned revenues. E Liability Account Revenue Account N T Adjusting Adjusting Entry Entry Debit Credit Amount equals price of services performed or goods delivered. 114 CHAPTER 3 Measuring Business Income Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity UNEARNED DESIGN REVENUE DESIGN REVENUE Dr. Cr. Dr. Cr. July 31 800 July 19 1,400 July 10 2,800 Bal. 600 15 9,600 31 800 Bal. 13,200 Entry in Journal Form: Dr. Cr. July 31 Unearned Design Revenue 800 Design Revenue 800 Comment: Unearned Design Revenue now reflects the amount of work still to be performed, $600. Application to Netflix, Inc. Netflix has a current liability account called Deferred (Unearned) Revenue. Deferred revenue consists of subscriptions (monthly payments) billed in advance to customers for which revenues have not yet been earned. Subscription revenues are recognized by prorating them over each subscriber’s monthly subscription period. As time passes and customers use the service, the revenue is transferred from Netflix’s Deferred Revenue account to its Subscription Revenue account. Type 4 Adjustment: Recognizing Unrecorded, Earned Revenues (Accrued Revenues) Accrued revenues are revenues that a company has earned by performing a service or delivering goods but for which no entry has been made in the accounting records. Any revenues earned but not recorded during an account- ing period require an adjusting entry that debits an asset account and credits a revenue account, as shown in Figure 3-6. For example, the interest on a note FIGURE 3-6 BALANCE SHEET Adjustment for Unrecorded Asset Liability (Accrued) Revenues 1. Allocating recorded 2. Recognizing I Expense costs between two unrecorded, incurred N or more accounting expenses. C periods. O M E 4. Recognizing unrecorded, earned revenues. 3. Allocating recorded, S unearned revenues T Asset Account Revenue Account between two or more A accounting periods. T Adjusting Adjusting E M Revenue Entry Entry E Debit Credit N T Amount equals price of services performed. The Adjustment Process 115 receivable is earned day by day but may not be received until another account- ing period. The Interest Receivable account should be debited and the Interest Income account should be credited for the interest accrued at the end of the current period. When a company earns revenue by performing a service—such as designing a series of brochures or developing marketing plans—but will not receive the revenue for the service until a future accounting period, it must make an adjust- ing entry. This type of adjusting entry involves an asset account and a revenue account. During July, Miller Design Studio agreed to create two advertisements for Maggio’s Pizza Company. It also agreed that the first advertisement would be finished by July 31. By the end of the month, Miller had earned $400 for com- pleting the first advertisement. The client will not be billed until the entire proj- ect has been completed. Adjustment for Design Revenue July 31: Accrual of unrecorded revenue, $400 Analysis: Accrual of unrecorded revenue increases the owner’s equity account

Design Revenue with a credit and increases the asset account Accounts Receivable with a debit. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ACCOUNTS RECEIVABLE DESIGN REVENUE Dr. Cr. Dr. Cr. July 15 9,600 July 22 5,000 July 10 2,800 31 400 15 9,600 Bal. 5,000 31 800 31 400 Bal. 13,600 Entry in Journal Form: Dr. Cr. July 31 Accounts Receivable 400 Design Revenue 400 Comment: Design Revenue now reflects the total revenue earned during July, $13,600. Some companies prefer to debit an account called Unbilled Accounts Receivable. Other companies simply flag the transactions in Accounts Receivable as “unbilled.” On the balance sheet, they are usually combined with accounts receivable. Application to Netflix, Inc. Since Netflix’s subscribers pay their subscrip- tions in advance by credit card, Netflix does not need to bill customers for ser- vices provided but not paid. The company is in the enviable position of having no accounts receivable and thus a high degree of liquidity. A Note About Journal Entries Thus far, we have presented a full analysis of each journal entry. The analyses showed you the thought process behind each entry. By now, you should be fully 116 CHAPTER 3 Measuring Business Income aware of the effects of transactions on the accounting equation and the rules of debit and credit. For this reason, in the rest of the book, we present journal entries without full analysis. STOP & APPLY The four types of adjusting entries are as follows: Type 1. Allocating recorded costs between two Type 3. Allocating recorded, unearned revenues or more accounting periods between two or more accounting periods Type 2. Recognizing unrecorded, incurred Type 4. Recognizing unrecorded, earned revenues expenses For each of the following items, identify the type of adjusting entry required: ___ a. Revenues earned but not yet collected or billed to customers ___ b. Interest incurred but not yet recorded ___ c. Unused supplies ___ d. Costs of plant and equipment SOLUTION a. Type 4; b. Type 2; c. Type 1; d. Type 1 Using the After adjusting entries have been recorded and posted, an adjusted trial balance Adjusted Trial is prepared by listing all accounts and their balances. If the adjusting entries have been posted to the accounts correctly, the adjusted trial balance will have equal Balance to debit and credit totals. The adjusted trial balance for Miller Design Studio is Prepare Financial shown in Exhibit 3-2. Statements Some accounts in Exhibit 3-2, such as Cash and Accounts Payable, have the same balances as in the trial balance in Exhibit 3-1 because no adjusting entries affected them. The balances of other accounts, such as Office Supplies and Pre- LO4 Prepare financial paid Rent, differ from those in the trial balance because adjusting entries did affect statements from an adjusted them. The adjusted trial balance also has some new accounts, such as depreciation trial balance. accounts and Wages Payable, that are not in the trial balance. The adjusted trial balance facilitates the preparation of the financial state- ments. As shown in Exhibit 3-2, the revenue and expense accounts are used to prepare the income statement. Using the Adjusted Trial Balance to Prepare Financial Statements 117 EXHIBIT 3-2 Relationship of the Adjusted Trial Balance to the Income Statement Miller Design Studio Miller Design Studio Adjusted Trial Balance Income Statement July 31, 2011 For the Month Ended July 31, 2011 Cash $22,480 Revenues Accounts Receivable 5,000 Design revenue $13,600 Office Supplies 3,660 Expenses Prepaid Rent 1,600 Wages expense $5,520 Office Equipment 16,320 Utilities expense 680 Accumulated Depreciation– Rent expense 1,600 Office Equipment $ 300 Office supplies expense 1,540 Accounts Payable 6,280 Depreciation expense– 300 Unearned Design Revenue 600 office equipment 9,640 Wages Payable 720 Total expenses $ 3,960 J. Miller, Capital 40,000 Net income J. Miller, Withdrawals 2,800 Design Revenue 13,600 Study Note Wages Expense 5,520 The net income figure from the Utilities Expense 680 income statement is needed to

Rent Expense 1,600 prepare the statement of owner’s equity, and the bottom-line figure of Office Supplies Expense 1,540 that statement is needed to prepare Depreciation Expense– the balance sheet. This dictates the 300 Office Equipment order in which the statements are $61,500 $61,500 prepared. Then, as shown in Exhibit 3-3, the statement of owner’s equity and the bal- Study Note ance sheet are prepared. Notice that the net income from the income statement is combined with the Withdrawals account on the statement of owner’s equity to The adjusted trial balance is a give the net change in the J. Miller, Capital account. second check that the ledger The resulting balance of J. Miller, Capital at July 31 is used in preparing the is still in balance. Because it balance sheet, as are the asset and liability account balances in the adjusted trial reflects updated information balance. from the adjusting entries, it is used in preparing the formal financial statements. It does not mean there are no accounting errors. 118 CHAPTER 3 Measuring Business Income EXHIBIT 3-3 Relationship of the Adjusted Trial Balance to the Balance Sheet and Statement of Owner’s Equity Miller Design Studio Miller Design Studio Adjusted Trial Balance Balance Sheet July 31, 2011 July 31, 2011 Cash $22,480 Assets Accounts Receivable 5,000 Cash $22,480 Office Supplies 3,660 Accounts receivable 5,000 Prepaid Rent 1,600 Office supplies 3,660 Office Equipment 16,320 Prepaid rent 1,600 Accumulated Depreciation– Office equipment $16,320 Office Equipment $ 300 Less accumulated Accounts Payable 6,280 300 16,020 depreciation Unearned Design Revenue 600 $48,760 Total assets Wages Payable 720 J. Miller, Capital 40,000 Liabilities J. Miller, Withdrawals 2,800 Accounts payable $ 6,280 Design Revenue 13,600 Unearned design revenue 600 Wages Expense 5,520 Wages payable 720 Utilities Expense 680 Total liabilities $ 7,600 Rent Expense 1,600 Owner’s Equity Office Supplies Expense 1,540 41,160 J. Miller, Capital Depreciation Expense–Office Equipment 300 Total liabilities and owner’s equity $48,760 $61,500 $61,500 Miller Design Studio Statement of Owner’s Equity For the Month Ended July 31, 2011 J. Miller, Capital, July 1, 2011 $ 0 Investment by J. Miller 40,000 3,960 Net income Subtotal $43,960 2,800 Less withdrawals $41,160 J. Miller, Capital, July 31, 2011 Cash Flows from Accrual-Based Information 119 STOP & APPLY The adjusted trial balance for Carroll Company on December 31, 2010, contains the follow- ing accounts and balances: D. C arroll, Capital, $300; D. Carroll, W ithdrawals, $100; Service Revenue, $1,000; Rent Expense, $300; Wages Expense, $400; and Telephone Expense, $100. Compute net income and prepare a statement of owner’s equity in proper form for the month of December. SOLUTION Net income (cid:2) $1,000 (cid:4) $300 (cid:4) $400 (cid:4) $100 Carroll Company (cid:2) $1,000 (cid:4) $800 Statement of Owner’s Equity (cid:2) $200 For the Month Ended December 31, 2010 D. Carroll, Capital, Dec. 1, 2010 $ 300 Net income 200 Subtotal $ 500 Less withdrawals 100 D. Carroll, Capital, Dec. 31, 2010 $ 400 Cash Flows Management has the short-range goal of ensuring that its company has sufficient from Accrual- cash to pay ongoing obligations—in other words, management must ensure the company’s liquidity. To plan payments to creditors and assess the need for short- Based term borrowing, managers must know how to use accrual-based information to Information analyze cash flows. Almost every revenue or expense account on the income statement has one LO5 Use accrual-based or more related accounts on the balance sheet. For instance, Office Supplies information to analyze cash flows. Expense is related to Office Supplies, Wages Expense is related to Wages Payable, and Design Revenue is related to Unearned Design Revenue. As we have shown, these accounts are related by making adjusting entries, the purpose of which is to apply the matching rule to the measurement of net income. The cash inflows that a company’s operations generate and the cash outflows Study Note that they require can also be determined by analyzing these relationships. For exam-

ple, suppose that after receiving the financial statements in Exhibits 3-2 and 3-3, Income as determined by management wants to know how much cash was expended for office supplies. On accrual accounting is important the income statement, Office Supplies Expense is $1,540, and on the balance sheet, to a company’s profitability. Office Supplies is $3,660. Because July was the company’s first month of operation, Cash flows are related to a company’s liquidity. Both are there was no prior balance of office supplies, so the amount of cash expended for important to a company’s office supplies during the month was $5,200 ($1,540 (cid:3) $3,660 (cid:2) $5,200). success. Thus, the cash flow used in purchasing office supplies—$5,200—was much greater than the amount expensed in determining income—$1,540. In planning for August, management can anticipate that the cash needed may be less than the amount expensed because, given the large inventory of office supplies, the company will probably not have to buy office supplies in the coming month. Understanding these cash flow effects enables management to better predict the business’s need for cash in August. The general rule for determining the cash flow received from any revenue or paid for any expense (except depreciation, which is a special case not covered 120 CHAPTER 3 Measuring Business Income here) is to determine the potential cash payments or cash receipts and deduct the amount not paid or not received. As shown below, the application of the general rule varies with the type of asset or liability account: Potential Payment or Receipt Not Paid or Type of Account Received Result Prepaid Expense Ending Balance (cid:3) Expense (cid:2) Cash Payments for for the Period (cid:4) Beginning Expenses Balance Unearned Revenue Ending Balance (cid:3) Revenue (cid:2) Cash Receipts from for the Period (cid:4) Beginning Revenues Balance Accrued Expense Beginning Balance (cid:3) (cid:2) Cash Payments for Expense for the Period (cid:4) Expenses Ending Balance Accrued Revenue Beginning Balance (cid:3) (cid:2) Cash Receipts from Revenue for the Period (cid:4) Revenues Ending Balance For instance, suppose that on May 31, a company had a balance of $480 in Prepaid Insurance and that on June 30, the balance was $670. If the insurance expense during June was $120, the amount of cash expended on insurance dur- ing June can be computed as follows: Prepaid Insurance at June 30 $670 Insurance Expense during June 120 Potential cash payments for insurance $790 Less Prepaid Insurance at May 31 480 Cash payments for insurance during June $310 The beginning balance is deducted because it was paid in a prior accounting period. Note that the cash payments equal the expense plus the increase in the balance of the Prepaid Insurance account [$120 (cid:3) ($670 (cid:4) $480) (cid:2) $310]. In this case, the cash paid was almost three times the amount of insurance expense. In future months, cash payments are likely to be less than the expense. STOP & APPLY Supplies had a balance of $400 at the end of May and $360 at the end of June. Supplies Expense was $550 for the month of June. How much cash was received for services provided during June? SOLUTION Supplies at June 30 $360 Supplies Expense during June 550 Potential cash payments for supplies $910 Less Supplies at May 31 400 Cash payments for supplies during June $510 Reliable Answering Service: Review Problem 121 (cid:2) RELIABLE ANSWERING SERVICE: REVIEW PROBLEM In the Decision Point at the beginning of the chapter, we noted that Reliable Answering Service has many transactions that span accounting periods. We asked these questions: • What assumptions must Reliable Answering Service make to account for transactions that span accounting periods? • How does Reliable assign its revenues and expenses to the proper accounting period so that net income is properly measured? • Why are the adjustments that these transactions require important to Reliable’s financial performance? Two of the assumptions Reliable must make are that it will continue as a going con-

cern for an indefinite time (the continuity assumption) and that it can make useful esti- mates of its income in terms of accounting periods (the periodicity assumption). These assumptions enable the company to apply the matching rule—that is, revenues are assigned to the accounting period in which goods are sold or services are performed, and Posting to T Accounts, expenses are assigned to the accounting period in which they are used to produce rev- Determining Adjusting enue. These adjustments are important in order to measure net income adequately. Entries, and Using an Adjusted Trial Balance to Prepare Financial In addition to Reliable’s trial balance, which appears at the beginning of the chapter, Statements the following information is also available for the company on December 31, 2011: LO3 LO4 • Why are the adjustments that these transactions require important to Reliable’s financial performance? a. Insurance that expired during December amounted to $40. b. Office supplies on hand on December 31 totaled $75. c. Depreciation for December totaled $100. d. Accrued wages on December 31 totaled $120. e. Revenues earned for services performed in December but not billed by the end of the month totaled $300. f. R evenues received in December in advance of services yet to be performed totaled $160. Required 1. Prepare T accounts for the accounts in the trial balance, and enter the balances. 2. Determine the required adjusting entries, and record them directly in the T accounts. Open new T accounts as needed. 3. Prepare an adjusted trial balance. 4. Prepare an income statement, a statement of owner’s equity, and a balance sheet for the month ended December 31, 2011. 5. User insight: Which accounts on Reliable’s income statement are potentially affected by adjusting entries? Which account on Reliable’s balance sheet is never affected by an adjusting entry? 122 CHAPTER 3 Measuring Business Income Answers to 1. T accounts set up and amounts from trial balance entered Review Problem 2. Adjusting entries recorded Reliable Answering Service: Review Problem 123 3. Adjusted trial balance prepared 4. Financial statements prepared 124 CHAPTER 3 Measuring Business Income 5. All accounts on the income statement are potentially affected by adjusting entries. Cash on the balance sheet is never affected by an adjusting entry. Stop & Review 125 STOP & REVIEW LO1 Defi ne net income, and Net income is the net increase in owner’s equity that results from a company’s explain the assump- operations. Net income equals revenues minus expenses; when expenses exceed tions underlying income revenues, a net loss results. Revenues equal the price of goods sold or services measurement and their rendered during a specific period. Expenses are the costs of goods and services ethical application. used in the process of producing revenues. The continuity assumption recognizes that even though businesses face an uncertain future, without evidence to the contrary, accountants must assume that a business will continue to operate indefinitely. The periodicity assumption recognizes that although the lifetime of a business is uncertain, it is nonetheless useful to estimate the business’s net income in terms of account- ing periods. The matching rule holds that revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the accounting period in which they are used to produce revenue. Because applying the matching rule involves making assumptions and exercis- ing judgment, it can lead to earnings management, which is the manipulation of revenues and expenses to achieve a specific outcome. When the estimates involved in earnings management move outside a reasonable range, financial statements become misleading. Financial statements that are intentionally misleading consti- tute fraudulent financial reporting. LO2 Defi ne accrual account- Accrual accounting consists of all the techniques accountants use to apply the ing, and explain how it is matching rule. It is accomplished by recognizing revenues when they are earned,

accomplished. by recognizing expenses when they are incurred, and by adjusting the accounts. LO3 Identify four situations Adjusting entries are required when (1) recorded costs must be allocated between that require adjusting two or more accounting periods, (2) unrecorded expenses exist, (3) recorded, entries, and illustrate unearned revenues must be allocated between two or more accounting periods, typical adjusting entries. and (4) unrecorded, earned revenues exist. The preparation of adjusting entries is summarized as follows: Type of Account Type of Adjusting Entry Debited Credited Examples of Balance Sheet Accounts 1. Allocating recorded costs Expense Asset (or Prepaid rent (previously paid, expired) contra-asset) Prepaid insurance Office supplies Accumulated depreciation–office equipment 2. Accrued expenses (incurred, Expense Liability Interest payable not paid) Wages payable 3. Allocating recorded, unearned Liability Revenue Unearned design revenue revenues (previously received, earned) 4. Accrued revenues (earned, not Asset Revenue Accounts receivable received) Interest receivable 126 CHAPTER 3 Measuring Business Income LO4 Prepare fi nancial state- An adjusted trial balance is prepared after adjusting entries have been posted to the ments from an adjusted accounts. Its purpose is to test whether the adjusting entries have been posted cor- trial balance. rectly before the financial statements are prepared. The balances in the revenue and expense accounts in the adjusted trial balance are used to prepare the income state- ment. The balances in the asset and liability accounts in the adjusted trial balance and in the statement of owner’s equity are used to prepare the b alance sheet. LO5 Use accrual-based infor- To ensure a company’s liquidity, managers must know how to use accrual-based mation to analyze cash information to analyze cash flows. The general rule for determining the cash flow fl ows. received from any revenue or paid for any expense (except depreciation) is to determine the potential cash receipts or cash payments and deduct the amount not received or not paid. REVIEW of Concepts and Terminology The following concepts and terms Cash basis of accounting 102 (LO1) Matching rule 102 (LO1) were introduced in this chapter: Continuity 101 (LO1) Net income 100 (LO1) Accrual 107 (LO3) Contra account 110 (LO3) Net loss 100 (LO1) Accrual accounting 104 (LO2) Deferral 107 (LO3) Periodicity 101 (LO1) Accrued expenses 111 (LO3) Depreciation 110 (LO3) Prepaid expenses 108 (LO3) Accrued revenues 114 (LO3) Earnings management 103 (LO1) Profit 100 (LO1) Accumulated Depreciation Expenses 101 (LO1) Revenue recognition 104 (LO2) accounts 110 (LO3) Fiscal year 102 (LO1) Revenues 100 (LO1) Adjusted trial balance 116 (LO4) Going concern 101 (LO1) Unearned revenues 113 (LO3) Adjusting entries 107 (LO3) Interim periods 102 (LO1) Carrying value 110 (LO3) Chapter Assignments 127 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises LO1 LO2 Accrual Accounting Concepts SE 1. Match the concepts of accrual accounting on the right with the assumptions or actions on the left: ___ 1. Assumes expenses should be assigned a. Periodicity to the accounting period in which they b. Continuity are used to produce revenues c. Matching rule ___ 2. Assumes a business will last indefinitely d. Revenue recognition ___ 3. Assumes revenues are earned at a point in time ___ 4. Assumes net income that is measured for a short period of time, such as one quarter, is a useful measure LO3 Adjustment for Prepaid Insurance SE 2. The Prepaid Insurance account began the year with a balance of $920. Dur- ing the year, insurance in the amount of $2,080 was purchased. At the end of the year (December 31), the amount of insurance still unexpired was $1,400. Prepare the year-end entry in journal form to record the adjustment for insurance expense for the year. LO3 Adjustment for Supplies SE 3. The Supplies account began the year with a balance of $760. During the year, sup- plies in the amount of $1,960 were purchased. At the end of the year (December 31),

the inventory of supplies on hand was $880. Prepare the year-end entry in journal form to record the adjustment for supplies expense for the year. LO3 Adjustment for Depreciation SE 4. The depreciation expense on office equipment for the month of March is $100. This is the third month that the office equipment, which cost $1,900, has been owned. Prepare the adjusting entry in journal form to record depreciation for March and show the balance sheet presentation for office equipment and related accounts after the March 31 adjustment. LO3 Adjustment for Accrued Wages SE 5. Wages are paid each Saturday for a six-day workweek. Wages are currently running $1,380 per week. Prepare the adjusting entry required on June 30, assuming July 1 falls on a Tuesday. LO3 Adjustment for Unearned Revenue SE 6. During the month of August, deposits in the amount of $2,200 were received for services to be performed. By the end of the month, services in the amount of $1,520 had been performed. Prepare the necessary adjustment for Service Revenue at the end of the month. 128 CHAPTER 3 Measuring Business Income LO4 Preparation of an Income Statement and Statement of Owner’s Equity from an Adjusted Trial Balance SE 7. The adjusted trial balance for Shimura Company on December 31, 2010, contains the following accounts and balances: J. Shimura, Capital, $4,300; J. Shimura, Withdrawals, $175; Service Revenue, $1,300; Rent Expense, $200; Wages Expense, $450; Utilities Expense, $100; and Telephone Expense, $25. Prepare an income statement and statement of owner’s equity in proper form for the month of December. LO5 Determination of Cash Flows SE 8. Unearned Revenue had a balance of $650 at the end of November and $450 at the end of December. Service Revenue was $2,550 for the month of December. How much cash was received for services provided during December? Exercises LO1 LO2 Discussion Questions LO3 E 1. Develop a brief answer to each of the following questions. 1. When a company has net income, what happens to its assets and/or to its liabilities? 2. Is accrual accounting more closely related to a company’s goal of profitability or liquidity? 3. Will the carrying value of a long-term asset normally equal its market value? LO4 Discussion Questions E 2. Develop a brief answer to each of the following questions. 1. If, at the end of the accounting period, you were looking at the T account for a prepaid expense like supplies, would you look for the amounts expended in cash on the debit or credit side? On which side would you find the amount expensed during the period? 2. Would you expect net income to be a good measure of a company’s liquid- ity? Why or why not? LO1 LO2 Applications of Accounting Concepts Related to Accrual Accounting LO3 E 3. The accountant for Ronaldo Company makes the assumptions or per- forms the activities listed below. Tell which of the following concepts of accrual accounting most directly relates to each assumption or action: (a) periodicity, (b) continuity, (c) matching rule, (d) revenue recognition, (e) deferral, and (f) accrual. 1. In estimating the life of a building, assumes that the business will last indefinitely 2. Records a sale when the customer is billed 3. Postpones the recognition of a one-year insurance policy as an expense by initially recording the expenditure as an asset 4. Recognizes the usefulness of financial statements prepared on a monthly basis even though they are based on estimates 5. Recognizes, by making an adjusting entry, wages expense that has been incurred but not yet recorded 6. Prepares an income statement that shows the revenues earned and the expenses incurred during the accounting period Chapter Assignments 129 LO2 Application of Conditions for Revenue Recognition E 4. Four conditions must be met before revenue should be recognized. In each of the following cases, tell which condition has not been met. a. Company A accepts a contract to perform services in the future for $2,000. b. Company B ships products worth $3,000 to another company without an order from the other company but tells the company it can return the prod-

ucts if it does not sell them. c. Company C performs $10,000 of services for a firm with financial problems. d. Company D agrees to work out a price later for services that it performs for another company. LO3 Adjusting Entry for Unearned Revenue E 5. Fargo Voice of Fargo, North Dakota, publishes a monthly magazine featur- ing local restaurant reviews and upcoming social, cultural, and sporting events. Subscribers pay for subscriptions either one year or two years in advance. Cash received from subscribers is credited to an account called Magazine Subscriptions Received in Advance. On December 31, 2009, the end of the company’s fiscal year, the balance of this account is $840,000. Expiration of subscriptions revenue is as follows: During 2009 $175,000 During 2010 415,000 During 2011 250,000 Prepare the adjusting entry in journal form for December 31, 2009. LO3 Adjusting Entries for Prepaid Insurance E 6. An examination of the Prepaid Insurance account shows a balance of $16,845 at the end of an accounting period, before adjustment. Prepare entries in journal form to record the insurance expense for the period under the following indepen- dent assumptions: 1. An examination of the insurance policies shows unexpired insurance that cost $8,270 at the end of the period. 2. An examination of the insurance policies shows insurance that cost $2,150 has expired during the period. LO3 Adjusting Entries for Supplies: Missing Data E 7. Each of the following columns represents a Supplies account: a b c d Supplies on hand at July 1 $264 $346 $196 $ ? Supplies purchased during the month 113 ? 174 1,928 Supplies consumed during the month 194 972 ? 1,741 Supplies on hand at July 31 ? 436 85 1,118 1. Determine the amounts indicated by the question marks. 2. Make the adjusting entry for column a, assuming supplies purchased are deb- ited to an asset account. LO3 Adjusting Entry for Accrued Salaries E 8. Hugo Company has a five-day workweek and pays salaries of $35,000 each Friday. 1. Prepare the adjusting entry required on May 31, assuming that June 1 falls on a Wednesday. 2. Prepare the entry to pay the salaries on June 3, including the amount of sala- ries payable from requirement 1. 130 CHAPTER 3 Measuring Business Income LO3 Revenue and Expense Recognition E 9. Optima Company produces computer software that Tech Company sells. Optima receives a royalty of 15 percent of sales. Tech Company pays royalties to Optima Company semiannually—on May 1 for sales made in July through December of the previous year and on November 1 for sales made in January through June of the current year. Royalty expense for Tech Company and royalty income for Optima Company in the amount of $6,000 were accrued on Decem- ber 31, 2008. Cash in the amounts of $6,000 and $10,000 was paid and received on May 1 and November 1, 2009, respectively. Software sales during the July to December 2009 period totaled $150,000. 1. Calculate the amount of royalty expense for Tech Company and royalty income for Optima during 2009. 2. Record the adjusting entry that each company made on December 31, 2009. LO4 Preparation of Financial Statements E 10. Prepare the monthly income statement, monthly statement of owner’s equity, and the balance sheet at August 31, 2011, for Alvin Cleaning Company from the data provided in the adjusted trial balance below. The owner made no investments during the period. Alvin Cleaning Company Adjusted Trial Balance August 31, 2011 Cash $ 4,750 Accounts Receivable 2,592 Prepaid Insurance 380 Prepaid Rent 200 Cleaning Supplies 152 Cleaning Equipment 3,875 Accumulated Depreciation–Cleaning Equipment $ 320 Truck 7,200 Accumulated Depreciation–Truck 720 Accounts Payable 420 Wages Payable 295 Unearned Janitorial Revenue 1,690 A. Wish, Capital 15,034 A. Wish, Withdrawals 2,000 Janitorial Revenue 14,620 Wages Expense 5,680 Rent Expense 1,350 Gas, Oil, and Other Truck Expenses 580 Insurance Expense 380 Supplies Expense 2,920 Depreciation Expense–Cleaning Equipment 320 Depreciation Expense–Truck 720 $33,099 $33,099 Chapter Assignments 131 LO3 Adjusting Entries

E 11. Prepare year-end adjusting entries for each of the following: 1. Office Supplies has a balance of $336 on January 1. Purchases debited to Office Supplies during the year amount to $1,660. A year-end inventory reveals supplies of $1,140 on hand. 2. Depreciation of office equipment is estimated to be $2,130 for the year. 3. Property taxes for six months, estimated at $1,800, have accrued but have not been recorded. 4. Unrecorded interest income on U.S. government bonds is $850. 5. Unearned Revenue has a balance of $1,800. Services for $750 received in advance have now been performed. 6. Services totaling $800 have been performed; the customer has not yet been billed. LO3 Accounting for Revenue Received in Advance E 12. Robert Shapiro, a lawyer, received $84,000 on October 1 to represent a cli- ent in real estate negotiations over the next 12 months. 1. Record the entries required in Shapiro’s records on October 1 and at the end of the fiscal year, December 31. 2. How would this transaction be reflected on the income statement and bal- ance sheet on December 31? LO5 Determination of Cash Flows E 13. After adjusting entries had been made, the balance sheets of Ramiro’s Com- pany showed the following asset and liability amounts at the end of 2009 and 2010: 2010 2009 Prepaid insurance $2,400 $2,900 Wages payable 1,200 2,200 Unearned fees 4,200 1,900 The following amounts were taken from the 2010 income statement: Insurance expense $ 3,800 Wages expense 19,500 Fees earned 8,900 Calculate the amount of cash paid for insurance and wages and the amount of cash received for fees during 2010. LO5 Relationship of Expenses to Cash Paid E 14. The income statement for Sahan Company included the following expenses for 2011: Rent expense $ 75,000 Interest expense 11,700 Salaries expense 121,000 132 CHAPTER 3 Measuring Business Income Listed below are the related balance sheet account balances at year end for last year and this year. Last Year This Year Prepaid rent — $ 1,350 Interest payable $1,500 — Salaries payable 7,500 114,000 1. Compute the cash paid for rent during the year. 2. Compute the cash paid for interest during the year. 3. Compute the cash paid for salaries during the year. Problems LO3 Determining Adjustments P 1. At the end of the first three months of operation, the trial balance of City Answering Service appears as shown below. Tim Bass, the owner of City Answer- ing Service, has hired an accountant to prepare financial statements to determine how well the company is doing after three months. Upon examining the account- ing records, the accountant finds the following items of interest: a. An inventory of office supplies reveals supplies on hand of $150. b. The Prepaid Rent account includes the rent for the first three months plus a deposit for April’s rent. c. Depreciation on the equipment for the first three months is $416. d. The balance of the Unearned Answering Service Revenue account represents a 12-month service contract paid in advance on February 1. e. On March 31, accrued wages total $105. City Answering Service Trial Balance March 31, 2010 Cash $ 3,582 Accounts Receivable 4,236 Office Supplies 933 Prepaid Rent 800 Equipment 4,700 Accounts Payable $ 2,673 Unearned Answering Service Revenue 888 T. Bass, Capital 5,933 T. Bass, Withdrawals 2,100 Answering Service Revenue 9,102 Wages Expense 1,900 Office Cleaning Expense 345 $18,596 $18,596 Required All adjustments affect one balance sheet account and one income statement account. For each of the above situations, show the accounts affected, the amount Chapter Assignments 133 of the adjustment (using a (cid:3) or – to indicate an increase or decrease), and the balance of the account after the adjustment in the following format: Balance Amount of Income Amount of Sheet Adjustment Balance After Statement Adjustment Balance After Account ((cid:4) or (cid:2)) Adjustment Account ((cid:4) or (cid:2)) Adjustment LO2 LO3 Preparing Adjusting Entries P 2. On November 30, the end of the current fiscal year, the following infor- mation is available to assist Caruso Company’s accountants in making adjusting entries:

a. Caruso Company’s Supplies account shows a beginning balance of $2,350. Purchases during the year were $4,218. The end-of-year inventory reveals supplies on hand of $1,397. b. The Prepaid Insurance account shows the following on November 30: Beginning balance $4,720 July 1 4,200 October 1 7,272 The beginning balance represents the unexpired portion of a one-year policy purchased in September of the previous year. The July 1 entry repre- sents a new one-year policy, and the October 1 entry represents additional coverage in the form of a three-year policy. c. The following table contains the cost and annual depreciation for buildings and equipment, all of which Caruso Company purchased before the current year: Account Cost Annual Depreciation Buildings $298,000 $16,000 Equipment 374,000 40,000 d. On September 1, the company completed negotiations with a client and accepted an advance of $18,600 for services to be performed monthly in the next year. The $18,600 was credited to Unearned Services Revenue. e. The company calculated that as of November 30, it had earned $7,000 on an $11,000 contract that would be completed and billed in January. f. Among the liabilities of the company is a note payable in the amount of $300,000. On November 30, the accrued interest on this note amounted to $18,000. g. On Saturday, December 2, the company, which is on a six-day workweek, will pay its regular employees their weekly wages of $15,000. h. On November 29, the company completed negotiations and signed a con- tract to provide services to a new client at an annual rate of $23,000. Required 1. Prepare adjusting entries for each item listed above. User insight (cid:2) 2. Explain how the conditions for revenue recognition are applied to transac- tions e and h. 134 CHAPTER 3 Measuring Business Income LO3 LO4 Determining Adjusting Entries, Posting to T Accounts, and Preparing an Adjusted Trial Balance P 3. The trial balance for Prima Consultants Company on December 31, 2010, appears below. The following information is also available: a. Ending inventory of office supplies, $97 b. Prepaid rent expired, $500 c. Depreciation of office equipment for the period, $720 d. Interest accrued on the note payable, $600 e. Salaries accrued at the end of the period, $230 f. Service revenue still unearned at the end of the period, $1,410 g. Service revenue earned but not billed, $915 Required 1. Open T accounts for the accounts in the trial balance plus the following: Inter- est Payable; Salaries Payable; Office Supplies Expense; Depreciation Expense– Office Equipment; and Interest Expense. Enter the account balances. 2. Determine the adjusting entries and post them directly to the T accounts. 3. Prepare an adjusted trial balance. User insight (cid:2) 4. Which financial statements do each of the above adjustments affect? What financial statement is not affected by the adjustments? Prima Consultants Company Trial Balance December 31, 2010 Cash $ 13,786 Accounts Receivable 24,840 Offi ce Supplies 991 Prepaid Rent 1,400 Offi ce Equipment 7,300 Accumulated Depreciation–Offi ce Equipment $ 2,600 Accounts Payable 1,820 Notes Payable 10,000 Unearned Service Revenue 2,860 M. Sirot, Capital 30,387 M. Sirot, Withdrawals 15,000 Service Revenue 58,500 Salaries Expense 33,400 Utilities Expense 1,750 Rent Expense 7,700 $106,167 $106,167 Chapter Assignments 135 LO3 LO4 Determining Adjusting Entries and Tracing Their Effects to Financial Statements P 4. VIP Limo Service was organized to provide limousine service between the airport and various suburban locations. It has just completed its second year of business. Its trial balance is below. VIP Limo Service Trial Balance June 30, 2010 Cash (111) $ 9,812 Accounts Receivable (113) 14,227 Prepaid Rent (117) 12,000 Prepaid Insurance (118) 4,900 Prepaid Maintenance (119) 12,000 Spare Parts (140) 11,310 Limousines (148) 220,000 Accumulated Depreciation–Limousines (149) $ 35,000 Notes Payable (211) 45,000 Unearned Passenger Service Revenue (213) 30,000 A. Pham, Capital (311) 88,211 A. Pham, Withdrawals (313) 20,000 Passenger Service Revenue (411) 428,498

Gas and Oil Expense (510) 89,300 Salaries Expense (511) 206,360 26,800 Advertising Expense (516) $626,709 $626,709 The following information is also available: a. To obtain space at the airport, VIP Limo paid two years’ rent in advance when it began the business. b. An examination of insurance policies reveals that $1,800 expired during the year. c. To provide regular maintenance for the vehicles, VIP Limo deposited $12,000 with a local garage. An examination of maintenance invoices reveals charges of $10,944 against the deposit. d. An inventory of spare parts shows $2,016 on hand. e. VIP Limo depreciates all of its limousines at the rate of 12.5 percent per year. No limousines were purchased during the year. f. A payment of $10,500 for one full year’s interest on notes payable is now due. g. Unearned Passenger Service Revenue on June 30 includes $17,815 for tick- ets that employers purchased for use by their executives but which have not yet been redeemed. Required 1. Determine the adjusting entries and enter them in the general journal (Page 14). 2. Open ledger accounts for the accounts in the trial balance plus the following: Interest Payable (213); Rent Expense (514); Insurance Expense (515); Spare Parts Expense (516); Depreciation Expense–Limousines (517); Maintenance Expense (518); and Interest Expense (519). Record the balances shown in the trial balance. 136 CHAPTER 3 Measuring Business Income 3. Post the adjusting entries from the general journal to the ledger accounts, showing proper references. User insight (cid:2) 4. Prepare an adjusted trial balance, an income statement, a statement of o wner’s equity, and a balance sheet. The owner made no investments during the period. Alternate Problems LO3 Determining Adjustments P 5. At the end of its fiscal year, the trial balance for Andy’s Cleaners appears as shown below: Andy’s Cleaners Trial Balance September 30, 2010 Cash $ 11,788 Accounts Receivable 26,494 Prepaid Insurance 3,400 Cleaning Supplies 7,374 Land 18,000 Building 186,000 Accumulated Depreciation–Building $ 45,600 Accounts Payable 18,400 Unearned Cleaning Revenue 1,700 Mortgage Payable 110,000 A. Kopec, Capital 56,560 A. Kopec, Withdrawals 9,000 Cleaning Revenue 159,634 Wages Expense 101,330 Cleaning Equipment Rental Expense 6,100 Delivery Truck Expense 4,374 Interest Expense 11,000 Other Expenses 7,034 $391,894 $391,894 The following information is also available: a. A study of the company’s insurance policies shows ssssthat $680 is unexpired at the end of the year. b. An inventory of cleaning supplies shows $1,150 on hand. c. Estimated depreciation on the building for the year is $12,800. d. Accrued interest on the mortgage payable is $1,000. e. On September 1, the company signed a contract, effective immediately, with Hope County Hospital to dry clean, for a fixed monthly charge of $425, the uniforms used by doctors in surgery. The hospital paid for four months’ ser- vice in advance. f. Sales and delivery wages are paid on Saturday. The weekly payroll is $3,060. September 30 falls on a Thursday, and the company has a six-day pay week. Chapter Assignments 137 Required All adjustments affect one balance sheet account and one income statement account. For each of the above situations, show the accounts affected, the amount of the adjustment (using a (cid:3) or (cid:4) to indicate an increase or decrease), and the balance of the account after the adjustment in the following format: Balance Amount of Income Amount of Sheet Adjustment Balance After Statement Adjustment Balance After Account ((cid:4) or (cid:2)) Adjustment Account ((cid:4) or (cid:2)) Adjustment LO2 LO3 Preparing Adjusting Entries P 6. On June 30, the end of the current fiscal year, the following information is available to Conti Company’s accountants for making adjusting entries: a. Among the liabilities of the company is a mortgage payable in the amount of $260,000. On June 30, the accrued interest on this mortgage amounted to $13,000. b. On Friday, July 2, the company, which is on a five-day workweek and pays employees weekly, will pay its regular salaried employees $18,700.

c. On June 29, the company completed negotiations and signed a contract to provide monthly services to a new client at an annual rate of $7,200. d. The Supplies account shows a beginning balance of $1,615 and purchases during the year of $4,115. The end-of-year inventory reveals supplies on hand of $1,318. e. The Prepaid Insurance account shows the following entries on June 30: Beginning balance $1,620 January 1 2,900 May 1 3,366 The beginning balance represents the unexpired portion of a one-year policy purchased in April of the previous year. The January 1 entry represents a new one-year policy, and the May 1 entry represents the additional coverage of a three-year policy. f. The following table contains the cost and annual depreciation for buildings and equipment, all of which were purchased before the current year: Account Cost Annual Depreciation Buildings $170,000 $ 7,300 Equipment 218,000 20,650 g. On June 1, the company completed negotiations with another client and accepted an advance of $21,600 for services to be performed in the next year. The $21,600 was credited to Unearned Service Revenue. h. The company calculates that as of June 30 it had earned $4,500 on a $7,500 contract that will be completed and billed in August. Required 1. Prepare adjusting entries for each item listed above. User insight (cid:2) 2. Explain how the conditions for revenue recognition are applied to transac- tions c and h. 138 CHAPTER 3 Measuring Business Income LO3 Determining Adjusting Entries, Posting to T Accounts, and Preparing an Adjusted Trial Balance P 7. The trial balance for Best Advisors Service on December 31, 2011, is as follows: Best Advisors Service Trial Balance December 31, 2011 Cash $ 18,500 Accounts Receivable 8,250 Offi ce Supplies 2,662 Prepaid Rent 1,320 Offi ce Equipment 9,240 Accumulated Depreciation– Offi ce Equipment $ 1,540 Accounts Payable 5,940 Notes Payable 11,000 Unearned Service Revenue 2,970 M. Dabrowska, Capital 26,002 M. Dabrowska, Withdrawals 22,000 Service Revenue 72,600 Salaries Expense 49,400 Rent Expense 4,400 Utilities Expense 4,280 $120,052 $120,052 The following information is also available: a. Ending inventory of office supplies, $300 b. Prepaid rent expired, $610 c. Depreciation of office equipment for the period, $526 d. Accrued interest expense at the end of the period, $570 e. Accrued salaries at the end of the period, $330 f. Service revenue still unearned at the end of the period, $1,166 g. Service revenue earned but unrecorded, $3,100 Required 1. Open T accounts for the accounts in the trial balance plus the following: Interest Payable; Salaries Payable; Office Supplies Expense; Depreciation Expense–Office Equipment; and Interest Expense. Enter the balances shown on the trial balance. 2. Determine the adjusting entries and post them directly to the T accounts. User insight (cid:2) 3. Prepare an adjusted trial balance. 4. Which financial statements do each of the above adjustments affect? Which financial statement is not affected by the adjustments? Chapter Assignments 139 LO3 LO4 Determining Adjusting Entries and Tracing Their Effects to Financial Statements P 8. Helen Ortega opened a small tax-preparation service. At the end of its second year of operation, Ortega Tax Service had the trial balance that appears below. Ortega Tax Service Trial Balance December 31, 2010 Cash $ 3,700 Accounts Receivable 1,099 Prepaid Insurance 240 Offi ce Supplies 780 Offi ce Equipment 7,100 Accumulated Depreciation– Offi ce Equipment $ 770 Accounts Payable 635 Unearned Tax Fees 219 H. Ortega, Capital 6,939 H. Ortega, Withdrawals 6,000 Tax Fees Revenue 21,926 Offi ce Salaries Expense 8,300 Advertising Expense 650 Rent Expense 2,400 220 Telephone Expense $30,489 $30,489 The following information is also available: a. Office supplies on hand, December 31, 2010, $225. b. Insurance still unexpired, $100. c. Estimated depreciation of office equipment, $795. d. Telephone expense for December, $21; the bill was received but not recorded. e. The services for all unearned tax fees had been performed by the end of the year. Required

1. Open T accounts for the accounts in the trial balance plus the following: Office Supplies Expense; Insurance Expense; and Depreciation Expense– Office Equipment. Record the balances shown in the trial balance. 2. Determine the adjusting entries and post them directly to the T accounts. 3. Prepare an adjusted trial balance, an income statement, a statement of owner’s User insight (cid:2) equity, and a balance sheet. The owner made no investments during the period. 4. Why is it not necessary to show the effects of the above transactions on the statement of cash flows? 140 CHAPTER 3 Measuring Business Income ENHANCING Your Knowledge, Skills, and Critical Thinking LO1 LO2 Importance of Adjustments LO3 C 1. Never Flake Company, which operated in the northeastern part of the United States, provided a rust-prevention coating for the underside of new automobiles. The company advertised widely and offered its services through new car dealers. When a dealer sold a new car, the salesperson attempted to sell the rust-preven- tion coating as an option. The protective coating was supposed to make cars last longer in the severe northeastern winters. A key selling point was Never Flake’s warranty, which stated that it would repair any damage due to rust at no charge for as long as the buyer owned the car. For several years, Never Flake had been very successful in generating enough cash to continue operations. But in 2011, the company suddenly declared bank- ruptcy. Company officials said that the firm had only $5.5 million in assets against liabilities of $32.9 million. Most of the liabilities represented potential claims under the company’s lifetime warranty. It seemed that owners were keeping their cars longer now than previously. Therefore, more damage was being attributed to rust. Discuss what accounting decisions could have helped Never Flake survive under these circumstances. LO1 Earnings Management and Fraudulent Financial Reporting C 2. In recent years, the Securities and Exchange Commission (SEC) has been waging a public campaign against corporate accounting practices that manage or manipulate earnings to meet the expectations of Wall Street analysts. Corpora- tions engage in such practices in the hope of avoiding shortfalls that might cause serious declines in their stock price. For each of the following cases that the SEC challenged, tell why each is a violation of the matching rule and how it should be accounted for: a. Lucent Technologies sold telecommunications equipment to companies from which there was no reasonable expectation of payment because of the companies’ poor financial condition. b. America Online (AOL) recorded advertising as an asset rather than as an expense. c. Eclipsys recorded software contracts as revenue even though it had not yet rendered the services. d. KnowledgeWare recorded revenue from sales of software even though it told customers they did not have to pay until they had the software. LO2 LO3 Analysis of an Asset Account C 3. The Walt Disney Company is engaged in the financing, production, and distribution of motion pictures and television programming. In Disney’s 2008 annual report, the balance sheet contained an asset called “film and tele- vision costs.” Film and television costs, which consist of the costs associated with producing films and television programs less the amount expensed, were $5,394,000,000. The estimated amount of film and television costs expensed (amortized) during the next year were $3,500,000,000. The amount estimated to be spent for new film productions was $2,900,000,000. 1. What are film and television costs, and why would they be classified as an asset? 2. Prepare an entry in T account form to record the amount the company spent on new film and television productions during 2010 (assume all expenditures are paid for in cash). Chapter Assignments 141 3. Prepare an adjusting entry in T account form to record the expense for film and television productions during 2009. Show the balance of the Film and Television Costs account at the end of the next year.

4. Suggest a method by which The Walt Disney Company might have deter- mined the amount of the expense in 3 in accordance with the matching rule. LO1 LO2 Importance of Adjustments LO3 C 4. Main Street Service Co. has achieved fast growth in the St. Louis area by sell- ing service contracts on large appliances, such as washers, dryers, and refrigera- tors. For a fee, Main Street agrees to provide all parts and labor on an appliance after the regular warranty runs out. For example, by paying a fee of $200, a person who buys a dishwasher can add two years (years 2 and 3) to the regular one-year (year 1) warranty on the appliance. In 2009, the company sold service contracts in the amount of $1.8 million, all of which applied to future years. Management wanted all the sales recorded as revenues in 2009, contending that the amount of the contracts could be determined and the cash had been received. Discuss whether you agree with this logic. How would you record the cash receipts? What assumptions do you think Main Street should make? Would you consider it unethical to follow management’s recommendation? Who might be hurt or helped by this action? LO3 Real-World Observation of Business Activities C 5. Visit a company with which you are familiar and observe its opera- tions. (The company can be where you work, where you eat, or where you buy things.) Identify at least two sources of revenue for the company and six types of expenses. For each type of revenue and each type of expense, determine whether it is probable that an adjusting entry is required at the end of the accounting period. Then specify the adjusting entry as a deferred revenue, deferred expense, accrued revenue, or accrued expense. Design a table with columns and rows that summarizes your results in an easy-to- understand format. LO3 Analysis of Balance Sheet and Adjusting Entries C 6. In CVS Corporation’s annual report in the Supplement to Chapter 5, refer to the balance sheet and the Summary of Significant Accounting Policies in the notes to the financial statements. a. Examine the accounts in the current assets, property and equipment, and current liabilities sections of CVS’s balance sheet. Which are most likely to have had year-end adjusting entries? Describe the nature of the adjusting entries. For more information about the property and equipment section, refer to the notes to the financial statements. b. Where is depreciation (and amortization) expense disclosed in CVS’s finan- cial statements? c. CVS has a statement on the “Use of Estimates” in its Summary of Signifi- cant Accounting Policies. Read this statement and tell how important esti- mates are to the determination of depreciation expense. What assumptions do accountants make that allow these estimates to be made? C H A P T E R 4 Completing the Accounting Cycle Making a Statement A ll companies prepare financial statements annually, and whether required by law or not, preparing them every quar- INCOME STATEMENT ter, or even every month, is a good idea because these interim Revenues reports give management an ongoing view of a company’s financial – Expenses performance. The preparation of financial statements requires not = Net Income only adjusting entries, which we described in the last chapter, but also closing entries, which we explain in this chapter. STATEMENT OF OWNER’S EQUITY Beginning Balance LEARNING OBJECTIVES + Net Income – Withdrawals LO1 Describe the accounting cycle and the role of closing entries in the preparation of financial statements. (pp. 144–146) = Ending Balance LO2 Prepare closing entries. (pp. 147–151) BALANCE SHEET Assets Liabilities LO3 Prepare reversing entries. (pp. 152–153) Owner’s LO4 Prepare and use a work sheet. (pp. 154–158) Equity A = L + OE STATEMENT OF CASH FLOWS Operating activities + Investing activities + Financing activities = Change in Cash + Beginning Balance = Ending Cash Balance Closing entries set the accounts on the income statement to zero and transfer the resulting balance of net income or loss to the owner’s Capital account on the balance sheet. Closing entries

do not affect cash flows. 142 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What steps must a company follow to prepare its accounts for WESTWOOD MOVERS the next accounting period? (cid:2) After following these steps, Westwood Movers provides moving and storage services for the local how is the ending balance of college and its students and employees. Westwood’s business tends the owner’s Capital account determined? to be seasonal; its busiest times are generally in the late spring and early fall. Thus, to keep a careful eye on fluctuations in earnings and cash flows, Westwood prepares financial statements each quarter. As you know from Chapter 3, before a company prepares financial statements, it must make adjusting entries to the income statement and owner’s equity accounts. After those entries have been made, an adjusted trial balance listing all the accounts and balances is pre- pared. Accounts from the adjusted trial balance are then used to pre- pare the financial statements. For example, in preparing its income statement, Westwood Movers would use the revenue and expense accounts from its adjusted trial balance, which appear on the follow- ing page. (This adjusted trial balance is “partial” in that it omits all balance sheet accounts except the owner’s equity accounts.) In addi- tion, Westwood, like all other companies, must prepare its accounts for the next accounting period by making closing entries. Doing all this takes time and effort, but the results benefit both management and external users of the company’s financial statements by provid- ing important information about revenues and operating income. To accomplish these tasks, Westwood Movers needs to be able to answer the questions on the right. 114433 144 CHAPTER 4 Completing the Accounting Cycle From Transactions To interpret and analyze a company’s performance requires an understanding to Financial of how transactions are recognized and eventually end up in financial state- ments. Two concepts that foster this understanding are the accounting cycle Statements and closing entries. LO1 Describe the accounting The Accounting Cycle cycle and the role of closing As Figure 4-1 shows, the accounting cycle is a series of steps whose ultimate pur- entries in the preparation of pose is to provide useful information to decision makers. These steps are as follows: financial statements. 1. Analyze business transactions from source documents. 2. Record the transactions by entering them in the general journal. 3. Post the journal entries to the ledger, and prepare a trial balance. 4. Adjust the accounts, and prepare an adjusted trial balance. 5. Prepare financial statements. 6. Close the accounts, and prepare a post-closing trial balance. You are already familiar with Steps 1 through 5 from previous chapters. In the next section, we describe Step 6, which may be performed before or after Step 5. Closing Entries Balance sheet accounts, such as Cash and Accounts Payable, are considered permanent accounts, or real accounts, because they carry their end-of-period balances into the next accounting period. In contrast, revenue and expense accounts, such as Revenues Earned and Wages Expense, are considered tempo- rary accounts, or nominal accounts, because they begin each accounting period with a zero balance, accumulate a balance during the period, and are then cleared by means of closing entries. Closing entries are journal entries made at the end of an accounting period. They have two purposes: 1. They set the stage for the next accounting period by clearing revenue and expense accounts and the Withdrawals account of their balances. From Transactions to Financial Statements 145 Decisions and Actions THE ACCOUNTING CYCLE PROCESSING 2. Record the entries 3. Post the journal entries in the journal. to the ledger and prepare a trial balance. General Journal Post. Date Description Ref. Debit Credit 20xx July 3 Prepaid Rent 3,200 Cash 3,200 Paid two months’ rent in advance 5 Office Supplies 5,200 Accounts Payable 5,200 Purchased office supplies on credit A F AUNN AICNANI TROPER L L

FIGURE 4-1 Overview of the Accounting Cycle BUSINESS ACTIVITIES DECISION MAKERS Purchase Order MEASUREMENT COMMUNICATION 1. Analyze business 5. Prepare financial transactions from statements. source documents. SALES INVOICE $5,200 4. Adjust the accounts 6. Close the accounts and and prepare an prepare a post-closing adjusted trial balance. trial balance. General Journal Date Description PRoesft.. Debit Credit 2 JA u0c D lx yc xao tu en 3t 359 0s Pay Ia teb mle CAOPOAc r ca f fef fG P c cs i iR cpco oJJJ J hoe e eau ue 111 2sn in nf SdEt.e t t u q. s sRr p u a R Pep ipl n ael i m1 tL yceD a, es ee 0e bi nd v0b lta eg 0i bte lM er ilC l35 er ,, TJr22e ru 700d Dilay000i elt 3Bs 1iag ,A l a21nDc n0, c 0e Scxo 0 exb tB u0u ia t dn l it a o nN $C 35 12co r 62453,,e. 22e ,,,,, 346222 700d 280001 000i 00000t2 $6,280 REx ep vee nn use e 1 4 . . c o p u eA Ro r e n al e l s r r rmo ci e nt oc s oo c eda g or db st e nA ri e .n d r iF at ezs g ew io c vs n dr e c eu e e g ,oe ntr c un uoT n er ty twd sip n .e oe gds of Adju 2 3 s . . t u e u bi R An n x n eleg lpr e toc we e acE o c en ragn oL n es tn r it ei e nndar i dz s i geb te i . w n rdis r el eg , oi vt ci y n e ooc n rr u ud mr eer osde r ,d e 2J0uxlyx3 Prep 2Ia Jn 0i ucd D xlo y xar me ten e 33t 11S C AOP OA— Aum c r c ca f fe Of fCC c c cs i im cp cI o u ollh ft oo e e faa e u m uiss c ir m n nii Sd Ey uenn t t u qgg l s sR aE p u tR Pe qep ipn ae udli mt yce i G P pR DJJ aes eo me 44 be4 i ens vn f l1 eptt a e.e .1 P nrbr ea to le cl s i3ML D at ,3 e - 2 tei, C id l 12 oblg e 0l0 J ni ote r0 us r D li ynCe 43gsr ,4 8e 1 i, T 0gd ,8 0rin 20 t ia 0 0S l xA tB xuDc ac de lo biaB ou i na tn $l ct a 12enN C 531 6241co ,,, ,,r ,,e 066 34. 85e 3 06009 28d1 00i 000 00t4 $ 6 , 23 80 00 accounting periods. $60,080 $60,080 $49,060 $49,060 146 CHAPTER 4 Completing the Accounting Cycle FIGURE 4-2 Overview of the Closing Process Expense Accounts Revenue Accounts xxx xxx Step 2: Step 1: To close the To close the expense revenue accounts Income Summary accounts xxx xxx xx Step 3: To close Income Summary Withdrawals Capital Step 4: xx To close xx xx Withdrawals 2. They summarize a period’s revenues and expenses by transferring the bal- ances of revenue and expense accounts to the Income Summary account. The Income Summary account is a temporary account that summarizes all revenues and expenses for the period. It is used only in the closing process— never in the financial statements. Its balance equals the net income or loss reported on the income statement. The net income or loss is then transferred to the owner’s Capital account. Figure 4-2 shows an overview of the closing process. The net income or loss is transferred from the Income Summary account to the owner’s Capital account because even though revenues and expenses are recorded in individual accounts, they represent increases and decreases in owner’s Capital. Closing entries transfer the net effect of increases (revenues) and decreases (expenses) to owner’s Capi- tal. For corporations like Netflix, the net income or loss is transferred from the Income Summary account to the Retained Earnings account, which is part of the stockholders’ (owner’s) equity of a corporation. STOP & APPLY In each of the following pairs of activities, tell which activity is done first in the accounting cycle: 1. Close the accounts or adjust the accounts 3. Record the transactions in the journal or 2. Analyze the transactions or post the entries prepare the initial trial balance to the ledger 4. Prepare the post-closing trial balance or prepare the adjusted trial balance SOLUTION 1. Adjust the accounts 3. Record the transactions in the journal 2. Analyze the transactions 4. Prepare the adjusted trial balance Preparing Closing Entries 147 Preparing The steps involved in making closing entries are as follows: Closing Entries Step 1. Close the credit balances on the income statement accounts to the Income Summary account. LO2 Prepare closing entries. Step 2. Close the debit balances on the income statement accounts to the Income Summary account.

Study Note Step 3. Close the Income Summary account balance to the owner’s Capital account. Although it is not absolutely necessary to use the Income Step 4. Close the Withdrawals account balance to the owner’s Capital account. Summary account when As you will learn in later chapters, not all revenue accounts have credit bal- preparing closing entries, doing ances and not all expense accounts have debit balances. For that reason, when so simplifies the procedure. referring to closing entries, we often use the term credit balances instead of rev- enue accounts and the term debit balances instead of expense accounts. An adjusted trial balance provides all the data needed to record the closing entries. Exhibit 4-1 shows the relationships of the four kinds of closing entries to Miller Design Studio’s adjusted trial balance. Step 1: Closing the Credit Balances On the credit side of the adjusted trial balance in Exhibit 4-1, Design Revenue shows Study Note a balance of $13,600. To close this account, a journal entry must be made debiting the account in the amount of its balance and crediting it to the Income Summary After Step 1 has been completed, account. Exhibit 4-2 shows how the entry is posted. Notice that the entry sets the the Income Summary account balance of the revenue account to zero and transfers the total revenues to the credit reflects the account balance of the Design Revenue account side of the Income Summary account. before it was closed. Step 2: Closing the Debit Balances Several expense accounts show balances on the debit side of the adjusted trial bal- ance in Exhibit 4-1. A compound entry is needed to credit each of these expense accounts for its balance and to debit the Income Summary account for the total. Exhibit 4-3 shows the effect of posting the closing entry. Notice how the entry reduces the expense account balances to zero and transfers the total of the account balances to the debit side of the Income Summary account. Step 3: Closing the Income Summary Account Balance After the entries closing the revenue and expense accounts have been posted, the Study Note balance of the Income Summary account equals the net income or loss for the period. A credit balance in the Income Summary account represents a net income After Step 3 has been completed, (i.e., revenues exceed expenses), and a debit balance represents a net loss (i.e., the credit balance of the Income Summary account ($3,960) expenses exceed revenues). represents net income—the key At this point, the balance of the Income Summary account, whatever its nature, measure of performance. When a is closed to the owner’s Capital account, as shown in Exhibit 4-1. Exhibit 4-4 net loss occurs, debit the owner’s shows how the closing entry is posted when a company has a net income. Notice Capital account (to reduce it) the dual effect of closing the Income Summary account and transferring the bal- and credit the Income Summary ance to owner’s Capital. account (to close it). Step 4: Closing the Withdrawals Account Balance The Withdrawals account shows the amount by which owner’s Capital decreased during an accounting period. The debit balance of the Withdrawals account is closed to the owner’s Capital account, as illustrated in Exhibit 4-1. Exhibit 4-5 148 CHAPTER 4 Completing the Accounting Cycle EXHIBIT 4-1 Preparing Closing Entries from the Adjusted Trial Balance Miller Design Studio Entry 1: Adjusted Trial Balance July 31, 2011 July 31 Design Revenue 411 13,600 Income Summary 314 13,600 Cash $22,480 To close the Accounts Receivable 5,000 revenue Office Supplies 3,660 account Prepaid Rent 1,600 Office Equipment 16,320 Entry 2: Accumulated Depreciation– July 31 Income Summary 314 9,640 Office Equipment $ 300 Wages Expense 511 5,520 Accounts Payable 6,280 Utilities Expense 512 680 Unearned Design Revenue 600 Rent Expense 514 1,600 Wages Payable 720 Office Supplies Expense 517 1,540 J. Miller, Capital 40,000 Depreciation J. Miller, Withdrawals 2,800 Expense–Office Design Revenue 13,600 Equipment 520 300 Wages Expense 5,520 To close the Utilities Expense 680 expense

Rent Expense 1,600 accounts Office Supplies Expense 1,540 Depreciation Expense– INCOME SUMMARY Office Equipment 300 July 31 9,640 July 31 13,600 $61,500 $61,500 July 31 3,960 Bal. — Entry 3: July 31 Income Summary 314 3,960 J. Miller, Capital 312 3,960 To close the Income Summary account Entry 4: July 31 J. Miller, Capital 312 2,800 J. Miller, Withdrawals 313 2,800 To close the Withdrawals account shows the posting of the closing entry and the transfer of the balance of the With- Study Note drawals account to the owner’s Capital account. In a corporation like Netflix, payments to owners are called dividends, and they are closed to the Retained Note that the Withdrawals account is closed to the owner’s Earnings account. Capital account, not to the Income Summary account. The Accounts After Posting After all the steps in the closing process have been completed and all closing entries have been posted, everything is ready for the next accounting period. Preparing Closing Entries 149 EXHIBIT 4-2 Posting the Closing Entry of a Design Revenue Account No. 411 Credit Balance to the Income Balance Summary Account Post. Date Item Ref. Debit Credit Debit Credit July 10 J2 2,800 2,800 15 J2 9,600 12,400 31 Adj. J3 800 13,200 31 Adj. J3 400 13,600 31 Closing J4 13,600 — Income Summary Account No. 314 Balance Post. Date Item Ref. Debit Credit Debit Credit July 31 Closing J4 13,600 13,600 The revenue, expense, and Withdrawals accounts (temporary accounts) have zero balances. The owner’s Capital account has been increased or decreased to reflect net income or net loss (net income in our example) and has been decreased for withdrawals. The balance sheet accounts (permanent accounts) show the correct balances, which are carried into the next period. EXHIBIT 4-3 Posting the Closing Entry of Debit Balances to the Income Summary Account Wages Expense Account No. 511 Office Supplies Expense Account No. 517 Balance Balance Post. Post. Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit July 26 J2 4,800 4,800 July 31 Adj. J3 1,540 1,540 31 Adj. J3 720 5,520 31 Closing J4 1,540 — 31 Closing J4 5,520 — Depreciation Expense–Office Utilities Expense Account No. 512 Equipment Account No. 520 Balance Balance Post. Post. Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit July 30 J2 680 680 July 31 Adj. J3 300 300 31 Closing J4 680 — 31 Closing J4 300 — Rent Expense Account No. 514 Income Summary Account No. 314 Balance Balance Post. Post. Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit July 31 Adj. J3 1,600 1,600 July 31 Closing J4 13,600 13,600 31 Closing J4 1,600 — 31 Closing J4 9,640* 3,960 *Total of all credit closing entries to expense accounts is debited to the Income Summary account. 150 CHAPTER 4 Completing the Accounting Cycle EXHIBIT 4-4 Posting the Closing Entry of the Income Summary Account Balance to the Owner’s Equity Account Income Summary Account No. 314 J. Miller, Capital Account No. 312 Balance Balance Post. Post. Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit July 31 Closing J4 13,600 13,600 July 1 J1 40,000 40,000 31 Closing J4 9,640 3,960 31 Closing J4 3,960 43,960 31 Closing J4 3,960 — EXHIBIT 4-5 Posting the Closing Entry of the Withdrawals Account Balance to the Owner’s Capital Account J. Miller, Withdrawals Account No. 313 J. Miller, Capital Account No. 312 Balance Balance Post. Post. Date Item Ref. Debit Credit Debit Credit Date Item Ref. Debit Credit Debit Credit July 31 J2 2,800 2,800 July 1 J1 40,000 40,000 31 Closing J4 2,800 — 31 Closing J4 3,960 43,960 31 Closing J4 2,800 41,160 The Post-Closing Trial Balance Because errors can be made in posting closing entries to the ledger accounts, it is necessary to prepare a post-closing trial balance. As you can see in Exhibit 4-6, a post-closing trial balance contains only balance sheet accounts because the income statement accounts and the Withdrawals account have been closed and now have zero balances. It is a final check that total debits equal total credits.

EXHIBIT 4-6 Miller Design Studio Post-Closing Trial Balance Post-Closing Trial Balance July 31, 2011 Cash $22,480 Accounts Receivable 5,000 Office Supplies 3,660 Prepaid Rent 1,600 Office Equipment 16,320 Accumulated Depreciation–Office Equipment $ 300 Accounts Payable 6,280 Unearned Design Revenue 600 Wages Payable 720 J. Miller, Capital 41,160 $49,060 $49,060 Preparing Closing Entries 151 STOP & APPLY Prepare the necessary closing entries from the following partial adjusted trial balance for Fountas Recreational Park, and compute the ending balance of the owner’s Capital account. (Except for K. Fountas, Capital, balance sheet accounts have been omitted.) Fountas Recreational Park Partial Adjusted Trial Balance June 30, 2010 K. Fountas, Capital $93,070 K. Fountas, Withdrawals $36,000 Campsite Rentals 88,200 Wages Expense 23,850 Insurance Expense 3,784 Utilities Expense 1,800 Supplies Expense 1,320 Depreciation Expense–Building 6,000 SOLUTION Closing entries prepared: June 30 Campsite Rentals 88,200 Income Summary 88,200 To close the credit balance account 30 Income Summary 36,754 Wages Expense 23,850 Insurance Expense 3,784 Utilities Expense 1,800 Supplies Expense 1,320 Depreciation Expense–Building 6,000 To close the debit balance accounts 30 Income Summary 51,446 K. Fountas, Capital 51,446 To close the Income Summary account $88,200 (cid:4) $36,754 (cid:2) $51,446 30 K. Fountas, Capital 36,000 K. Fountas, Withdrawals 36,000 To close the Withdrawals account Ending balance of the K. Fountas, Capital account computed: K. FOUNTAS, CAPITAL June 30 36,000 Beg. Bal. 93,070 June 30 51,446 End. Bal. 108,516 152 CHAPTER 4 Completing the Accounting Cycle Reversing Entries: A reversing entry is an optional journal entry made on the first day of an account- An Optional ing period. It has the opposite effect of an adjusting entry made at the end of the previous period—that is, it debits the credits and credits the debits of an ear- First Step lier adjusting entry. The sole purpose of reversing entries is to simplify routine bookkeeping procedures, and they apply only to certain adjusting entries. Defer- LO3 Prepare reversing rals should not be reversed because doing so would not simplify bookkeeping in entries. future accounting periods. As used in this text, reversing entries apply only to accruals (accrued revenues and expenses). To see how reversing entries can be helpful, consider this adjusting entry Study Note made in the records of Miller Design Studio to accrue wages expense: Reversing entries are the opposite of adjusting entries and are dated the first day of Assets (cid:2) Liabilities (cid:3) Owner’s Equity the new period. They apply only to certain adjusting entries and WAGES PAYABLE WAGES EXPENSE are never required. Dr. Cr. Dr. Cr. July 31 720 July 31 720 Entry in Journal Form: Dr. Cr. July 31 Wages Expense 720 Wages Payable 720 Accrued unrecorded wages When the company pays its assistant on the next regular payday, its accountant would make this entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH WAGES PAYABLE WAGES EXPENSE Dr. Cr. Dr. Cr. Dr. Cr. Aug. 23 4,800 Aug. 23 720 Aug. 23 4,080 Entry in Journal Form: Dr. Cr. Aug. 23 Wages Payable 720 Wages Expense 4,080 Cash 4,800 Paid four weeks wages to assistant, $720 of which accrued in the previous period If no reversing entry is made at the time of payment, the accountant would have to look in the records to find out how much of the $4,800 applies to the current accounting period and how much applies to the previous period. That may seem easy in our example, but think how difficult and time-consuming it would be if a company had hundreds of employees working on different sched- ules. A reversing entry helps solve the problem of applying revenues and expenses to the correct accounting period. Reversing Entries: An Optional First Step 153 For example, consider the following sequence of entries and their effects on the Wages Expense account: 1. Adjusting Entry Dr. Cr. Wages Expense Account No. 511 July 31 Wages Expense 720 Balance Wages Payable 720 Post. 2. Closing Entry Date Ref. Debit Credit Debit Credit

July 31 Income Summary 5,520 Wages Expense 5,520 July 26 J2 4,800 4,800 3. Reversing Entry 31 J3 720 5,520 Aug. 1 Wages Payable 720 31 J4 5,520 — Wages Expense 720 Aug. 1 J5 720 720 4. Payment Entry 23 J6 4,800 4,080 Aug. 23 Wages Expense 4,800 Cash 4,800 Entry 1 adjusted Wages Expense to accrue $720 in the July accounting period. Entry 2 closed the $5,520 in Wages Expense for July to Income Summary, leav- ing a zero balance. Entry 3, the reversing entry, set up a credit balance of $720 on August 1 in Wages Expense, which is the expense recognized through the adjusting entry in July (and also reduced the liability account Wages Payable to a zero balance). The reversing entry always sets up an abnormal balance in the income statement account and produces a zero balance in the balance sheet account. Entry 4 recorded the $4,800 payment of wages as a debit to Wages Expense, automatically leaving a balance of $4,080, which represents the correct wages expense to date in August. The reversing entry simplified the process of making the payment entry on August 23. Reversing entries apply to any accrued expenses or revenues. Miller Design Stu- dio’s only accrued expense was wages expense. An adjusting entry for the company’s accrued revenue (Design Revenue) would require the following reversing entry: Dr. Cr. Aug. 1 Design Revenue 400 Accounts Receivable 400 Reversed the adjusting entry for accrued revenue earned STOP & APPLY Which of the following accounts after adjustment will most likely require reversing entries: a. Salaries Payable d. Supplies b. Accumulated Depreciation e. Taxes Payable c. Interest Payable SOLUTION a., c., and e. 154 CHAPTER 4 Completing the Accounting Cycle The Work Sheet: To organize data and avoid omitting important information that might affect the An Accountant’s financial statements, accountants use working papers. Because working papers provide evidence of past work, they enable accountants to retrace their steps when Tool they need to verify information in the financial statements. A work sheet is a special kind of working paper. The work sheet is extremely LO4 Prepare and use a work useful when a company prepares financial statements on both an annual and seasonal sheet. basis, as Netflix does, and when an accountant must make numerous adjustments. It is often used as a preliminary step in preparing financial statements. Using a work sheet lessens the possibility of omitting an adjustment and helps the accountant check Study Note the arithmetical accuracy of the accounts. The work sheet is never published and is The work sheet is not a financial rarely seen by management. It is a tool for the accountant. Because preparing a work statement, it is not required, and sheet is a mechanical process, many accountants use a computer for this purpose. it is not made public. Preparing the Work Sheet A work sheet often has one column for account names and multiple columns with headings like the ones shown in Exhibit 4-7. A heading that includes the name of the company and the period of time covered (as on the income statement) identifies the work sheet. As Exhibit 4-7 shows, preparation of a work sheet involves five steps. Step 1. Enter and Total the Account Balances in the Trial Balance Study Note Columns The debit and credit balances of the accounts on the last day of an accounting period are copied directly from the ledger into the Trial Balance col- The Trial Balance columns of a umns (the green columns in Exhibit 4-7). When accountants use a work sheet, work sheet take the place of a they do not have to prepare a separate trial balance. trial balance. Step 2. Enter and Total the Adjustments in the Adjustments Columns The required adjustments are entered in the Adjustments columns of the work sheet (the purple columns in Exhibit 4-7). As each adjustment is entered, a let- ter is used to identify its debit and credit parts. For example, in Exhibit 4-7, the letter (a) identifies the adjustment made for the rent that Miller Design Studio prepaid on July 3, which results in a debit to Rent Expense and a credit

to Prepaid Rent. These identifying letters may be used to reference supporting computations or documentation for the related adjusting entries and can sim- plify the recording of adjusting entries in the general journal. A trial balance includes only accounts that have balances. If an adjustment involves an account that does not appear in the trial balance, the new account is added below the accounts listed on the work sheet. For example, Rent Expense has been added to Exhibit 4-7. Accumulated depreciation accounts, which have a zero balance only in the initial period of operation, are the sole exception to this rule. They are listed immediately after their associated asset accounts. For exam- ple, in Exhibit 4-7, the Accumulated Depreciation–Office Equipment account is listed immediately after Office Equipment. When all the adjustments have been made, the two Adjustments columns must be totaled. This procedure proves that the debits and credits of the adjust- ments are equal, and it generally reduces errors in the work sheet. Step 3. Enter and Total the Adjusted Account Balances in the Adjusted Trial Balance Columns The adjusted trial balance in the work sheet is prepared by combining the amount of each account in the Trial Balance columns with the corresponding amount in the Adjustments columns and entering each result in the Adjusted Trial Balance columns (the yellow columns in Exhibit 4-7). Exhibit 4-7 contains examples of crossfooting, or adding and subtracting a group of numbers horizontally. The first line shows Cash with a debit balance The Work Sheet: An Accountant’s Tool 155 EXHIBIT 4-7 The Work Sheet Miller Design Studio Work Sheet For the Month Ended July 31, 2011 Adjusted Income Trial Balance Adjustments Trial Balance Statement Balance Sheet Account Name Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Cash 22,480 22,480 22,480 Accounts Receivable 4,600 (f) 400 5,000 5,000 Office Supplies 5,200 (b) 1,540 3,660 3,660 Prepaid Rent 3,200 (a) 1,600 1,600 1,600 Office Equipment 16,320 16,320 16,320 Accumulated Depreciation–Office Equipment (c) 300 300 300 Accounts Payable 6,280 6,280 6,280 Unearned Design Revenue 1,400 (e) 800 600 600 J. Miller, Capital 40,000 40,000 40,000 J. Miller, Withdrawals 2,800 2,800 2,800 Design Revenue 12,400 (e) 800 13,600 13,600 (f) 400 Wages Expense 4,800 (d) 720 5,520 5,520 Utilities Expense 680 680 680 60,080 60,080 Rent Expense (a) 1,600 1,600 1,600 Office Supplies Expense (b) 1,540 1,540 1,540 Depreciation Expense– Office Equipment (c) 300 300 300 Wages Payable (d) 720 720 720 5,360 5,360 61,500 61,500 9,640 13,600 51,860 47,900 Net Income 3,960 3,960 13,600 13,600 51,860 51,860 Note: The columns of the work sheet are prepared in the following order: (1) Trial Balance, (2) Adjustments, (3) Adjusted Trial Balance, and (4) Income Statement and Balance Sheet columns. In the fifth step, the Income Statement and Balance Sheet columns are totaled. of $22,480. Because there are no adjustments to the Cash account, $22,480 is entered in the debit column of the Adjusted Trial Balance columns. On the second line, Accounts Receivable shows a debit of $4,600 in the Trial Balance columns. Because there is a debit of $400 from adjustment f in the Adjustments columns, it is added to the $4,600 and carried over to the debit column of the Adjusted Trial Balance columns at $5,000. On the next line, Office Supplies shows a debit of $5,200 in the Trial Balance columns and a credit of $1,540 156 CHAPTER 4 Completing the Accounting Cycle from adjustment b in the Adjustments columns. Subtracting $1,540 from $5,200 results in a $3,660 debit balance in the Adjusted Trial Balance columns. This process is followed for all the accounts, including those added below the trial bal- ance totals. The Adjusted Trial Balance columns are then footed (totaled) to check the accuracy of the crossfooting. Step 4. Extend the Account Balances from the Adjusted Trial Bal- ance Columns to the Income Statement or Balance Sheet Columns Every account in the adjusted trial balance is an income statement account or a

balance sheet account. Each account is extended to its proper place as a debit or credit in either the Income Statement columns or the Balance Sheet col- umns (the blue columns in Exhibit 4-7). As shown in Exhibit 4-7, revenue and expense accounts are extended to the Income Statement columns, and asset, liability, Capital, and Withdrawals accounts are extended to the Balance Sheet columns. To avoid overlooking an account, the accounts are extended line by line, beginning with the first line (Cash) and not omitting any subsequent lines. For instance, the Cash debit balance of $22,480 is extended to the debit column of the Balance Sheet columns; then, the Accounts Receivable debit balance of $5,000 is extended to the debit column of the Balance Sheet columns; and so forth. Step 5. Total the Income Statement Columns and the Balance Sheet Columns. Enter the Net Income or Net Loss in Both Pairs of Columns as a Balancing Figure, and Recompute the Column Totals This fifth and last step, shown in the brown columns at the bottom of Exhibit 4-7, is neces- sary to compute net income or net loss and to prove the arithmetical accuracy of the work sheet. Net income (or net loss) is equal to the difference between the total debits and credits of the Income Statement columns. It is also equal to the difference between the total debits and credits of the Balance Sheet columns. Revenues (Income Statement credit column total) $13,600 Expenses (Income Statement debit column total) (9,640) Net Income $ 3,960 In this case, revenues (credit column) exceed expenses (debit column). Thus, Miller Design Studio has a net income of $3,960. The same difference occurs between the total debits and credits of the Balance Sheet columns. The $3,960 is entered in the debit side of the Income Statement columns and in the credit side of the Balance Sheet columns to balance the columns. Remember that the excess of revenues over expenses (net income) increases own- er’s equity and that increases in owner’s equity are recorded by credits. When a net loss occurs, the opposite rule applies. The excess of expenses over revenues—net loss—is placed in the credit side of the Income Statement columns as a balancing figure. It is then placed in the debit side of the Balance Sheet col- umns because a net loss decreases owner’s equity, and decreases in owner’s equity are recorded by debits. As a final check, the four columns are totaled again. If the Income Statement columns and the Balance Sheet columns do not balance, an account may have been extended or sorted to the wrong column, or an error may have been made in adding the columns. Of course, equal totals in the two pairs of columns are not absolute proof of accuracy. If an asset has been carried to the Income Statement debit column (or an expense has been carried to the Balance Sheet debit column) The Work Sheet: An Accountant’s Tool 157 or a similar error with revenues or liabilities has been made, the work sheet will balance, but the net income figure will be wrong. Study Note Theoretically, adjusting Using the Work Sheet entries can be recorded in the accounting records before Accountants use the completed work sheet in performing three principal tasks. the financial statements are These tasks are as follows: prepared or even before the 1. Recording the adjusting entries in the general journal. Because the work sheet is completed. However, they always precede information needed to record the adjusting entries can be copied from the preparation of closing the work sheet, entering the adjustments in the journal is an easy step, entries. as shown in Exhibit 4-8. The adjusting entries are then posted to the general ledger. EXHIBIT 4-8 Adjustments from the Work General Journal Page 3 Sheet Entered in the General Journal Post. Date Description Ref. Debit Credit 2011 (a) July 31 Rent Expense 514 1,600 Prepaid Rent 117 1,600 To recognize expiration of one month’s rent (b) 31 Office Supplies Expense 517 1,540 Office Supplies 116 1,540 To recognize office supplies used during the month (c) 31 Depreciation Expense–Office