Accounting

Accounting Principles: A Business Perspective, Financial Accounting (Chapters 1 – 8)

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Textbook Provenance (1998 - 2011) 1998 Edition Accounting: A Business Perspective (Irwin/Mcgraw-Hill Series in Principles of Accounting) [Hardcover] Roger H. Hermanson (Author), James Don Edwards (Author), Michael W. Maher (Author) Eighth Edition

Hardcover: 944 pages

Publisher: Richard D Irwin; 7 Sub edition (April 1998)

Language: English

ISBN-10: 0075615851

ISBN-13: 978-0075615859

Product Dimensions: 11.1 x 8.7 x 1.8 inches

Current Hardbound Price $140.00 (Amazon.com)

2010 Editions (http://globaltext.terry.uga.edu/books/) Global Text Project Conversion to Creative Commons License CC-BY “Accounting Principles: A Business Perspective First Global Text Edition, Volume 1 Financial Accounting”, Revision Editor: Donald J. McCubbrey, PhD.

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“Accounting Principles: A Business Perspective First Global Text Edition, Volume 2 Managerial Accounting”, Revision Editor: Donald J. McCubbrey, PhD.

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Preface from the eight edition:

Philosophy and purpose Imagine that you have graduated from college without taking an accounting course. You are

employed by a company as a sales person, and you eventually become the sales manager of a territory.

While attending a sales managers' meeting, financial results are reviewed by the Vice President of Sales

and terms such as gross margin percentage, cash flows from operating activities, and LIFO inventory

methods are being discussed. The Vice President eventually asks you to discuss these topics as they

relate to your territory. You try to do so, but it is obvious to everyone in the meeting that you do not

know what you are talking about.

Accounting principles courses teach you the "language of business" so you understand terms and

concepts used in business decisions. If you understand how accounting information is prepared, you

will be in an even stronger position when faced with a management decision based on accounting

information.

The importance of transactions analysis and proper recording of transactions has clearly been

demonstrated in some of the recent business failures that have been reported in the press. If the

financial statements of an enterprise are to properly represent the results of operations and the

financial condition of the company, the transactions must be analyzed and recorded in the accounts

following generally accepted accounting principles. The debits and credits are important not only to

accounting majors but also to those entering or engaged in a business career to become managers

because the ultimate effects of these journal entries are reflected in the financial statements. If

expenses are reported as assets, liabilities and their related expenses are omitted from the financial

statements, or reported revenues are recorded prematurely or do not really exist, the financial

statements are misleading. The financial statements are only useful and meaningful if they are fair and

clearly represent the business events of the company.

We wrote this text to give you an understanding of how to use accounting information to analyze

business performance and make business decisions. The text takes a business perspective. We use the

annual reports of real companies to illustrate many of the accounting concepts. You are familiar with

many of the companies we use, such as The Limited, The Home Depot, and Coca-Cola Company.

Gaining an understanding of accounting terminology and concepts, however, is not enough to

ensure your success. You also need to be able to find information on the Internet, analyze various

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business situations, work effectively as a member of a team, and communicate your ideas clearly. This

text was developed to help you develop these skills.

Curriculum concerns Significant changes have been recommended for accounting education. Some parties have

expressed concern that recent accounting graduates do not possess the necessary set of skills to

succeed in an accounting career. The typical accounting graduate seems unable to successfully deal

with complex and unstructured "real world" accounting problems and generally lacks communication

and interpersonal skills. One recommendation is the greater use of active learning techniques in a re-

energized classroom environment. The traditional lecture and structured problem solving method

approach would be supplemented or replaced with a more informal classroom setting dealing with

cases, simulations, and group projects. Both inside and outside the classroom, there would be two-way

communication between (1) professor and student and (2) student and student. Study groups would be

formed so that students could tutor other students. The purposes of these recommendations include

enhancing students' critical thinking skills, written and oral communication skills, and interpersonal

skills.

One of the most important benefits you can obtain from a college education is that you "learn how

to learn". The concept that you gain all of your learning in school and then spend the rest of your life

applying that knowledge is not valid. Change is occurring at an increasingly rapid pace. You will

probably hold many different jobs during your career, and you will probably work for many different

companies. Much of the information you learn in college will be obsolete in just a few years. Therefore,

you will be expected to engage in life-long learning. Memorizing is much less important than learning

how to think critically.

With this changing environment in mind, we have developed a text that will lend itself to developing

the skills that will lead to success in your future career in business. The section at the end of each

chapter titled, "Beyond the numbers—Critical thinking", provides the opportunity for you to address

unstructured case situations, the analysis of real companies' financial situations, ethics cases, and team

projects. Each chapter also includes one or two Internet projects in the section titled "Using the

Internet—A view of the real world". For many of these items, you will use written and oral

communication skills in presenting your results.

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Objectives and overall approach of the eighth edition

The Accounting Education Change Commission (AECC) made specific recommendations regarding

teaching materials and methods used in the first-year accounting course. As a result, significant

changes have taken place in that course at many universities. The AECC states:

The first course in accounting can significantly benefit those who enter business,

government, and other organizations, where decision-makers use accounting

information. These individuals will be better prepared for their responsibilities if they

understand the role of accounting information in decision-making by managers,

investors, government regulators, and others. All organizations have accountability

responsibilities to their constituents, and accounting, properly used, is a powerful tool in

creating information to improve the decisions that affect those constituents.1

One of the purposes of the first course should be to recruit accounting majors. To help accomplish

this, the text has a section preceding each chapter entitled, "Careers in accounting".

We retained a solid coverage of accounting that serves business students well regardless of the

majors they select. Those who choose not to major in accounting, which is a majority of those taking

this course, will become better users of accounting information because they will know something

about the preparation of that information.

Approach and organization

Business emphasis Without actual business experience, business students sometimes lack a frame of reference in

attempting to apply accounting concepts to business transactions. We seek to involve the business

student more in real world business applications as we introduce and explain the subject matter.

• "An accounting perspective: Business insight" boxes throughout the text provide

examples of how companies featured in text examples use accounting information every day, or

they provide other useful information.

1 Accounting Education Change Commission, Position Statement No. Two, “The First Course in

Account” (Torrance, CA, June 1992), pp. 1-2.

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• "Accounting perspective: Uses of technology" boxes throughout the text demonstrate

how technology has affected the way accounting information is prepared, manipulated, and

accessed.

• Some chapters contain "A broader perspective". These situations, taken from annual reports

of real companies and from articles in current business periodicals such as Accounting Today, and

Management Accounting, relate to subject matter discussed in that chapter or present other

useful information. These real world examples demonstrate the business relevance of accounting.

• Real world questions and real world business decision cases are included in almost every

chapter.

• The annual report appendix included with this text contains significant portions of the annual

report of The Limited, Inc. Many of the real world questions and business decision cases are based

on this annual report.

• Numerous illustrations adapted from Accounting Trends & Techniques show the frequency of

use in business of various accounting techniques. Placed throughout the text, these illustrations

give students real world data to consider while learning about different accounting techniques.

• Throughout the text we have included numerous references to the annual reports of many

companies.

• Chapters 1-16 contain a section entitled, "Analyzing and using the financial results". This section

discusses and illustrates a ratio or other analysis technique that pertains to the content of the

chapter. For instance, this section in Chapter 4 discusses the current ratio as it relates to a

classified balance sheet.

• Some of the chapters contain end-of-chapter questions, exercises, or business decision cases that

require the student to refer to the Annual report appendix and answer certain questions. As stated

earlier, this appendix is included with the text and contains the significant portions of the annual

report of The Limited, Inc.

• Each chapter contains a section entitled, "Beyond the numbers—Critical thinking". This section

contains business decision cases, annual report analysis problems, writing assignments based on

the Ethical perspective and Broader perspective boxes, group projects, and Internet projects.

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Pedagogy Students often come into accounting principles courses feeling anxious about learning the subject

matter. Recognizing this apprehension, we studied ways to make learning easier and came up with

some helpful ideas on how to make this edition work even better for students.

• Improvements in the text's content reflect feedback from adopters, suggestions by reviewers,

and a serious study of the learning process itself by the authors and editors. New subject matter is

introduced only after the stage has been set by transitional paragraphs between topic headings.

These paragraphs provide students with the reasons for proceeding to the new material and

explain the progression of topics within the chapter.

• The Introduction contains a section entitled "How to study the chapters in this text", which

should be very helpful to students.

• Each chapter has an "Understanding the learning objectives" section. These "summaries" enable

the student to determine how well the learning objectives were accomplished. We were the first

authors (1974) to ever include Learning objectives in an accounting text. These objectives have

been included at the beginning of the chapter, as marginal notes within the chapter, at the end of

the chapter, and in supplements such as the Test bank, Instructors' resource guide, Computerized

test bank, and Study guide. The objectives are also indicated for each exercise and problem.

• Demonstration problems and solutions are included for each chapter, and a different one

appears for each chapter in the Study guide. These demonstration problems help students to

assess their own progress by showing them how problems that focus on the topic(s) covered in the

chapter are worked before students do assigned homework problems.

• Key terms are printed for emphasis. End-of-chapter glossaries contain the definition.

• Each chapter includes a "Self-test" consisting of true-false and multiple-choice questions. The

answers and explanations appear at the end of the chapter. These self-tests are designed to

determine whether the student has learned the essential information in each chapter.

• In the margin beside each exercise and problem, we have included a description of the

requirements and the related Learning objective(s). These descriptions let students know what

they are expected to do in the problem.

• Throughout the text we use examples taken from everyday life to relate an accounting concept

being introduced or discussed to students' experiences.

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Ethics There is no better time to emphasize high ethical standards to students. This text includes many

items throughout the text entitled, "An ethical perspective". These items present situations in which

students are likely to find themselves throughout their careers. They range from resisting pressure by a

superior or a client to do the wrong thing to deciding between alternative corporate behaviors that have

environmental and profit consequences.

End-of-chapter materials Describing teaching methods, the AECC stated, "Teachers...should place a priority on their

interaction with students and on interaction among students. Students' involvement should be

promoted by methods such as cases, simulations, and group projects..."2 A section entitled "Beyond the

numbers—Critical thinking" at the end of every chapter is designed to implement these

recommendations. Business decision cases require critical thinking in complex situations often based

on real companies. The Annual report analysis section requires analyzing annual reports and

interpreting the results in writing. The Ethics cases require students to respond in writing to situations

they are likely to encounter in their careers. These cases do not necessarily have one right answer. The

Group projects for each chapter teach students how to work effectively in teams, a skill that was

stressed by the AECC and is becoming increasingly necessary for success in business. The Internet

projects teach students how to retrieve useful information from the Internet.

A team approach can also be introduced in the classroom using the regular exercises and problems

in the text. Teams can be assigned the task of presenting their solutions to exercises or problems to the

rest of the class. Using this team approach in class can help re-energize the classroom by creating an

active, informal environment in which students learn from each other. (Two additional group projects

are described in the Instructor's resource guide. These projects are designed to be used throughout the

semester or quarter.)

We have included a vast amount of other resource materials for each chapter within the text from

which the instructor may draw: (1) one of the largest selections of end-of-chapter questions, exercises,

and problems available; (2) several comprehensive review problems that allow students to review all

major concepts covered to that point; and (3) from one to three business decision cases per chapter.

Other key features regarding end-of-chapter material follow.

2Ibid, p.2.

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• A uniform chart of accounts appears in a separate file you can download. This uniform chart of

accounts is used consistently throughout the first 11 chapters. We believe students will benefit

from using the same chart of accounts for all homework problems in those chapters.

• A comprehensive review problem at the end of Chapter 4 serves as a mini practice set to test all

material covered to that point. Another comprehensive problem at the end of Chapter 19 reviews

the material covered in Chapters 18 and 19. Two comprehensive budgeting problems are also

included as business decision cases at the end of Chapter 23.

• Some of the end-of-chapter problem materials (questions, exercises, problems, business decision

cases, other "Beyond the numbers" items, and comprehensive review problems) have been

updated. Each exercise and problem is identified with the learning objective(s) to which it relates.

• All end-of-chapter exercises and problems have been traced back to the chapters to ensure that

nothing is asked of a student that does not appear in the book. This feature was a strength of

previous editions, ensuring that instructors could confidently assign problems without having to

check for applicability. Also, we took notes while teaching from the text and clarified problem and

exercise instructions that seemed confusing to our students.

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Table of Contents

1 The Accounting Environment...........................................................................................14

1.1 Learning objectives.........................................................................................................14 Defined........................................................................................................15 1.2 Accounting

1.3 Employment opportunities in accounting......................................................................17 1.4 Financial accounting versus managerial accounting......................................................21 1.5 Development of financial accounting standards............................................................23 1.6 Ethical behavior of accountants.....................................................................................25

and communication skills...................................................................26 1.7 Critical thinking 1.8 Internet skills..................................................................................................................27 1.9 How to study the chapters in this text............................................................................27

2 Accounting and its use in business decisions...................................................................30

2.1 Learning objectives........................................................................................................30 2.2 A career as an entrepreneur..........................................................................................30 2.3 Forms of business organizations....................................................................................31 2.4 Types of activities performed by business organizations..............................................33 2.5 Financial statements of business organizations............................................................34 2.6 The financial accounting process...................................................................................39 2.7 Underlying assumptions or concepts ...........................................................................40 2.8 Transactions affecting only the balance sheet ..............................................................41 2.9 Transactions affecting the income statement and/or balance sheet ............................45

and income statement transactions.................................482.10 Summary of balance sheet 2.11 Dividends paid to owners (stockholders).....................................................................49 2.12 Analyzing and using the financial results—the equity ratio.........................................52 2.13 Understanding the learning objectives........................................................................53 2.14 Appendix: A comparison of corporate accounting with accounting for a sole

proprietorship and a partnership.........................................................................................54 2.15 Demonstration problem...............................................................................................55 2.16 Solution to demonstration problem.............................................................................57 2.17 Key terms......................................................................................................................58 2.18 Self-test........................................................................................................................60

3 Recording business transactions.......................................................................................77

3.1 Learning objectives.........................................................................................................77 3.2 Salary potential of accountants......................................................................................77 3.3 The account and rules of debit and credit......................................................................79 3.4 Recording changes in assets, liabilities, and stockholders' equity.................................81

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3.5 The accounting cycle......................................................................................................86 3.6 The journal.....................................................................................................................87 3.7 The ledger......................................................................................................................90 3.8 The accounting process in operation.............................................................................91 3.9 The use of ledger accounts...........................................................................................105 3.10 Analyzing and using the financial results— Horizontal and vertical analyses...........115 3.11 Key terms.....................................................................................................................123 3.12 Self-test.......................................................................................................................124

4 Adjustments for financial reporting................................................................................144

4.1 Learning objectives.......................................................................................................144 4.2 A career as a tax specialist............................................................................................144 4.3 Cash versus accrual basis accounting...........................................................................145 4.4 The need for adjusting entries......................................................................................147

entries..........................................................................149 4.5 Classes and types of adjusting deferred items....................................................................................151 4.6 Adjustments for

4.7 Adjustments for accrued items.....................................................................................162 entries..............................................................166 4.8 Effects of failing to prepare adjusting

4.9 Analyzing and using the financial results—trend percentages....................................166 4.10 Understanding the learning objectives.......................................................................167

5 Completing the accounting cycle....................................................................................190

5.1 Learning objectives.......................................................................................................190 5.2 A career in information systems..................................................................................190 5.3 The accounting cycle summarized................................................................................191 5.4 The work sheet..............................................................................................................191

financial statements from the work sheet...................................................199 5.5 Preparing 5.6 Journalizing adjusting entries.....................................................................................200 5.7 The closing process.......................................................................................................201 5.8 Accounting systems: From manual to computerized..................................................210 5.9 A classified balance sheet.............................................................................................216 5.10 Analyzing and using the financial results — the current ratio...................................223 5.11 Understanding the learning objectives.......................................................................224

6 Accounting theory...........................................................................................................254

6.1 Learning objectives......................................................................................................254 6.2 A career as an accounting professor............................................................................254 6.3 Traditional accounting theory.....................................................................................255 6.4 Underlying assumptions or concepts..........................................................................256 6.5 Other basic concepts....................................................................................................258 6.6 The measurement process in accounting....................................................................259 6.7 The major principles....................................................................................................260 6.8 Modifying conventions (or constraints)......................................................................268 6.9 The financial accounting standards board's conceptual framework project...............270

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6.10 Objectives of financial reporting................................................................................271 6.11 Qualitative characteristics..........................................................................................273 6.12 The basic elements of financial statements................................................................277 6.13 Recognition and measurement in financial statements.............................................279 6.14 Summary of significant accounting policies..............................................................279 6.15 Significant accounting policies..................................................................................280 6.16 Understanding the learning objectives......................................................................283

7 Introduction to inventories and the classified income statement..................................303

7.1 Learning objective .......................................................................................................303 7.2 A career as a CEO.........................................................................................................303 7.3 Two income statements compared— Service company and merchandising company

............................................................................................................................................305 7.4 Sales revenues..............................................................................................................305 7.5 Cost of goods sold.........................................................................................................313 7.6 Classified income statement........................................................................................324 7.7 Analyzing and using the financial results—Gross margin percentage.........................329 7.8 Understanding the learning objectives........................................................................329 7.9 Appendix: The work sheet for a merchandising company...........................................331 7.10 Key terms...................................................................................................................338 7.11 Self-test.......................................................................................................................340

8 Measuring and reporting inventories.............................................................................359

8.1 Learning objectives......................................................................................................359 8.2 Choosing an accounting career....................................................................................359 8.3 Inventories and cost of goods sold..............................................................................360 8.4 Importance of proper inventory valuation..................................................................361 8.5 Determining inventory cost.........................................................................................363 8.6 Departures from cost basis of inventory measurement..............................................387 8.7 Analyzing and using financial results—inventory turnover ratio................................395 8.8 Understanding the learning objectives........................................................................395

Appendix "The Limited, Inc" 2000 Financials

Alphabetical Index..............................................................................................................427

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1 The Accounting Environment

1.1 Learning objectives

After studying this introduction, you should be able to:

• Define accounting.

• Describe the functions performed by accountants.

• Describe employment opportunities in accounting.

• Differentiate between financial and managerial accounting.

• Identify several organizations that have a role in the development of financial accounting

standards.

You have embarked on the challenging and rewarding study of accounting—an old and time-

honored discipline. History indicates that all developed societies require certain accounting records.

Record-keeping in an accounting sense is thought to have begun about 4000 BCE

The record-keeping, control, and verification problems of the ancient world had many

characteristics similar to those we encounter today. For example, ancient governments also kept

records of receipts and disbursements and used procedures to check on the honesty and reliability of

employees.

A study of the evolution of accounting suggests that accounting processes have developed primarily

in response to business needs. Also, economic progress has affected the development of accounting

processes. History shows that the higher the level of civilization, the more elaborate the accounting

methods.

The emergence of double-entry bookkeeping was a crucial event in accounting history. In 1494, a

Franciscan monk, Luca Pacioli, described the double-entry Method of Venice system in his text called

Summa de Arithmetica, Geometric, Proportion et Proportionate (Everything about arithmetic,

geometry, and proportion). Many consider Pacioli's Summa to be a reworked version of a manuscript

that circulated among teachers and pupils of the Venetian school of commerce and arithmetic.

Since Pacioli's days, the roles of accountants and professional accounting organizations have

expanded in business and society. As professionals, accountants have a responsibility for placing public

service above their commitment to personal economic gain. Complementing their obligation to society,

accountants have analytical and evaluative skills needed in the solution of ever-growing world

p. 14 of 433

problems. The special abilities of accountants, their independence, and their high ethical standards

permit them to make significant and unique contributions to business and areas of public interest.

You probably will find that of all the business knowledge you have acquired or will learn, the study

of accounting will be the most useful. Your financial and economic decisions as a student and

consumer involve accounting information. When you file income tax returns, accounting information

helps determine your taxes payable. Understanding the discipline of accounting also can influence

many of your future professional decisions. You cannot escape the effects of accounting information on

your personal and professional life.

Every profit-seeking business organization that has economic resources, such as money, machinery,

and buildings, uses accounting information. For this reason, accounting is called the language of

business. Accounting also serves as the language providing financial information about not-for-profit

organizations such as governments, churches, charities, fraternities, and hospitals. However, this text

concentrates on accounting for business firms.

The accounting system of a profit-seeking business is an information system designed to provide

relevant financial information on the resources of a business and the effects of their use. Information is

relevant if it has some impact on a decision that must be made. Companies present this relevant

information in their financial statements. In preparing these statements, accountants consider the

users of the information, such as owners and creditors, and decisions they make that require financial

information.

As a background for studying accounting, this Introduction defines accounting and lists the

functions accountants perform. In addition to surveying employment opportunities in accounting, it

differentiates between financial and managerial accounting. Because accounting information must

conform to certain standards, we discuss several prominent organizations contributing to these

standards. As you continue your study of accounting in this text, accounting—the language of business

—will become your language also. You will realize that you are constantly exposed to accounting

information in your everyday life.

1.2 Accounting Defined

The American Accounting Association—one of the accounting organizations discussed later in this

Introduction—defines accounting as "the process of identifying, measuring, and communicating

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economic information to permit informed judgments and decisions by the users of the information".1

This information is primarily financial—stated in money terms. Accounting, then, is a measurement

and communication process used to report on the activities of profit-seeking business organizations

and not-for-profit organizations. As a measurement and communication process for business,

accounting supplies information that permits informed judgments and decisions by users of the data.

The accounting process provides financial data for a broad range of individuals whose objectives in

studying the data vary widely. Bank officials, for example, may study a company's financial statements

to evaluate the company's ability to repay a loan. Prospective investors may compare accounting data

from several companies to decide which company represents the best investment. Accounting also

supplies management with significant financial data useful for decision making.

Reliable information is necessary before decision makers can make a sound decision involving the

allocation of scarce resources. Accounting information is valuable because decision makers can use it

to evaluate the financial consequences of various alternatives. Accountants eliminate the need for a

crystal ball to estimate the future. They can reduce uncertainty by using professional judgment to

quantify the future financial impact of taking action or delaying action.

Although accounting information plays a significant role in reducing uncertainty within the

organization, it also provides financial data for persons outside the company. This information tells

how management has discharged its responsibility for protecting and managing the company's

resources. Stockholders have the right to know how a company is managing its investments. In

fulfilling this obligation, accountants prepare financial statements such as an income statement, a

statement of retained earnings, a balance sheet, and a statement of cash flows. In addition, they

prepare tax returns for federal and state governments, as well as fulfill other governmental filing

requirements.

Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process that records

the routine economic activities of a business. Accounting includes bookkeeping but goes well beyond it

in scope. Accountants analyze and interpret financial information, prepare financial statements,

conduct audits, design accounting systems, prepare special business and financial studies, prepare

forecasts and budgets, and provide tax services.

Specifically the accounting process consists of the following groups of functions (see Exhibit 1

below):

1 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, III.,

1966), p. 1.

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• Accountants observe many events (or activities) and identify and measure in financial terms

(dollars) those events considered evidence of economic activity. (Often, these three functions are

collectively referred to as analyze.) The purchase and sale of goods and services are economic

events.

• Next, the economic events are recorded, classified into meaningful groups, and summarized.

• Accountants report on economic events (or business activity) by preparing financial statements

and special reports. Often accountants interpret these statements and reports for various groups

such as management, investors, and creditors. Interpretation may involve determining how the

business is performing compared to prior years and other similar businesses.

1.3 Employment opportunities in accounting

During the last half-century, accounting has gained the same professional status as the medical and

legal professions. Today, the accountants in the United States number well over a million. In addition,

several million people hold accounting-related positions. Typically, accountants provide services in

various branches of accounting. These include public accounting, management (industrial) accounting,

governmental or other not-for-profit accounting, and higher education. The demand for accountants

will likely increase dramatically in the future. This increase is greater than for any other profession.

You may want to consider accounting as a career.

Public accounting firms offer professional accounting and related services for a fee to

companies, other organizations, and individuals. An accountant may become a Certified Public

Accountant (CPA) by passing an examination prepared and graded by the American Institute of

Certified Public Accountants (AICPA). The exam is administered by computer. In addition to passing

the exam, CPA candidates must meet other requirements, which include obtaining a state license.

These requirements vary by state. A number of states require a CPA candidate to have completed

specific accounting courses and earned a certain number of college credits (five years of study in many

states); worked a certain number of years in public accounting, industry, or government; and lived in

that state a certain length of time before taking the CPA examination. As of the year 2000, five years of

course work were required to become a member of the AICPA.

After a candidate passes the CPA examination, some states (called one-tier states) insist that the

candidate meet all requirements before the state grants the CPA certificate and license to practice.

Other states (called two-tier states) issue the CPA certificate immediately after the candidate passes the

exam. However, these states issue the license to practice only after all other requirements have been

met. CPAs who want to renew their licenses to practice must stay current through continuing

p. 17 of 433

professional education programs and must prove that they have done so. No one can claim to be a CPA

and offer the services normally provided by a CPA unless that person holds an active license to

practice.

Exhibit 1: Functions performed by accountants

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The public accounting profession in the United States consists of the Big-Four international CPA

firms, several national firms, many regional firms, and numerous local firms. The Big-Four firms

include Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers. At all levels, these

public accounting firms provide auditing, tax, and, for nonaudit clients, management advisory (or

consulting) services.

Auditing A business seeking a loan or attempting to have its securities traded on a stock exchange

usually must provide financial statements to support its request. Users of a company's financial

statements are more confident that the company is presenting its statements fairly when a CPA has

audited the statements. For this reason, companies hire CPA firms to conduct examinations

(independent audits) of their accounting and related records. Independent auditors of the CPA

firm check some of the company's records by contacting external sources. For example, the accountant

may contact a bank to verify the cash balances of the client. After completing a company audit,

independent auditors give an independent auditor's opinion or report. (For an example of an

auditor's opinion, see The Limited, Inc. annual report in the Annual report appendix at the end of the

text.) This report states whether the company's financial statements fairly (equitably) report the

economic performance and financial condition of the business. As you will learn in the next section,

auditors within a business also conduct audits, which are not independent audits. Currently auditing

standards are established by the Public Company Accounting Oversight Board.

In 2002 The Sarbanes-Oxley Act was passed. The Act was passed as one result of the large losses to

the employees and investors from accounting fraud situations involving companies such as Enron and

WorldCom. The Act created the Public Company Accounting Oversight Board. The Board consists of

five members appointed and overseen by the Securities and Exchange Commission. The Board

oversees and investigates the audits and auditors of public companies and can sanction both firms and

individuals for violations of laws, regulations, and rules. The Chief Executive Officer and Chief

Financial Officer of a public company must now certify the company's financial statements. Corporate

audit committees, rather than the corporate management, are now responsible for hiring,

compensating, and overseeing the external auditors.

Tax services CPAs often provide expert advice on tax planning and preparing federal, state, and

local tax returns. The objective in preparing tax returns is to use legal means to minimize the taxes

paid. Almost every major business decision has a tax impact. Tax planning helps clients know the tax

effects of each financial decision.

Management advisory (or consulting) services Before Sarbanes-Oxley management advisory

services were the fastest growing service area for most large and many smaller CPA firms. Management

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frequently identifies projects for which it decides to retain the services of a CPA. However, the

Sarbanes-Oxley Act specifically prohibits providing certain types of consulting services to a publicly-

held company by its external auditor. These services include bookkeeping, information systems design

and implementation, appraisals or valuation services, actuarial services, internal audits, management

and human resources services, broker/dealer and investment services, and legal or expert services

related to audit services. Accounting firms can perform many of these services for publicly held

companies they do not audit. Other services not specifically banned are allowed if pre-approved by the

company's audit committee.

In contrast to public accountants, who provide accounting services for many clients, management

accountants provide accounting services for a single business. In a company with several management

accountants, the person in charge of the accounting activity is often the controller or chief financial

officer.

Management accountants may or may not be CPAs. If management accountants pass an

examination prepared and graded by the Institute of Certified Management Accountants (ICMA) and

meet certain other requirements, they become Certified Management Accountants (CMAs). The

ICMA is an affiliate of the Institute of Management Accountants, an organization primarily consisting

of management accountants employed in private industry.

A career in management accounting can be very challenging and rewarding. Many management

accountants specialize in one particular area of accounting. For example, some may specialize in

measuring and controlling costs, others in budgeting (the development of plans for future operations),

and still others in financial accounting and reporting. Many management accountants become

specialists in the design and installation of computerized accounting systems. Other management

accountants are internal auditors who conduct internal audits. They ensure that the company's

divisions and departments follow the policies and procedures of management. This last group of

management accountants may earn the designation of Certified Internal Auditor (CIA). The

Institute of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully

completed the IIA examination and met certain other requirements.

Many accountants, including CPAs, work in governmental and other not-for-profit

accounting. They have essentially the same educational background and training as accountants in

public accounting and management accounting.

Governmental agencies at the federal, state, and local levels employ governmental accountants.

Often the duties of these accountants relate to tax revenues and expenditures. For example, Internal

Revenue Service employees use their accounting backgrounds in reviewing tax returns and

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investigating tax fraud. Government agencies that regulate business activity, such as a state public

service commission that regulates public utilities (e.g. telephone company, electric company), usually

employ governmental accountants. These agencies often employ governmental accountants who can

review and evaluate the utilities' financial statements and rate increase requests. Also, FBI agents

trained as accountants find their accounting backgrounds useful in investigating criminals involved in

illegal business activities, such as drugs or gambling.

Not-for-profit organizations, such as churches, charities, fraternities, and universities, need

accountants to record and account for funds received and disbursed. Even though these agencies do

not have a profit motive, they should operate efficiently and use resources effectively.

Approximately 10,000 accountants are employed in higher education. The activities of these

academic accountants include teaching accounting courses, conducting scholarly and applied

research and publishing the results, and performing service for the institution and the community.

Faculty positions exist in two-year colleges, four-year colleges, and universities with graduate

programs. A significant shortage of accounting faculty has developed due to the retirement beginning

in the late 1990s of many faculty members. Starting salaries will continue to rise significantly because

of the shortage. You may want to talk with some of your professors about the advantages and

disadvantages of pursuing an accounting career in higher education.

A section preceding each chapter, entitled "Careers in accounting", describes various accounting

careers. You might find one that you would like to pursue.

1.4 Financial accounting versus managerial accounting

An accounting information system provides data to help decision makers both outside and inside

the business. Decision makers outside the business are affected in some way by the performance of the

business. Decision makers inside the business are responsible for the performance of the business. For

this reason, accounting is divided into two categories: financial accounting for those outside and

managerial accounting for those inside.

Financial accounting information appears in financial statements that are intended primarily for

external use (although management also uses them for certain internal decisions). Stockholders and

creditors are two of the outside parties who need financial accounting information. These outside

parties decide on matters pertaining to the entire company, such as whether to increase or decrease

their investment in a company or to extend credit to a company. Consequently, financial accounting

information relates to the company as a whole, while managerial accounting focuses on the parts or

segments of the company.

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Management accountants in a company prepare the financial statements. Thus, management

accountants must be knowledgeable concerning financial accounting and reporting. The financial

statements are the representations of management, not the CPA firm that performs the audit.

The external users of accounting information fall into six groups; each has different interests in the

company and wants answers to unique questions. The groups and some of their possible questions are:

• Owners and prospective owners. Has the company earned satisfactory income on its total

investment? Should an investment be made in this company? Should the present investment be

increased, decreased, or retained at the same level? Can the company install costly pollution

control equipment and still be profitable?

• Creditors and lenders. Should a loan be granted to the company? Will the company be able

to pay its debts as they become due?

• Employees and their unions. Does the company have the ability to pay increased wages? Is

the company financially able to provide long-term employment for its workforce?

• Customers. Does the company offer useful products at fair prices? Will the company survive

long enough to honor its product warranties?

• Governmental units. Is the company, such as a local public utility, charging a fair rate for its

services?

• General public. Is the company providing useful products and gainful employment for citizens

without causing serious environmental problems?

General-purpose financial statements provide much of the information needed by external users of

financial accounting. These financial statements are formal reports providing information on a

company's financial position, cash inflows and outflows, and the results of operations. Many

companies publish these statements in annual reports. (See The Limited, Inc., annual report in the

Annual report appendix.) The annual report also contains the independent auditor's opinion as to

the fairness of the financial statements, as well as information about the company's activities, products,

and plans.

Financial accounting information is historical in nature, reporting on what has happened in the

past. To facilitate comparisons between companies, this information must conform to certain

accounting standards or principles called generally accepted accounting principles (GAAP).

These generally accepted accounting principles for businesses or governmental organizations have

developed through accounting practice or been established by an authoritative organization. We

describe several of these authoritative organizations in the next major section of this Introduction.

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Managerial accounting information is for internal use and provides special information for the

managers of a company. The information managers use may range from broad, long-range planning

data to detailed explanations of why actual costs varied from cost estimates. Managerial accounting

information should:

• Relate to the part of the company for which the manager is responsible. For example, a

production manager wants information on costs of production but not of advertising.

• Involve planning for the future. For instance, a budget would show financial plans for the

coming year.

• Meet two tests: the accounting information must be useful (relevant) and must not cost more to

gather and process than it is worth.

Managerial accounting generates information that managers can use to make sound decisions. The

four major types of internal management decisions are:

• Financial decisions—deciding what amounts of capital (funds) are needed to run the business

and whether to secure these funds from owners (stockholders) or creditors. In this sense, capital

means money used by the company to purchase resources such as machinery and buildings and to

pay expenses of conducting the business.

• Resource allocation decisions—deciding how the total capital of a company is to be

invested, such as the amount to be invested in machinery.

• Production decisions—deciding what products are to be produced, by what means, and

when.

• Marketing decisions—setting selling prices and advertising budgets; determining the location

of a company's markets and how to reach them.

1.5 Development of financial accounting standards

Several organizations are influential in the establishment of generally accepted accounting

principles (GAAP) for businesses or governmental organizations. These are the American Institute of

Certified Public Accountants, the Financial Accounting Standards Board, the Governmental

Accounting Standards Board, the Securities and Exchange Commission, the American Accounting

Association, the Financial Executives Institute, and the Institute of Management Accountants. Each

organization has contributed in a different way to the development of GAAP.

The American Institute of Certified Public Accountants (AICPA) is a professional organization of

CPAs. Many of these CPAs are in public accounting practice. Until recent years, the AICPA was the

dominant organization in the development of accounting standards. In a 20-year period ending in

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1959, the AICPA Committee on Accounting Procedure issued 51 Accounting Research Bulletins

recommending certain principles or practices. From 1959 through 1973, the committee's successor, the

Accounting Principles Board (APB), issued 31 numbered Opinions that CPAs generally are

required to follow. Through its monthly magazine, the Journal of Accountancy, its research division,

and its other divisions and committees, the AICPA continues to influence the development of

accounting standards and practices. Two of its committees—the Accounting Standards Committee and

the Auditing Standards Committee—are particularly influential in providing input to the Financial

Accounting Standards Board (the current rule-making body) and to the Securities and Exchange

Commission and other regulatory agencies.

In 1973, an independent, seven-member, full-time Financial Accounting Standards Board

(FASB) replaced the Accounting Principles Board. The FASB has issued numerous Statements of

Financial Accounting Standards. The old Accounting Research Bulletins and Accounting Principles

Board Opinions are still effective unless specifically superseded by a Financial Accounting Standards

Board Statement. The FASB is the private sector organization now responsible for the development of

new financial accounting standards.

The Emerging Issues Task Force of the FASB interprets official pronouncements for general

application by accounting practitioners. The conclusions of this task force must also be followed in

filings with the Securities and Exchange Commission.

In 1984, the Governmental Accounting Standards Board (GASB) was established with a

full-time chairperson and four part-time members. The GASB issues statements on accounting and

financial reporting in the governmental area. This organization is the private sector organization now

responsible for the development of new governmental accounting concepts and standards. The GASB

also has the authority to issue interpretations of these standards.

Created under the Securities and Exchange Act of 1934, the Securities and Exchange

Commission (SEC) is a government agency that administers important acts dealing with the

interstate sale of securities (stocks and bonds). The SEC has the authority to prescribe accounting and

reporting practices for companies under its jurisdiction. This includes virtually every major US

business corporation. Instead of exercising this power, the SEC has adopted a policy of working closely

with the accounting profession, especially the FASB, in the development of accounting standards. The

SEC indicates to the FASB the accounting topics it believes the FASB should address.

Consisting largely of accounting educators, the American Accounting Association (AAA) has

sought to encourage research and study at a theoretical level into the concepts, standards, and

principles of accounting. One of its quarterly magazines, The Accounting Review, carries many articles

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reporting on scholarly accounting research. Another quarterly journal, Accounting Horizons, reports

on more practical matters directly related to accounting practice. A third journal, Issues in Accounting

Education, contains articles relating to accounting education matters. Students may join the AAA as

associate members by contacting the American Accounting Association, 5717 Bessie Drive, Sarasota,

Florida 34233.

The Financial Executives Institute is an organization established in 1931 whose members are

primarily financial policy-making executives. Many of its members are chief financial officers (CFOs)

of very large corporations. The role of the CFO has evolved in recent years from number cruncher to

strategic planner. These CFOs played a major role in restructuring American businesses in the early

1990s. Slightly more than 14,000 financial officers, representing approximately 7,000 companies in

the United States and Canada, are members of the FEI. Through its Committee on Corporate

Reporting (CCR) and other means, the FEI is very effective in representing the views of the private

financial sector to the FASB and to the Securities and Exchange Commission and other regulatory

agencies.

The Institute of Management Accountants (formerly the National Association of Accountants)

is an organization with approximately 70,000 members, consisting of management accountants in

private industry, CPAs, and academics. The primary focus of the organization is on the use of

management accounting information for internal decision making. However, management accountants

prepare the financial statements for external users. Thus, through its Management Accounting

Practices (MAP) Committee and other means, the IMA provides input on financial accounting

standards to the Financial Accounting Standards Board and to the Securities and Exchange

Commission and other regulatory agencies.

Many other organizations such as the Financial Analysts Federation (composed of investment

advisers and investors), the Securities Industry Associates (composed of investment bankers), and CPA

firms have committees or task forces that respond to Exposure Drafts of proposed FASB Statements.

Their reactions are in the form of written statements sent to the FASB and testimony given at FASB

hearings. Many individuals also make their reactions known to the FASB.

1.6 Ethical behavior of accountants

Several accounting organizations have codes of ethics governing the behavior of their members. For

instance, both the American Institute of Certified Public Accountants and the Institute of Management

Accountants have formulated such codes. Many business firms have also developed codes of ethics for

their employees to follow.

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Ethical behavior involves more than merely making sure you are not violating a code of ethics. Most

of us sense what is right and wrong. Yet get-rich-quick opportunities can tempt many of us. Almost any

day, newspaper headlines reveal public officials and business leaders who did not do the right thing.

Greed won out over their sense of right and wrong. These individuals followed slogans such as: "Get

yours while the getting is good"; "Do unto others before they do unto you"; and "You have done wrong

only if you get caught". More appropriate slogans might be: "If it seems too good to be true, it usually

is"; "There are no free lunches"; and the golden rule, "Do unto others as you would have them do unto

you".

An accountant's most valuable asset is an honest reputation. Those who take the high road of ethical

behavior receive praise and honor; they are sought out for their advice and services. They also like

themselves and what they represent. Occasionally, accountants do take the low road and suffer the

consequences. They sometimes find their names mentioned in The Wall Street Journal and news

programs in an unfavorable light, and former friends and colleagues look down on them. Some of these

individuals are removed from the profession. Fortunately, the accounting profession has many leaders

who have taken the high road, gained the respect of friends and colleagues, and become role models for

all of us to follow.

Many chapters in the text include an ethics case entitled, "An ethical perspective". We know you will

benefit from thinking about the situational ethics in these cases. Often you will not have much

difficulty in determining "right and wrong". Instead of making the cases "close calls", we have

attempted to include situations business students might actually encounter in their careers.

1.7 Critical thinking and communication skills

Accountants in practice and business executives have generally been dissatisfied with accounting

graduates' ability to think critically and to communicate their ideas effectively. The Accounting

Education Change Commission has recommended that changes be made in the education of

accountants to remove these complaints.

To address these concerns, we have included a section at the end of each chapter entitled, "Beyond

the numbers—Critical thinking". In that section, you are required to work relatively unstructured

business decision cases, analyze real-world annual report data, write about situations involving ethics,

and participate in group projects. Most of the other end-of-chapter materials also involve analysis and

written communication of ideas.

In some of the cases, (analysis, ethics situations, and group projects), you are asked to write a

memorandum regarding the situation. In writing such a memorandum, identify your role (auditor,

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consultant), the audience (management, stockholders, and creditors), and the task (the specific

assignment). Present your ideas clearly and concisely.

The purpose of the group projects is to assist you in learning to listen to and work with others.

These skills are important in succeeding in the business world. Team players listen to the views of

others and work cohesively with them to achieve group goals.

1.8 Internet skills

The Internet is a fact of life. It is important for accountants and students to be able to use the

Internet to find relevant information. Thus, each chapter contains approximately two Internet projects

related to accounting. Your instructor might assign some of these, or you could pursue them on your

own.

1.9 How to study the chapters in this text

In studying each chapter:

• Begin by reading the learning objectives at the beginning of each chapter.

• Read "Understanding the learning objectives" at the end of the chapter for a preview of the

chapter content.

• Read the chapter content. Each exercise at the end of the chapters identifies the learning

objective(s) to which it pertains. If you learn best by reading about a concept and then working a

short exercise that illustrates that concept, work the exercises as you read the chapter.

• Reread "Understanding the learning objectives" to determine if you have achieved each

objective.

• Study the Key terms to see if you understand each term. If you do not understand a certain term,

refer to the page indicated to read about the term in its original context.

• Take the Self-test and then check your answers with those at the end of the chapter.

• Work the Demonstration problem to further reinforce your understanding of the chapter

content. Then, compare your solution to the correct solution that follows immediately.

• Look over the questions at the end of the chapter and think out an answer to each one. If you

cannot answer a particular question, refer back into the chapter for the needed information.

• Work at least some of the exercises at the end of the chapter.

• Work the Problems assigned by your instructor, using the forms available. They can be

downloaded from the publisher's website (www.freeloadpress.com).

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• Study the items in the "Beyond the numbers—Critical thinking" section and the "Using the

Internet—A view of the real world" section at the end of each chapter to relate what you have

learned to real-world situations.

• Work the Study guide for the chapter. The Study guide is a supplement that contains (for each

chapter) Learning objectives; Demonstration problem and solution (different from the one in the

text); Matching, Completion, True-false, and Multiple-choice questions; and Solutions to all

questions and exercises in the study guide. The Study guide can be downloaded from the

publisher's website (www.freeloadpress.com).

If you perform each of these steps for each chapter, you should do well in the course. Remember

that a knowledge of accounting will serve you well regardless of the career you pursue.

International accounting standards In recent years, there has been a movement to develop a single set of global accounting

standards for use around the world. Proponents of this movement say that it will boost

cross-border investment, deepen international capital markets and save multinational

companies, who must currently report under multiple systems, a lot of time and

money. The International Accounting Standards Committee (IASC) Foundation was

established as an independent, not-for profit, private sector organisation to work

towards this goal. It seeks to develop a globally accepted set of financial reporting

standards (IFRSs) under the direction of its standards-setting body, the International

Accounting Standards Board (IASB). The AICPA (as well as the other entities

mentioned above) supports this effort and, as of early 2010, states on its website that:

“The growing acceptance of International Financial Reporting Standards (IFRS) as a

basis for U.S. financial reporting represents a fundamental change for the U.S.

accounting profession. Today approximately 113 countries require or allow the use of

IFRS for the preparation of financial statements by publicly held companies. In the

United States, the Securities and Exchange Commission (SEC) has been taking steps to

set a date to allow U.S. public companies to use IFRS, and perhaps make its adoption

mandatory. In fact, on November 14, 2008, the SEC released for public comment a

proposed roadmap with a timeline and key milestones for adopting IFRS beginning in

2014”. Clearly, many new issues can emerge between now and 2014, but the direction

seems to be clear. The AICPA has a link on its website to a page with current

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information on the planned migration to IFRS. You might like to check it out from

time to time at http://www.ifrs.com/Backgrounder_Get_Ready.html. There is also a

wealth of information on the IFRS website at http://ifrs.org.

Students from countries other than the US should check the website of the professional accounting organization in your country for an update on the current status. For example, if you go to the website of the Institute of Chartered Accountants of India at http://icai.org and search on IFRS you will find a number of links to documents covering the planned migration to IFRS in India.

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2 Accounting and its use in business decisions

2.1 Learning objectives

• Identify and describe the three basic forms of business organizations.

• Distinguish among the three types of activities performed by business organizations.

• Describe the content and purposes of the income statement, statement of retained earnings,

balance sheet, and statement of cash flows.

• State the basic accounting equation and describe its relationship to the balance sheet.

• Using the underlying assumptions or concepts, analyze business transactions and determine

their effects on items in the financial statements.

• Prepare an income statement, a statement of retained earnings, and a balance sheet.

• Analyze and use the financial results—the equity ratio.

2.2 A career as an entrepreneur

When today’s college students are polled about their long-term career choice, a surprisingly large

number respond that they wish to someday own and manage their own business. In fact, the aspiration

to start a business, to be an entrepreneur, is nearly universal. It is widely acknowledged that a degree in

accounting offers many advantages to a would-be entrepreneur. In fact, if you ask owners of small

businesses which skill they wish they had more expertise in, they will very frequently reply

“accounting”. No matter what the business may be, the owner and/or manager must be able to

understand the accounting and financial consequences of business decisions.

Most successful entrepreneurs have learned that it takes a lot more than a great marketing idea or

product innovation to make a successful business. There are many steps involved before an idea

becomes a successful and rewarding business. Entrepreneurs must be able to raise capital, either from

banks or investors. Once a business has been launched, the entrepreneur must be a manager—a

manager of people, inventory, facilities, customer relationships, and relationships with the very banks

and investors that provided the capital. Business owners quickly learn that in order to survive they

need to be well-rounded, savvy individuals who can successfully manage these diverse relationships.

An accounting education is ideal for providing this versatile background.

In addition to providing a good foundation for entrepreneurship in any business, an accounting

degree offers other ways of building your own business. For example, a large percentage of public

accountants work as sole proprietors—building and managing their own professional practice. This can

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be a very rewarding career, working closely with individuals and small businesses. One advantage of

this career is that you can establish your practice in virtually any location ranging from large cities to

rural settings. Finally, many accountants who have gained specialized expertise and experience in a

particular field start their own practice as consultants. Expertise such as this, which may be in a field

outside of traditional accounting practice, can generate billing rates well in the excess of USD 100 an

hour.

The introduction to this text provided a background for your study of accounting. Now you are

ready to learn about the forms of business organizations and the types of business activities they

perform. This chapter presents the financial statements used by businesses. These financial statements

show the results of decisions made by management. Investors, creditors, and managers use these

statements in evaluating management’s past decisions and as a basis for making future decisions.

In this chapter, you also study the accounting process (or accounting cycle) that accountants use to

prepare those financial statements. This accounting process uses financial data such as the records of

sales made to customers and purchases made from suppliers. In a systematic manner, accountants

analyze, record, classify, summarize, and finally report these data in the financial statements of

businesses. As you study this chapter, you will begin to understand the unique, systematic nature of

accounting—the language of business.

2.3 Forms of business organizations

Accountants frequently refer to a business organization as an accounting entity or a business

entity. A business entity is any business organization, such as a hardware store or grocery store, that

exists as an economic unit. For accounting purposes, each business organization or entity has an

existence separate from its owner(s), creditors, employees, customers, and other businesses.1 This

separate existence of the business organization is known as the business entity concept. Thus, in

the accounting records of the business entity, the activities of each business should be kept separate

from the activities of other businesses and from the personal financial activities of the owner(s).

Assume, for example, that you own two businesses, a physical fitness center and a horse stable.

According to the business entity concept, you would consider each business as an independent

business unit. Thus, you would normally keep separate accounting records for each business. Now

1 When first studying any discipline, students encounter new terms. Usually these terms are set in

bold. The boldface color terms are also listed and defined at the end of each chapter (see Key

terms).

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assume your physical fitness center is unprofitable because you are not charging enough for the use of

your exercise equipment. You can determine this fact because you are treating your physical fitness

center and horse stable as two separate business entities. You must also keep your personal financial

activities separate from your two businesses. Therefore, you cannot include the car you drive only for

personal use as a business activity of your physical fitness center or your horse stable. However, the use

of your truck to pick up feed for your horse stable is a business activity of your horse stable.

As you will see shortly, the business entity concept applies to the three forms of businesses—single

proprietorships, partnerships, and corporations. Thus, for accounting purposes, all three business

forms are separate from other business entities and from their owner(s). Since most large businesses

are corporations, we use the corporate approach in this text and include only a brief discussion of

single proprietorships and partnerships.

A single proprietorship is an unincorporated business owned by an individual and often

managed by that same person. Single proprietors include physicians, lawyers, electricians, and other

people in business for themselves. Many small service businesses and retail establishments are also

single proprietorships. No legal formalities are necessary to organize such businesses, and usually

business operations can begin with only a limited investment.

In a single proprietorship, the owner is solely responsible for all debts of the business. For

accounting purposes, however, the business is a separate entity from the owner. Thus, single

proprietors must keep the financial activities of the business, such as the receipt of fees from selling

services to the public, separate from their personal financial activities. For example, owners of single

proprietorships should not enter the cost of personal houses or car payments in the financial records of

their businesses.

A partnership is an unincorporated business owned by two or more persons associated as

partners. Often the same persons who own the business also manage the business. Many small retail

establishments and professional practices, such as dentists, physicians, attorneys, and many CPA

firms, are partnerships.

A partnership begins with a verbal or written agreement. A written agreement is preferable because

it provides a permanent record of the terms of the partnership. These terms include the initial

investment of each partner, the duties of each partner, the means of dividing profits or losses between

the partners each year, and the settlement after the death or withdrawal of a partner. Each partner may

be held liable for all the debts of the partnership and for the actions of each partner within the scope of

the business. However, as with the single proprietorship, for accounting purposes, the partnership is a

separate business entity.

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A corporation is a business incorporated under the laws of a state and owned by a few

stockholders or thousands of stockholders. Almost all large businesses and many small businesses are

incorporated.

The corporation is unique in that it is a separate legal business entity. The owners of the corporation

are stockholders, or shareholders. They buy shares of stock, which are units of ownership, in the

corporation. Should the corporation fail, the owners would only lose the amount they paid for their

stock. The corporate form of business protects the personal assets of the owners from the creditors of

the corporation.2

Stockholders do not directly manage the corporation. They elect a board of directors to represent

their interests. The board of directors selects the officers of the corporation, such as the president and

vice presidents, who manage the corporation for the stockholders.

Accounting is necessary for all three forms of business organizations, and each company must

follow generally accepted accounting principles (GAAP). Since corporations have such an important

impact on our economy, we use them in this text to illustrate basic accounting principles and concepts.

An accounting perspective: Business insight

Although corporations constitute about 17 per cent of all business organizations, they

account for almost 90 per cent of all sales volume. Single proprietorships constitute

about 75 per cent of all business organizations but account for less than 10 per cent of

sales volume.

2.4 Types of activities performed by business organizations

The forms of business entities discussed in the previous section are classified according to the type

of ownership of the business entity. Business entities can also be grouped by the type of business

activities they perform—service companies, merchandising companies, and manufacturing companies.

Any of these activities can be performed by companies using any of the three forms of business

organizations.

2 When individuals seek a bank loan to finance the formation of a small corporation, the bank often

requires those individuals to sign documents making them personally responsible for repaying the

loan if the corporation cannot pay. In this instance, the individuals can lose their original

investments plus the amount of the loan they are obligated to repay.

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• Service companies perform services for a fee. This group includes accounting firms, law

firms, and dry cleaning establishments. The early chapters of this text describe accounting for

service companies.

• Merchandising companies purchase goods that are ready for sale and then sell them to

customers. Merchandising companies include auto dealerships, clothing stores, and

supermarkets. We begin the description of accounting for merchandising companies in

Chapter 6.

• Manufacturing companies buy materials, convert them into products, and then sell the

products to other companies or to the final consumers. Manufacturing companies include steel

mills, auto manufacturers, and clothing manufacturers.

All of these companies produce financial statements as the final end product of their accounting

process. These financial statements provide relevant financial information both to those inside the

company—management—and to those outside the company—creditors, stockholders, and other

interested parties. The next section introduces four common financial statements—the income

statement, the statement of retained earnings, the balance sheet, and the statement of cash flows.

2.5 Financial statements of business organizations

Business entities may have many objectives and goals. For example, one of your objectives in

owning a physical fitness center may be to improve your physical fitness. However, the two primary

objectives of every business are profitability and solvency. Profitability is the ability to generate

income. Solvency is the ability to pay debts as they become due. Unless a business can produce

satisfactory income and pay its debts as they become due, the business cannot survive to realize its

other objectives.

There are four basic financial statements. Together they present the profitability and strength of a

company. The financial statement that reflects a company’s profitability is the income statement.

The statement of retained earnings shows the change in retained earnings between the beginning

and end of a period (e.g. a month or a year). The balance sheet reflects a company’s solvency and

financial position. The statement of cash flows shows the cash inflows and outflows for a company

over a period of time. The headings and elements of each statement are similar from company to

company. You can see this similarity in the financial statements of actual companies in the appendix of

this textbook.

The income statement, sometimes called an earnings statement, reports the profitability of a

business organization for a stated period of time. In accounting, we measure profitability for a period,

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such as a month or year, by comparing the revenues earned with the expenses incurred to produce

these revenues. Revenues are the inflows of assets (such as cash) resulting from the sale of products

or the rendering of services to customers. We measure revenues by the prices agreed on in the

exchanges in which a business delivers goods or renders services. Expenses are the costs incurred to

produce revenues. Expenses are measured by the assets surrendered or consumed in serving

customers. If the revenues of a period exceed the expenses of the same period, net income results.

Thus,

Net income = Revenues – Expenses

Net income is often called the earnings of the company. When expenses exceed revenues, the

business has a net loss, and it has operated unprofitably.

In Exhibit 2, Part A shows the income statement of Metro Courier, Inc., for July 2010. This

corporation performs courier delivery services of documents and packages in San Diego in the state of

California, USA.

Metro’s income statement for the month ended 2010 July 31, shows that the revenues (or delivery

fees) generated by serving customers for July totaled USD 5,700. Expenses for the month amounted to

USD 3,600. As a result of these business activities, Metro’s net income for July was USD 2,100. To

determine its net income, the company subtracts its expenses of USD 3,600 from its revenues of USD

5,700. Even though corporations are taxable entities, we ignore corporate income taxes at this point.

One purpose of the statement of retained earnings is to connect the income statement and the

balance sheet. The statement of retained earnings explains the changes in retained earnings

between two balance sheet dates. These changes usually consist of the addition of net income (or

deduction of net loss) and the deduction of dividends.

Dividends are the means by which a corporation rewards its stockholders (owners) for providing it

with investment funds. A dividend is a payment (usually of cash) to the owners of the business; it is a

distribution of income to owners rather than an expense of doing business. Corporations are not

required to pay dividends and, because dividends are not an expense, they do not appear on the income

statement.

The effect of a dividend is to reduce cash and retained earnings by the amount paid out. Then, the

company no longer retains a portion of the income earned but passes it on to the stockholders.

Receiving dividends is, of course, one of the primary reasons people invest in corporations.

The statement of retained earnings for Metro Courier, Inc., for July 2010 is relatively simple (see

Part B of Exhibit 2). Organized on June 1, Metro did not earn any revenues or incur any expenses

during June. So Metro’s beginning retained earnings balance on July 1 is zero. Metro then adds its USD

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2,100 net income for July. Since Metro paid no dividends in July, the USD 2,100 would be the ending

balance of retained earnings. See below.

A. Income Statement METRO COURIIER INC

Income Statement For the Month Ended 2010 July 31

Revenues: Service $ 5,700 revenue

Expenses: Salaries $ 2,600 expense Rent expense 400 Gas and oil 600 expense Total 3,600 expenses

Net income $ 2,100 (A)

B. Statement of Retained Earnings

METRO COURIER , INC. Statement of Retained Earnings For the Month Ended 2010 July 31

Retained earnings, July 1 -0- Add: Net income for July (A)2,100

Retained earnings, July 31 $ 2,100 (B)

C. Balance Sheet

METRO COURIER, INC. Balance Sheet 2010 July 31

Assets Liabilities and Stockholder's Equity Cash $ 15,500 Liabilities: Account receivables 700 Accounts payable $ 600 Trucks 20,000 Notes payable 6,000 Office equipment 2,500 Total liabilities $ 6,600

Stockholders equity:

Capital stock $ 30,000

Retained earnings (B)2,100

Total stockholders' equity $ 32,100 Total assets $ 38,700 Total liabilities and stockholders' equity $ 38,700

Exhibit 2:

Next, Metro carries this USD 2,100 ending balance in retained earnings to the balance sheet (Part

C). If there had been a net loss, it would have deducted the loss from the beginning balance on the

statement of retained earnings. For instance, if during the next month (August) there is a net loss of

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USD 500, the loss would be deducted from the beginning balance in retained earnings of USD 2,100.

The retained earnings balance at the end of August would be USD 1,600.

Dividends could also have affected the Retained Earnings balance. To give a more realistic

illustration, assume that (1) Metro Courier, Inc.’s net income for August was actually USD 1,500

(revenues of USD 5,600 less expenses of USD 4,100) and (2) the company declared and paid dividends

of USD 1,000. Then, Metro’s statement of retained earnings for August would be: METRO COURIER, INC.

Statement of Retained Earnings For the Month Ended 2010 August 31

Retained earnings, August 1.......................... $2,100 Add: Net income for August..................... 1,500

Total.......................................... $3,600 Less: Dividends................................... 1,000

Retained earnings, August 31........................ $2,600

The balance sheet, sometimes called the statement of financial position, lists the company’s

assets, liabilities, and stockholders’ equity (including dollar amounts) as of a specific moment in time.

That specific moment is the close of business on the date of the balance sheet. Notice how the heading

of the balance sheet differs from the headings on the income statement and statement of retained

earnings. A balance sheet is like a photograph; it captures the financial position of a company at a

particular point in time. The other two statements are for a period of time. As you study about the

assets, liabilities, and stockholders’ equity contained in a balance sheet, you will understand why this

financial statement provides information about the solvency of the business.

Assets are things of value owned by the business. They are also called the resources of the

business. Examples include cash, machines, and buildings. Assets have value because a business can

use or exchange them to produce the services or products of the business. In Part C of Exhibit 2 the

assets of Metro Courier, Inc., amount to USD 38,700. Metro’s assets consist of cash, accounts

receivable (amounts due from customers for services previously rendered), trucks, and office

equipment.

Liabilities are the debts owed by a business. Typically, a business must pay its debts by certain

dates. A business incurs many of its liabilities by purchasing items on credit. Metro’s liabilities consist

of accounts payable (amounts owed to suppliers for previous purchases) and notes payable

(written promises to pay a specific sum of money) totaling USD 6,600.3

3 Most notes bear interest, but in this chapter we assume that all notes bear no interest. Interest is

an amount paid by the borrower to the lender (in addition to the amount of the loan) for use of the

money over time.

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Metro Courier, Inc., is a corporation. The owners’ interest in a corporation is referred to as

stockholders’ equity. Metro’s stockholders’ equity consists of (1) USD 30,000 paid for shares of

capital stock and (2) retained earnings of USD 2,100. Capital stock shows the amount of the owners’

investment in the corporation. Retained earnings generally consists of the accumulated net income

of the corporation minus dividends distributed to stockholders. We discuss these items later in the

text. At this point, simply note that the balance sheet heading includes the name of the organization

and the title and date of the statement. Notice also that the dollar amount of the total assets is equal to

the claims on (or interest in) those assets. The balance sheet shows these claims under the heading

“Liabilities and Stockholders’ Equity”.

Management is interested in the cash inflows to the company and the cash outflows from the

company because these determine the company’s cash it has available to pay its bills when due. The

statement of cash flows shows the cash inflows and cash outflows from operating, investing, and

financing activities. Operating activities generally include the cash effects of transactions and other

events that enter into the determination of net income. Investing activities generally include business

transactions involving the acquisition or disposal of long-term assets such as land, buildings, and

equipment. Financing activities generally include the cash effects of transactions and other events

involving creditors and owners (stockholders).

Chapter 16 describes the statement of cash flows in detail. Our purpose here is to merely introduce

this important financial statement. Normally, a firm prepares a statement of cash flows for the same

time period as the income statement. The following statement, however, shows the cash inflows and

outflows for Metro Courier, Inc., since it was formed on 2010 June 1. Thus, this cash flow statement is

for two months. METRO COURIER, INC.

Statement of Cash Flows For the Two-Month Period Ended 2010 July 31

Cash flows from operating activities:

Net income.......................................................................... $2.100 Adjustments to reconcile net income to net cash provided by operating activities:

Increase in accounts receivable......................................

Increase in accounts payable.........................................

Net cash provided by operating activities.................

Cash flows from investing activities:

Purchase of trucks................................................................

Purchase of office equipment................................................

Net cash used by investing activities...............................

Cash flows from financing activities:

Proceeds from notes payable.................................................

Proceeds from sale of capital stock........................................

(700)

600

$2,000

$(20,000)

(2,500)

(22,500)

$6,000

30,000

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Net cash provided by financing activities......................... 36,000

Net increase in cash..................................................................... $15,500

At this point in the course, you need to understand what a statement of cash flows is rather than

how to prepare it. We do not ask you to prepare such a statement until you have studied Chapter 16.

The income statement, the statement of retained earnings, the balance sheet, and the statement of

cash flows of Metro Courier, Inc., show the results of management’s past decisions. They are the end

products of the accounting process, which we explain in the next section. These financial statements

give a picture of the solvency and profitability of the company. The accounting process details how this

picture was made. Management and other interested parties use these statements to make future

decisions. Management is the first to know the financial results; then, it publishes the financial

statements to inform other users. The most recent financial statements for most companies can be

found on their websites under “Investor Relations” or some similar heading.

2.6 The financial accounting process

In this section, we explain the accounting equation—the framework for the entire accounting

process. Then, we show you how to recognize a business transaction and describe underlying

assumptions that accountants use to record business transactions. Next you learn how to analyze and

record business transactions.

In the balance sheet presented in Exhibit 2 (Part C), the total assets of Metro Courier, Inc., were

equal to its total liabilities and stockholders’ equity. This equality shows that the assets of a business

are equal to its equities; that is,

Assets = Equities

Assets were defined earlier as the things of value owned by the business, or the economic resources

of the business. Equities are all claims to, or interests in, assets. For example, assume that you

purchased a new company automobile for USD 15,000 by investing USD 10,000 in your own

corporation and borrowing USD 5,000 in the name of the corporation from a bank. Your equity in the

automobile is USD 10,000, and the bank’s equity is USD 5,000. You can further describe the USD

5,000 as a liability because you owe the bank USD 5,000. If you are a corporation, you can describe

your USD 10,000 equity as stockholders’ equity or interest in the asset. Since the owners in a

corporation are stockholders, the basic accounting equation becomes:

Assets A = Liabilities L + Stockholders’ Equity SE

From Metro’s balance sheet in Exhibit 2 (Part C), we can enter in the amount of its assets, liabilities,

and stockholders’ equity:

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A = L + SE

USD 38,700 = USD 6,600 + USD 32,100

Remember that someone must provide assets or resources—either a creditor or a stockholder.

Therefore, this equation must always be in balance.

You can also look at the right side of this equation in another manner. The liabilities and

stockholders’ equity show the sources of an existing group of assets. Thus, liabilities are not only claims

against assets but also sources of assets.

Together, creditors and owners provide all the assets in a corporation. The higher the proportion of

assets provided by owners, the more solvent the company. However, companies can sometimes

improve their profitability by borrowing from creditors and using the funds effectively. As a business

engages in economic activity, the dollar amounts and composition of its assets, liabilities, and

stockholders’ equity change. However, the equality of the basic accounting equation always holds.

An accounting transaction is a business activity or event that causes a measurable change in the

accounting equation, Assets = Liabilities + Stockholders’ equity. An exchange of cash for merchandise

is a transaction. The exchange takes place at an agreed price that provides an objective measure of

economic activity. For example, the objective measure of the exchange may be USD 5,000. These two

factors—evidence and measurement—make possible the recording of a transaction. Merely placing an

order for goods is not a recordable transaction because no exchange has taken place.

A source document usually supports the evidence of the transaction. A source document is any

written or printed evidence of a business transaction that describes the essential facts of that

transaction. Examples of source documents are receipts for cash paid or received, checks written or

received, bills sent to customers for services performed or bills received from suppliers for items

purchased, cash register tapes, sales tickets, and notes given or received. We handle source documents

constantly in our everyday life. Each source document initiates the process of recording a transaction.

2.7 Underlying assumptions or concepts

In recording business transactions, accountants rely on certain underlying assumptions or

concepts. Both preparers and users of financial statements must understand these assumptions:

• Business entity concept (or accounting entity concept). Data gathered in an

accounting system relates to a specific business unit or entity. The business entity concept

assumes that each business has an existence separate from its owners, creditors, employees,

customers, other interested parties, and other businesses.

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• Money measurement concept. Economic activity is initially recorded and reported in a

common monetary unit of measure—the dollar in the United States. This form of measurement

is known as money measurement.

• Exchange-price (or cost) concept (principle). Most of the amounts in an accounting

system are the objective money prices determined in the exchange process. As a result, we

record most assets at their acquisition cost. Cost is the sacrifice made or the resources given

up, measured in money terms, to acquire some desired thing, such as a new truck (asset).

• Going-concern (continuity) concept. Unless strong evidence exists to the contrary,

accountants assume that the business entity will continue operations into the indefinite future.

Accountants call this assumption the going-concern or continuity concept. Assuming that the

entity will continue indefinitely allows accountants to value long-term assets, such as land, at

cost on the balance sheet since they are to be used rather than sold. Market values of these

assets would be relevant only if they were for sale. For instance, accountants would still record

land purchased in 1988 at its cost of USD 100,000 on the 2010 December 31, balance sheet

even though its market value has risen to USD 300,000.

• Periodicity (time periods) concept. According to the periodicity (time periods) concept

or assumption, an entity’s life can be meaningfully subdivided into time periods (such as

months or years) to report the results of its economic activities.

Now that you understand business transactions and the five basic accounting assumptions, you are

ready to follow some business transactions step by step. To begin, we divide Metro’s transactions into

two groups: (1) transactions affecting only the balance sheet in June, and (2) transactions affecting the

income statement and/or the balance sheet in July. Note that we could also classify these transactions

as operating, investing, or financing activities, as shown in the statement of cash flows.

2.8 Transactions affecting only the balance sheet

Since each transaction affecting a business entity must be recorded in the accounting records,

analyzing a transaction before actually recording it is an important part of financial accounting. An

error in transaction analysis results in incorrect financial statements.

To illustrate the analysis of transactions and their effects on the basic accounting equation, the

activities of Metro Courier, Inc., that led to the statements in Exhibit 2 follow. The first set of

transactions (for June), 1a, 2a, and so on, are repeated in the summary of transactions, Exhibit 3 (Part

A). The second set of transactions (for July) (1b–6b) are repeated in Exhibit 4 (Part A).

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2.8.1 1a. Owners invested cash

When Metro Courier, Inc., was organized as a corporation on 2010 June 1, the company issued

shares of capital stock for USD 30,000 cash to Ron Chaney, his wife, and their son. This transaction

increased assets (cash) of Metro by USD 30,000 and increased equities (the capital stock element of

stockholders’ equity) by USD 30,000. Consequently, the transaction yields the following basic

accounting equation:

Trans- Explan- action ation

Beginning balances

1a Stockholder s invested cash Balance after transaction

Cash

$ -0- 30,000

$ 30,000

Increased by

$30,000

Assets Accounts Receiv- able

$ -0-

Trucks

$ -0-

Office Equip- ment

$ -0-

=Liabilities +

Accounts Payable

= $ -0-

Notes Payable +

$ -0-

Stockholders' Equity

Capital Stock

$ -0- 30,000

$ 30,000

Increased by $30,000

2.8.2 2a. Borrowed money

The company borrowed USD 6,000 from Chaney’s father. Chaney signed the note for the company.

The note bore no interest and the company promised to repay (recorded as a note payable) the amount

borrowed within one year. After including the effects of this transaction, the basic accounting equation

is:

Trans- Explan- action ation

Balances before transaction Borrowed 2a money Balance after transaction

Cash

$ 30,000

6,000

$ 36,000

Increased by $6,000

Assets Accounts

Receivable

$ -0-

Trucks

$ -0-

Office Equipment

$ -0-

= Liabilities + Accounts Payable

= $ -0-

=

Notes Payable

$ -0-

6,000

$ 6,000

Increased by $6,000

Stockholder's Equity Capital

+ Stock

$ 30,000

+ $ 30,000

2.8.3 3a. Purchased trucks and office equipment for cash

Metro paid USD 20,000 cash for two used delivery trucks and USD 1,500 for office equipment.

Trucks and office equipment are assets because the company uses them to earn revenues in the future.

Note that this transaction does not change the total amount of assets in the basic equation but only

changes the composition of the assets. This transaction decreased cash and increased trucks and office

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equipment (assets) by the total amount of the cash decrease. Metro received two assets and gave up

one asset of equal value. Total assets are still USD 36,000. The accounting equation now is:

Assets = Liabilities + Stockholders' Equity

Cash Accounts Receivable Trucks Office

Equipment Accounts Payable

Notes Payable

Capital + Stock

$ 36,000 $ -0- $ -0- $ -0- = $ -0- $ 6,000 + $ 30,000

(21,500) 20,000 1,500

$ 14,500 $ 20,000 $ 1,500 = $ 6,000 + $ 30,000

Decreased by

$21,500

Increased by

$20,000

Increased by $1,500

2.8.4 4a. Purchased office equipment on account (for credit)

Metro purchased an additional USD 1,000 of office equipment on account, agreeing to pay within

10 days after receiving the bill. (To purchase an item on account means to buy it on credit.) This

transaction increased assets (office equipment) and liabilities (accounts payable) by USD 1,000. As

stated earlier, accounts payable are amounts owed to suppliers for items purchased on credit. Now you

can see the USD 1,000 increase in the assets and liabilities as follows:

Accounts Cash Receivable $ 14,500

$ 14,500

Assets

Trucks

$ 20,000

$ 20,000

= Liabilities

Office Equipment Accounts Payable

$ 1,500 =

1,000 1,000

$ 2,500 = $ 1,000 Increased by Increased by

$1,000 $1,000

+ Notes

Payable + $ 6,000

$ 6,000 +

Stockholders' Equity Capital Stock

$ 30,000

$ 30,000

2.8.5 5a. Paid an account payable

Eight days after receiving the bill, Metro paid USD 1,000 for the office equipment purchased on

account (transaction 4a). This transaction reduced cash by USD 1,000 and reduced accounts payable

by USD 1,000. Thus, the assets and liabilities both are reduced by USD 1,000, and the equation again

balances as follows:

p. 43 of 433

Trans- Explanatio action n

Balances before transaction Paid an

5a account payable Balance after transaction

Cash

$ 14,500

(1,000)

$ 13,500

Decreased by

$1,000

Assets Accounts

Receivable

$ -0-

$ -0-

Trucks

$ 20,000

$ 20,000

Office Equipment

$ 2,500 =

$ 2,500

= Liabilities + Accounts Payable

$ 1,000

(1,000)

$ -0-

Decreased by

$1,000

Notes Payable

$ 6,000

$ 6,000

Stockholders equity

+ Capital Stock

+ $30,000

+$30,000

A. Summary of Transactions

Transaction Explanation

Beginning balances 1a Stockholders invested cash

2a Borrowed money

3a Purchased trucks and office equipment for cash

4a Purchased office equipment on account

5a Paid an account payable End-of-month balances

B. Balance Sheet METRO COURIER, INC.

Balance Sheet 2010 June 30

METRO COURIER, INC. Summary of Transactions

Month of June 2010

Cash

$ -0 30,000

$ 30,000 6,000

$ 36,000 (21,500)

$ 14,500

$ 14,500

(1,000) $ 13,500(A)

Assets

Accounts Trucks Receivable $ -0- $ -0-

20,000 $20,000

$20,000

$ -0- $20,000(B)

Office Equipment $ -0-

1,500 $ 1,500

1,000

$ 2,500

$ 2,500(C)

Stockholders' =Liabilities + Equity Accounts Notes Capital Payable Payable + Stock

= $ -0- $ -0- $ -0- 30,000

$ 30,000 = 6,000 = $6000 +$30,000

= $ 6,000 + $ 30,000 1,000 $ 6,000 + $ 30,000

= $ 1,000 $ 6,000 + $ 30,000

(1,000) = $ -0- $6,000(D) + $ 30,000(E)

Assets Liabilities and Stockholders' Equity

Cash (A) $ 13,500 Liabilities:

Trucks (B) 20,000 Notes Payable

Office equipment (C)2,500 Total Liabilities Stockholders' equity:

Capital stock Total liabilities

Total assets $ 36,000 and stockholders' equity

Exhibit 3: Balance Sheet

(D) $6,000

$ 6,000

(E) 30,000

$ 36,000

Exhibit 3, Part A, is a summary of transactions prepared in accounting equation form for June. A

summary of transactions is a teaching tool used to show the effects of transactions on the

accounting equation. Note that the stockholders’ equity has remained at USD 30,000. This amount

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changes as the business begins to earn revenues or incur expenses. You can see how the totals at the

bottom of Part A of Exhibit 3 tie into the balance sheet shown in Part B. The date on the balance sheet

is 2010 June 30. These totals become the beginning balances for July 2010.

Thus far, all transactions have consisted of exchanges or acquisitions of assets either by borrowing

or by owner investment. We used this procedure to help you focus on the accounting equation as it

relates to the balance sheet. However, people do not form a business only to hold existing assets. They

form businesses so their assets can generate greater amounts of assets. Thus, a business increases its

assets by providing goods or services to customers. The results of these activities appear in the income

statement. The section that follows shows more of Metro’s transactions as it began earning revenues

and incurring expenses.

2.9 Transactions affecting the income statement and/or balance sheet

To survive, a business must be profitable. This means that the revenues earned by providing goods

and services to customers must exceed the expenses incurred.

In July 2010, Metro Courier, Inc., began selling services and incurring expenses. The explanations

of transactions that follow allow you to participate in this process and learn the necessary accounting

procedures.

2.9.1 1b. Earned service revenue and received cash

As its first transaction in July, Metro performed delivery services for customers and received USD

4,800 cash. This transaction increased an asset (cash) by USD 4,800. Stockholders’ equity (retained

earnings) also increased by USD 4,800, and the accounting equation was in balance.

The USD 4,800 is a revenue earned by the business and, as such, increases stockholders’ equity (in

the form of retained earnings) because stockholders prosper when the business earns profits. Likewise,

if the corporation sustains a loss, the loss would reduce retained earnings.

Revenues increase the amount of retained earnings while expenses and dividends decrease them.

(In this first chapter, we show all of these items as immediately affecting retained earnings. In later

chapters, the revenues, expenses, and dividends are accounted for separately from retained earnings

during the accounting period and are transferred to retained earnings only at the end of the accounting

period as part of the closing process described in Chapter 4.) The effects of this USD 4,800 transaction

on the financial position of Metro are:

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Metro would record the increase in stockholders’ equity brought about by the revenue transaction

as a separate account, retained earnings. This does not increase capital stock because the Capital Stock

account increases only when the company issues shares of stock. The expectation is that revenue

transactions will exceed expenses and yield net income. If net income is not distributed to

stockholders, it is in fact retained. Later chapters show that because of complexities in handling large

numbers of transactions, revenues and expenses affect retained earnings only at the end of an

accounting period. The preceding procedure is a shortcut used to explain why the accounting equation

remains in balance.

Transac Explanation tion Beginning balances (Exhibit 3) Earned service revenue 1b and received cash Balances after transaction

Cash

$ 13,500

4,800

$ 18,300

Increased by $4,800

Assets Accounts Receivable

$ -0-

Trucks

$ 20,000

$ 20,000

Office Equipment

$ 2,500 =

$ 2,500 =

=Liabilities + Stockholders' Equity Accounts Payable

$ -0-

Notes Capital + Retained Payable Stock Earnings

$ 6,000 $ 30,000 $ -0-

4,800

$ 6,000 + $ 30,000 $ 4,800 Increased

by $4,800

2.9.2 2b. Service revenue earned on account (for credit)

Metro performed courier delivery services for a customer who agreed to pay USD 900 at a later

date. The company granted credit rather than requiring the customer to pay cash immediately. This is

called earning revenue on account. The transaction consists of exchanging services for the customer’s

promise to pay later. This transaction is similar to the preceding transaction in that stockholders’

equity (retained earnings) increases because the company has earned revenues. However, the

transaction differs because the company has not received cash. Instead, the company has received

another asset, an account receivable. As noted earlier, an account receivable is the amount due from a

customer for goods or services already provided. The company has a legal right to collect from the

customer in the future. Accounting recognizes such claims as assets. The accounting equation,

including this USD 900 item, is as follows: Assets Liabilities

Transac Accounts Office Accounts Notes Explanation Cash Trucks tion Receivable Equipment Payable Payable

Stockholders' + Equity Capital Retained + Earnings Stock

Balances before transaction Earned service 2b revenue on account

Balances after transaction

$ 18,300

$ 18,300

$900

$900

Increased by $900

$ 20,000 $ 2,500 =

$ 20,000 $ 2,500 =

$ 6,000 $ 30,000 $ 4,800

900

$ 6,000 + $ 30,000 $5,700

Increased by

$900

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2.9.3 3b. Collected cash on accounts receivable

Metro collected USD 200 on account from the customer in transaction 2b. The customer will pay

the remaining USD 700 later. This transaction affects only the balance sheet and consists of giving up a

claim on a customer in exchange for cash. The transaction increases cash by USD 200 and decreases

accounts receivable by USD 200. Note that this transaction consists solely of a change in the

composition of the assets. When the company performed the services, it recorded the revenue.

Therefore, the company does not record the revenue again when collecting the cash.

Transact Explanation Cash ion

Balances before $ 18,300 transaction

3b Collected cash $ 200 on account

Balances after $ 18,500 transaction

Increased by $200

Assets Accounts Cash Receivable

$ 18,500 $ 700 (2,600) $ 15,900 $ 700

Decreased by $2,600

Trucks

$ 20,000

$ 20,000

Assets

Accounts Receivable

$ 900 $

(200)

$700

Decreased by $200

Trucks

20,000

20,000

Office Equip- ment

$ 2,500 =

$ 2,500 =

=Liabilities + Stockholders' +Equity

Accounts Notes Payable + Capital Payable Stock

$ 6,000 $ 30,000

$ 6,000 + $ 30,000

2.9.4 4b. Paid salaries

Metro paid employees USD 2,600 in salaries. This transaction is an exchange of cash for employee

services. Typically, companies pay employees for their services after they perform their work. Salaries

(or wages) are costs companies incur to produce revenues, and companies consider them an expense.

Thus, the accountant treats the transaction as a decrease in an asset (cash) and a decrease in

stockholders’ equity (retained earnings) because the company has incurred an expense. Expense

transactions reduce net income. Since net income becomes a part of the retained earnings balance,

expense transactions also reduce the retained earnings.

Office Equipment

$ 2,500 =

$ 2,500 =

= Liabilities + Accounts Payable

Notes Payable +

$6,000

$6,000 +

Stockholders' Equity

Capital Stock Retained Earnings

$ 5,700 $ 30,000 (2,600) $ 30,000 $ 3,100

Decreased by $2,600

2.9.5 5b. Paid rent

In July, Metro paid USD 400 cash for office space rental. This transaction causes a decrease in cash

of USD 400 and a decrease in retained earnings of USD 400 because of the incurrence of rent expense.

Transaction 5b has the following effects on the amounts in the accounting equation:

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Assets = Liabilities + Stockholders' Equity

Cash Accounts Receivable

$ 15,900 $ 700 (400) $ 15,500 $ 700

Decreased by $400

Trucks

$ 20,000

$ 20,000

Office Equipment

$ 2,500 =

$ 2,500 =

Accounts Payable

Notes Payable + Capital Stock Retained

Earnings

$ 6,000 $ 30,000 $ 3,100 (400)

$ 6,000 + $ 30,000 $ 2,700 Decreased by

$400

2.9.6 6b. Received bill for gas and oil used

At the end of the month, Metro received a USD 600 bill for gas and oil consumed during the month.

This transaction involves an increase in accounts payable (a liability) because Metro has not yet paid

the bill and a decrease in retained earnings because Metro has incurred an expense. Metro’s accounting

equation now reads: Assets

Cash Accounts Receivable

$ 15,500 $ 700

$ 15,500 $ 700

Trucks

$ 20,000

$ 20,000

=Liabilities + Stockholders' +Equity Office

Equipment Accounts Payable Notes Payable Capital + Stock Retained Earnings

$ 2,500 = $ 6,000 $ 30,000 $ 2,700

600 (600)

$ 2,500 = $ 600 $ 6,000 + $ 30,000 $ 2,100

Increased by Decreased by $600 $600

2.10 Summary of balance sheet and income statement transactions

Part A of Exhibit 4 summarizes the effects of all the preceding transactions on the assets, liabilities,

and stockholders’ equity of Metro Courier, Inc., in July. The beginning balances are the ending

balances in Part A of Exhibit 3. The summary shows subtotals after each transaction; these subtotals

are optional and may be omitted. Note how the accounting equation remains in balance after each

transaction and at the end of the month.

The ending balances in each of the columns in Part A of Exhibit 4 are the dollar amounts in Part B

and those reported earlier in the balance sheet in Part C of Exhibit 2. The itemized data in the Retained

Earnings column are the revenue and expense items in Part C of Exhibit 4 and those reported earlier in

the income statement in Part A of Exhibit 2. The beginning balance in the Retained Earnings column

(USD 0) plus net income for the month (USD 2,100) is equal to the ending balance in retained earnings

(USD 2,100) shown earlier in Part B of Exhibit 2. Remember that the financial statements are not an

end in themselves, but are prepared to assist users of those statements to make informed decisions.

Throughout the text we show how people use accounting information in decision making.

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2.11 Dividends paid to owners (stockholders)

Stockholders’ equity is (1) increased by capital contributed by stockholders and by revenues earned

through operations and (2) decreased by expenses incurred in producing revenues. The payment of

cash or other assets to stockholders in the form of dividends also reduces stockholders’ equity. Thus, if

the owners receive a cash dividend, the effect would be to reduce the retained earnings part of

stockholders’ equity; the amount of dividends is not an expense but a distribution of income.

An ethical perspective: State university

James Stevens was taking an accounting course at State University. Also, he was

helping companies find accounting systems that would fit their information needs. He

advised one of his clients to acquire a software computer package that could record the

business transactions and prepare the financial statements. The licensing agreement

with the software company specified that the basic charge for one site was USD 4,000

and that USD 1,000 must be paid for each additional site where the software was used.

James was pleased that his recommendation to acquire the software was followed.

However, he was upset that management wanted him to install the software at eight

other sites in the company and did not intend to pay the extra USD 8,000 due the

software company. A member of management stated, “The software company will

never know the difference and, besides, everyone else seems to be pirating software. If

they do find out, we will pay the extra fee at that time. Our expenses are high enough

without paying these unnecessary costs.” James believed he might lose this client if he

did not do as management instructed.

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An accounting perspective: Uses of technology Accountants and others can access the home pages of companies to find their annual

reports and other information, home pages of CPA firms to find employment

opportunities and services offered, and home pages of government agencies,

universities, and any other agency that has established a home page. By making on-

screen choices you can discover all kinds of interesting information about almost

anything. You can access libraries, even in foreign countries, newspapers, such as The

Wall Street Journal, and find addresses and phone numbers of anyone in the nation.

We have included some Internet Projects at the end of the chapters to give you some

experience at “surfing the net” for accounting applications.

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A. Summary of Transactions

Trans- Explanation action

Beginning balances (Illustration 1.2) Earned service revenue and 1b received cash

2b Earned service revenue on account

3b Collected cash on account

4b Paid salaries

5b Paid rent

6b Received bill for gas and oil used

End-of-month balances

B. Balance Sheet

Assets

Cash

$ 13,500

4,800

$ 18,300

$ 18,300

200 $

18,500 (2,600)

$ 15,900

(400) $

15,500

$15,500( F)

METRO COURIER, INC. Summary of Transactions

Accounts Receiv- able

$ -0-

900

$ 900

(200)

$ 700

$ 700

$ 700

$ 700(G)

Month of July 2010

Office Trucks Equipment

$ 20,000 $ 2,500 =

$ 20,000 $ 2,500 =

$ 20,000 $ 2,500 =

$ 20,000 $ 2,500 =

$ 20,000 $ 2,500 =

$ 20,000 $ 2,500 =

$ 2,500 $ 20,000(H) =(I)

$38,700

-Liabilities + Stockholders' Equity

Accounts Payable

$ -0-

600

$ 600(J)

Notes Payable Capital Retained + Stock Earnings

$ 6,000 + $ 30,000 $ -0-

4,800(A)

$ 6,000 + $ 30,000 $ 4,800

900(B)

$ 6,000 + $ 30,000 $ 5,700

$ 6,000 + $ 30,000 $ 5,700

(2,600)(C)

$ 6,000 + $ 30,000 $ 3,100

(400)(D)

$ 6,000 + $ 30,000 $ 2,700

(600)(E)

$ 6,000 + $ 30,000(L) $ 2,100(M)

(K)

$6,600 $32,100

METRO COURIER, INC. Balance Sheet 2010 July 31

Assets Liabilities and Stockholders'

Cash (F)$15,500 Liabilities:

Accounts receivable (G)700 Accounts payable (J)$600

Trucks (H)20,000 Notes payable (K)6,000

Office equipment (I)2,500 Total liabilities Stockholders' equity $6,600

Capital stock (L)$30,000

Retained earnings (M)2,100 Total stockholders' $32,100 equity Total liabilities and Total assets $38,700 $38,700 stockholders' equity

C. Income Statement METRO COURIER, INC.

Income Statement For the Month Ended 2010 July 31

Revenues:

Service revenue (A+B)$ 5,700

Expenses:

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Salaries expense (C)$ 2,600

Rent expense (D)400

Gas & oil expense (F)600

Total expenses 3,600

Net income $ 2,100

Exhibit 4:

2.12 Analyzing and using the financial results—the equity ratio

The two basic sources of equity in a company are stockholders and creditors; their combined

interests are called total equities. To find the equity ratio, divide stockholders’ equity by total equities

or total assets, since total equities equals total assets. In formula format: Stockholders 'equity Equity ratio=

Totalequities

The higher the proportion of equities (or assets) supplied by the owners, the more solvent the

company. However, a high portion of debt may indicate higher profitability because quite often the

interest rate on debt is lower than the rate of earnings realized from using the proceeds of the debt.

An example illustrates this concept: Suppose that a company with USD 100,000 in assets could

have raised the funds to acquire those assets in these two ways: Case 1 Assets................$100,000 Liabilities.........................$20,000

Stockholders' equity............$80,000

Case 2 Assets................$100,000 Liabilities.........................$80,000

Stockholders' equity............$20,000

When a company suffers operating losses, its assets decrease. In Case 1, the assets would have to

shrink by 80 per cent before the liabilities would equal the assets. In Case 2, the assets would have to

shrink only 20 per cent before the liabilities would equal the assets. When the liabilities exceed the

assets, the company is said to be insolvent. Therefore, creditors are safer in Case 1 and will more

readily lend money to the company.

However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2

is preferable in terms of profitability. Therefore, owners are better off in Case 2 if the borrowed funds

can earn more than they cost.

Next, we examine the recent equity ratios of some actual companies: Stockholders' Name of Company Equity ($ millions)

Johnson & Johnson $ 23,734 3M Corporation 6,166 General Electric Company 53,597

Total Equities ($ millions) Equity Ratio

$ 37,053 64.1% 15,205 40.6 460,097 11.6

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As you can see from the preceding data, the equity ratios of actual companies vary widely.

Companies such as Johnson & Johnson and 3M Corporation employ a higher proportion of

stockholders’ equity (a lower proportion of debt) than GE in an effort to have stronger balance sheets

(more solvency). GE employs a greater proportion of debt, possibly in an attempt to increase

profitability. Every company must strike a balance between solvency and profitability to ensure long-

run survival. The correct balance between proportions of stockholder and creditor equities depends on

the industry, general business conditions, and management philosophy.

Chapter 1 has introduced two important components of the accounting process—the accounting

equation and the business transaction. In Chapter 2, you learn about debits and credits and how

accountants use them in recording transactions. Understanding how data are accumulated, classified,

and reported in financial statements helps you understand how to use financial statement data in

making decisions.

An accounting perspective: Uses of technology

When you apply for your first job after graduation, prospective employers will expect

you to know how to use a PC to perform many tasks. Therefore, before you graduate

you should be able to use word processing, spreadsheet, and database software. You

should be able to use the Internet to find useful information. In many universities, you

can learn these skills in courses taken for credit. If your school does not offer credit

courses, take noncredit courses or attend a training center.

2.13 Understanding the learning objectives

• A single proprietorship is an unincorporated business owned by an individual and often

managed by that individual.

• A partnership is an unincorporated business owned by two or more persons associated as

partners and is often managed by them.

• A corporation is a business incorporated under the laws of a state and owned by a few

stockholders or by thousands of stockholders.

• Service companies perform services for a fee.

• Merchandising companies purchase goods that are ready for sale and then sell them to

customers.

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• Manufacturing companies buy materials, convert them into products, and then sell the

products to other companies or to final customers.

• The income statement reports the revenues and expenses of a company and shows the

profitability of that business organization for a stated period of time.

• The statement of retained earnings shows the change in retained earnings between the

beginning of the period (e.g. a month) and its end.

• The balance sheet lists the assets, liabilities, and stockholders’ equity (including dollar

amounts) of a business organization at a specific moment in time.

• The statement of cash flows shows the cash inflows and cash outflows for a company for a

stated period of time.

• The accounting equation is Assets = Liabilities + Stockholders’ equity.

• The left side of the equation represents the left side of the balance sheet and shows things of

value owned by the business.

• The right side of the equation represents the right side of the balance sheet and shows who

provided the funds to acquire the things of value (assets).

• Some transactions affect only balance sheet items: assets (such as cash, accounts

receivable, and equipment), liabilities (such as accounts payable and notes payable), and

stockholders’ equity (capital stock). Other transactions affect both balance sheet items and

income statement items (revenues, expenses, and eventually retained earnings).

• Exhibit 3 (Part A) and Exhibit 4 (Part A) show the effects of business transactions on the

accounting equation.

• The income statement appears in Exhibit 2 (Part A) and Exhibit 4 (Part C).

• The statement of retained earnings appears in Exhibit 2 (Part B).

• The balance sheet appears in Exhibit 2 (Part C) and Exhibit 4 (Part B).

• The equity ratio is the stockholders’ equity divided by total equities (or total assets).

• The equity ratio shows the percentage that assets would have to shrink before a company would

become insolvent (liabilities exceed assets).

2.14 Appendix: A comparison of corporate accounting with accounting for a sole proprietorship and a partnership

Some textbook authors use a sole proprietorship and a partnership form of business ownership to

illustrate accounting concepts and practices. In a survey of users and nonusers of our text, we learned

that the majority preferred the corporate approach because most students will probably work for or

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invest in corporations. Also, many small businesses operate as corporations because of the investors’

desire for limited liability.

This appendix briefly describes the differences in accounting for these three forms of business

ownership. The major difference is in the stockholders’ equity or owner’s equity section of the balance

sheet.

As you learned in this chapter, the stockholders’ equity section of the balance sheet for a

corporation consists of capital stock and retained earnings. The owner’s equity section of the balance

sheet for a sole proprietorship consists only of the owner’s capital account. The owner’s equity section

of a partnership is similar to that of a single proprietorship except that it shows a capital account and

its balance for each partner. Corporation Sole Proprietorship Partnership Stockholders' Owner's equity: Partners' capital: equity: John Smith, John Smith, Capital stock...$100,000 Capital....$150,000 Capital............ $75,000 Retained Sam Jones,

earnings..... 50,000 Capital............ 75,000 Total..................$150,000 $150,000 $150,000

The stockholders’ equity section of a corporate balance sheet can become more complex as you will

see later in the text. However, the items in the owner’s equity section of the balance sheets of a sole

proprietorship and a partnership always remain as just shown. In a sole proprietorship, the owner’s

capital balance consists of the owner’s investments in the business, plus cumulative net income since

the beginning of the business, less any amounts withdrawn by the owner. Thus, all of the amounts in

the various stockholders’ equity accounts for a corporation are in the owner’s capital account in a single

proprietorship. In a partnership, each partner’s capital account balance consists of that partner’s

investments in the business, plus that partner’s cumulative share of net income since that partner

became a partner, less any amounts withdrawn by that partner.

The Dividends account in a corporation is similar to an owner’s drawing account in a single

proprietorship. These accounts both show amounts taken out of the business by the owners. In a

partnership, each partner has a drawing account. Accountants treat asset, liability, revenue, and

expense accounts similarly in all three forms of organization.

2.15 Demonstration problem

On 2010 June 1, Green Hills Riding Stable, Incorporated, was organized. The following transactions

occurred during June:

June 1 Shares of capital stock were issued for USD 10,000 cash.

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4 A horse stable and riding equipment were rented (and paid for) for the month at a cost of USD

1,200.

8 Horse feed for the month was purchased on credit, USD 800.

15 Boarding fees of USD 3,000 for June were charged to those owning horses boarded at the stable.

(Fee is due on July 10.)

20 Miscellaneous expenses of USD 600 were paid.

29 Land was purchased from a savings and loan association by borrowing USD 40,000 on a note

from that association. The loan is due to be repaid in five years. Interest payments are due at the end of

each month beginning July 31.

30 Salaries of USD 700 for the month were paid.

30 Riding and lesson fees were billed to customers in the amount of USD 2,800. (Fees are due on

July 10.)

Prepare a summary of the preceding transactions. Use columns headed Cash, Accounts Receivable,

Land, Accounts Payable, Notes Payable, Capital Stock, and Retained Earnings. Determine balances

after each transaction to show that the basic accounting equation is in balance.

Prepare an income statement for June 2010.

Prepare a statement of retained earnings for June 2010.

Prepare a balance sheet as of 2010 June 30.

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2.16 Solution to demonstration problem

a.

Date Explanation

June Capital stock issued 1 4 Rent expense

8 Feed expense

15 Boarding fees

Miscellaneous 20 expenses

Purchased land by 29 borrowing

30 Salaries paid

Riding and lesson 30 fees billed

b)

c)

Assets

Cash

$ 10,000

(1,200)

$ 8,800

$ 8,800

$ 8,800

(600)

$ 8,200

$ 8,200

(700)

$ 7,500

$ 7,500

GREEN HILLS RIDING STABLE, INCORPORATED Summary of Transactions

Month of June 2010

Accounts Receivable

$ 3,000

$ 3,000

$ 3,000

$ 3,000

$ 3,000

2,800

$ 5,800

=

Land

=

=

=

=

=

$ 40,000

$ 40,000 =

$ 40,000 =

$ 40,000

Liabilities + Accounts Payable

$ 800

$ 800

$ 800

800

$ 800

$ 800

$ 800

GREEN HILLS RIDING STABLE, INCORPORATE Income Statement For the Month Ended 2010 June 30 Revenues:

Horse boarding fees revenue

Riding and lesson fee revenue

Total revenues

Expenses:

Rent expense

Feed expense

Salaries expense

Miscellaneous expense

Total expenses

Net income

$ 3,000

2,800

$ 1,200

800

700

600

$ 5,800

3,300

$ 2,500

GREEN HILLS RIDING STABLE, INCORPORATED Statement of Retained Earnings

For the Month Ended 2010 June 30 Retained earnings, June 1 $ -0-

Add: Net income for June 2,500 Total $ 2,500

Less: Dividends -0- Retained earnings, June 30 $ 2,500

Stockholders Equity Notes Capital + Retained Payable Stock Earnings

$ 10,000

$ (1,200)

+ $ 10,000 $ (1,200)

(800)

+ $ 10,000 $ (2,000)

3,000

+ $ 10,000 $ 1,000

(600)

+ $ 10,000 $ 400

$ 40,000

$ 40,000 + $ 10,000 $ 400

(700)

$ 40,000 + $ 10,000 $ (300)

2,800

$ 40,000 + $ 10,000 $ 2,500

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d)

GREEN HILLS RIDING STABLE, INCORPORATE Balance Sheet 2010 June 30

Assets Cash

Accounts receivable

Land

Total assets Liabilities and Stockholders' Equity

Liabilities:

Accounts payable

Noted payable

Total liabilities

Stockholders' equity:

Capital stock

Retained earnings

Total stockholders' equity

Total liabilities and stockholders' equity

2.17 Key terms

$ 10,000

2,500

$ 7,500

5,800

40,000

$ 53,300

$ 800

40,000

$ 40,800

$ 12,500

$53,300.00

Accounting equation Assets = Equities; or Assets = Liabilities + Stockholders’ equity. Accounts payable Amounts owed to suppliers for goods or services purchased on credit. Accounts receivable Amounts due from customers for services already provided. Assets Things of value owned by the business. Examples include cash, machines, and buildings. To their owners, assets possess service potential or utility that can be measured and expressed in money terms. Balance sheet Financial statement that lists a company’s assets, liabilities, and stockholders’ equity (including dollar amounts) as of a specific moment in time. Also called a statement of financial position. Business entity concept (or accounting entity concept) The separate existence of the business organization. Capital stock The title given to an equity account showing the investment in a business corporation by its stockholders. Continuity See going-concern concept. Corporation Business incorporated under the laws of one of the states and owned by a few stockholders or by thousands of stockholders. Cost Sacrifice made or the resources given up, measured in money terms, to acquire some desired thing, such as a new truck (asset). Dividend Payment (usually of cash) to the owners of a corporation; it is a distribution of income to owners rather than an expense of doing business. Entity A business unit that is deemed to have an existence separate and apart from its owners, creditors, employees, customers, other interested parties, and other businesses, and for which accounting records are maintained.

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Equities Broadly speaking, all claims to, or interests in, assets; includes liabilities and stockholders’ equity. Equity ratio A ratio found by dividing stockholders’ equity by total equities (or total assets). Exchange-price (or cost) concept (principle) The objective money prices determined in the exchange process are used to record most assets. Expenses Costs incurred to produce revenues, measured by the assets surrendered or consumed in serving customers. Going-concern (continuity) concept The assumption by the accountant that unless strong evidence exists to the contrary, a business entity will continue operations into the indefinite future. Income statement Financial statement that shows the revenues and expenses and reports the profitability of a business organization for a stated period of time. Sometimes called an earnings statement. Liabilities Debts owed by a business—or creditors’ equity. Examples: notes payable, accounts payable. Manufacturing companies Companies that buy materials, convert them into products, and then sell the products to other companies or to final customers. Merchandising companies Companies that purchase goods ready for sale and sell them to customers. Money measurement concept Recording and reporting economic activity in a common monetary unit of measure such as the dollar. Net income Amount by which the revenues of a period exceed the expenses of the same period. Net loss Amount by which the expenses of a period exceed the revenues of the same period. Notes payable Amounts owed to parties who loan the company money after the owner signs a written agreement (a note) for the company to repay each loan. Partnership An unincorporated business owned by two or more persons associated as partners. Periodicity (time periods) concept An assumption that an entity’s life can be meaningfully subdivided into time periods (such as months or years) for purposes of reporting its economic activities. Profitability Ability to generate income. The income statement reflects a company’s profitability. Retained earnings Accumulated net income less dividend distributions to stockholders. Revenues Inflows of assets (such as cash) resulting from the sale of products or the rendering of services to customers. Service companies Companies (such as accounting firms, law firms, or dry cleaning establishments) that perform services for a fee. Single proprietorship An unincorporated business owned by an individual and often managed by that individual. Solvency Ability to pay debts as they become due. The balance sheet reflects a company’s solvency. Source document Any written or printed evidence of a business transaction that describes the essential facts of that transaction, such as receipts for cash paid or received.

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Statement of cash flows Financial statement showing cash inflows and outflows for a company over a period of time. Statement of retained earnings Financial statement used to explain the changes in retained earnings that occurred between two balance sheet dates. Stockholders’ equity The owners’ interest in a corporation. Stockholders or shareholders Owners of a corporation; they buy shares of stock, which are units of ownership, in the corporation. Summary of transactions Teaching tool used in Chapter 1 to show the effects of transactions on the accounting equation. Transaction A business activity or event that causes a measurable change in the items in the accounting equation, Assets = Liabilities + Stockholders’ equity.

2.18 Self-test

2.18.1 True-False

Indicate whether each of the following statements is true or false.

The three forms of business organizations are single proprietorship, partnership, and trust.

The three types of business activity are service, merchandising, and manufacturing.

The income statement shows the profitability of the company and is dated as of a particular date,

such as 2010 December 31.

The statement of retained earnings shows both the net income for the period and the beginning and

ending balances of retained earnings.

The balance sheet contains the same major headings as appear in the accounting equation.

2.18.2 Multiple-choice

Select the best answer for each of the following questions.

The ending balance in retained earnings is shown in the:

a. Income statement.

b. Statement of retained earnings.

c. Balance sheet.

d. Both (b) and (c).

Which of the following is not a correct form of the accounting equation?

a. Assets = Equities.

b. Assets = Liabilities + Stockholders’ equity.

c. Assets – Liabilities = Stockholders’ equity.

d. Assets + Stockholders’ equity = Liabilities.

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Which of the following is not one of the five underlying assumptions or concepts mentioned in the

chapter?

a. Exchange-price concept.

b. Inflation accounting concept.

c. Business entity concept.

d. Going-concern concept.

When the stockholders invest cash in the business, what is the effect?

a. Liabilities increase and stockholders’ equity increases.

b. Both assets and liabilities increase.

c. Both assets and stockholders’ equity increase.

d. None of the above.

When services are performed on account, what is the effect?

a. Both cash and retained earnings decrease.

b. Both cash and retained earnings increase.

c. Both accounts receivable and retained earnings increase.

d. Accounts payable increases and retained earnings decreases.

Now turn to “Answers to self-test” at the end of your chapter to check your answers.

2.18.3 Questions

• Accounting has often been called the language of business. In what respects would you

agree with this description? How might you argue that this description is deficient?

• Define asset, liability, and stockholders’ equity.

• How do liabilities and stockholders’ equity differ? How are they similar?

• How do accounts payable and notes payable differ? How are they similar?

• Define revenues. How are revenues measured?

• Define expenses. How are expenses measured?

• What is a balance sheet? On what aspect of a business does the balance sheet provide

information?

• What is an income statement? On what aspect of a business does this statement provide

information?

• What information does the statement of retained earnings provide?

• Identify the three types of activities shown in a statement of cash flows.

• What is a transaction? What use does the accountant make of transactions? Why?

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• What is the accounting equation? Why must it always balance?

• Give an example from your personal life that illustrates your use of accounting

information in reaching a decision.

• You have been elected to the governing board of your church. At the first meeting you

attend, mention is made of building a new church. What accounting information would

the board need in deciding whether or not to go ahead?

• A company purchased equipment for USD 2,000 cash. The vendor stated that the

equipment was worth USD 2,400. At what amount should the equipment be recorded?

• What is meant by money measurement?

• Of what significance is the exchange-price (or cost) concept? How is the cost to acquire

an asset determined?

• What effect does the going-concern (continuity) concept have on the amounts at which

long-term assets are carried on the balance sheet?

• Of what importance is the periodicity (time periods) concept to the preparation of

financial statements?

• Describe a transaction that would:

• Increase both an asset and capital stock.

• Increase both an asset and a liability.

• Increase one asset and decrease another asset.

• Decrease both a liability and an asset.

• Increase both an asset and retained earnings.

• Decrease both an asset and retained earnings.

• Increase a liability and decrease retained earnings.

• Decrease both an asset and retained earnings.

• Identify the causes of increases and decreases in stockholders’ equity

• Real world question: Refer to the 2000 financial statements of The Limited in the

Annual Report Appendix at the back of the text. What were the net income or loss

amounts in the latest three years? Discuss the meaning of the changes after reading

management’s discussion and analysis of financial condition and results of operations.

• Real world question: Refer to the financial statements of The Limited in the Annual

Report Appendix. Has the solvency of the company improved from one year to the next?

Discuss.

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2.18.4 Exercises

Exercise A Match the descriptions in Column B with the appropriate terms in Column A.

Column A 1. Corporation. 2. Merchandising company. 3. Partnership. 4. Manufacturing company. 5. Service company. 6. Single proprietorship.

a. b. c. d.

e. f.

Column B An unincorporated business owned by an individual. The form of organization used by most large businesses. Buys raw materials and converts them into finished products. Buys goods in their finished form and sells them to customers in that same form. An unincorporated business with more than one owner. Performs services for a fee.

Exercise B Assume that retained earnings increased by USD 3,600 from 2010 June 30, to 2011

June 30. A cash dividend of USD 300 was declared and paid during the year.

a. Compute the net income for the year.

b. Assume expenses for the year were USD 9,000. Compute the revenue for the year.

Exercise C On 2010 December 31, Perez Company had assets of USD 150,000, liabilities of USD

97,500, and capital stock of USD 30,000. During 2011, Perez earned revenues of USD 45,000 and

incurred expenses of USD 33,750. Dividends declared and paid amounted to USD 3,000.

a. Compute the company’s retained earnings on 2010 December 31.

b. Compute the company’s retained earnings on 2011 December 31.

Exercise D At the start of the year, a company had liabilities of USD 50,000 and capital stock of

USD 150,000. At the end of the year, retained earnings amounted to USD 135,000. Net income for the

year was USD 45,000, and USD 15,000 of dividends were declared and paid. Compute retained

earnings and total assets at the beginning of the year.

Exercise E For each of the following events, determine if it has an effect on the specific items (such

as cash) in the accounting equation. For the events that do have an effect, present an analysis of the

transaction showing its two sides or dual nature.

a. Purchased equipment for cash, USD 12,000.

b. Purchased a truck for USD 40,000, signed a note (with no interest) promising payment in 10

days.

c. Paid USD 1,600 for the current month’s utilities.

d. Paid for the truck purchased in (b).

e. Employed Mary Childers as a salesperson at USD 1,200 per month. She is to start work next

week.

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f. Signed an agreement with a bank in which the bank agreed to lend the company up to USD

200,000 any time within the next two years.

Exercise F Bradley Company, engaged in a courier service business, completed the following

selected transactions during July 2010:

a. Purchased office equipment on account.

b. Paid an account payable.

c. Earned service revenue on account.

d. Borrowed money by signing a note at the bank.

e. Paid salaries for month to employees.

f. Received cash on account from a charge customer.

g. Received gas and oil bill for month.

h. Purchased delivery truck for cash.

i. Declared and paid a cash dividend.

Using a tabular form similar to Exhibit 4 (Part A), indicate the effect of each transaction on the

accounting equation using (+) for increase and (–) for decrease. No dollar amounts are needed, and

you need not fill in the Explanation column.

Exercise G Indicate the amount of change (if any) in the stockholders’ equity balance based on

each of the following transactions:

a. The stockholders invested USD 100,000 cash in the business by purchasing capital stock.

b. Land costing USD 40,000 was purchased by paying cash.

c. The company performed services for a customer who agreed to pay USD 18,000 in one month.

d. Paid salaries for the month, USD 12,000.

e. Paid USD 14,000 on an account payable.

Exercise H Give examples of transactions that would have the following effects on the items in a

firm’s financial statements:

a. Increase cash; decrease some other asset.

b. Decrease cash; increase some other asset.

c. Increase an asset; increase a liability.

d. Decrease retained earnings; decrease an asset.

e. Increase an asset other than cash; increase retained earnings.

f. Decrease an asset; decrease a liability.

Exercise I Which of the following transactions results in a decrease in retained earnings? Why?

a. Employees were paid USD 20,000 for services received during the month.

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b. USD 175,000 was paid to acquire land.

c. Paid an USD 18,000 note payable. No interest was involved.

d. Paid a USD 200 account payable.

Exercise J Assume that the following items were included in the Retained Earnings column in the

summary of transactions for Cinck Company for July 2010: Salaries expense $120,000 Service revenue 300,000 Gas and oil expense 27,000 Rent expense 48,000 Dividends paid 40,000

Prepare an income statement for July 2010.

Exercise K Given the following facts, prepare a statement of retained earnings for Brindle

Company, a tanning salon, for August 2010:

Balance in retained earnings at end of July, USD 188,000.

Dividends paid in August, USD 63,600.

Net income for August, USD 72,000.

The column totals of a summary of transactions for Speedy Printer Repair, Inc., as of 2010

December 31, were as follows: Accounts payable $60,000 Accounts receivable 90,000 Capital stock 100,000 Cash 40,000 Land 80,000 Building 50,000 Equipment 30,000 Notes payable 20,000 Retained earnings ?

Prepare a balance sheet. We have purposely listed the accounts out of order.

Exercise M Merck & Co., Inc. is a world leader in the discovery, development, manufacture and

marketing of a broad range of human and animal health products. The company, which has 70,000

employees, spends over USD 2 billion every year on the research and development of new drugs. As of

the end of 2, its 2.2 billion shares are valued in the stock market for a total of USD 132 billion. Given

the following data for Merck, calculate the equity ratios for 2003 and 2002. Then comment on the

results. 2003 2002

Stockholders' equity USD 14,832,400,000 USD 13,241,600,000

Total equities USD 39,910,400,000 USD 35,634,900,000

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2.18.5 Problems

Problem A Lakewood Personal Finance Company, which provides financial advisory services,

engaged in the following transactions during May 2010:

May 1Received USD 300,000 cash for shares of capital stock issued when company was organized.

2 The company borrowed USD 40,000 from the bank on a note.

7 The company bought USD 182,400 of computer equipment for cash.

11 Cash received for services performed to date was USD 15,200.

14 Services performed for a customer who agreed to pay within a month were USD 10,000.

15 Employee wages were paid, USD 13,200.

19 The company paid USD 14,000 on the note to the bank.

31 Interest paid to the bank for May was USD 140. (Interest is an expense, which reduces retained

earnings.)

31 The customer of May 14 paid USD 3,200 of the amount owed to the company.

31 An order was received from a customer for services to be rendered next week, which will be

billed at USD 12,000.

Prepare a summary of transactions (see Part A of Exhibit 4). Use money columns headed Cash,

Accounts Receivable, Equipment, Notes Payable, Capital Stock, and Retained Earnings. Determine

balances after each transaction to show that the accounting equation balances.

Problem B Reliable Lawn Care Service, Inc., a company that takes care of lawns and shrubbery of

personal residences, engaged in the following transactions in April 2010:

Apr.1 The company was organized and received USD 400,000 cash from the owners in exchange for

capital stock issued.

4 The company bought equipment for cash, USD 101,760.

9 The company bought additional mowing equipment that cost USD 9,120 and agreed to pay for it

in 30 days.

15 Cash received for services performed to date was USD 3,840.

16 Amount due from a customer for services performed totaled USD 5,280.

30 Of the receivable (see April 16), USD 3,072 was collected in cash.

30 Miscellaneous operating expenses of USD 6,240 were paid during the month.

30 An order was placed for miscellaneous equipment costing USD 28,800.

a. Prepare a summary of transactions (see Part A of Exhibit 4). Use money columns headed Cash,

Accounts Receivable, Equipment, Accounts Payable, Capital Stock, and Retained Earnings. Determine

balances after each transaction to show that the basic accounting equation balances.

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b. Prepare a balance sheet as of April 30.

Problem C Analysis of the transactions of the Moonlight Drive-In Theater for June 2010 disclosed

the following:

Ticket revenue USD 180000

Equipment rent expense 50000

Film rent expense 53400

Concession revenue 29600

Advertising expense 18600

Salaries expense 60000

Utilities expense 14100

Cash dividends declared and paid 12000

Balance sheet amounts at June 30 include the following:

Cash USD 140,000

Land 148000

Accounts payable 87600

Capital stock 114000

Retained earnings as of 2010 June 1 84900

a. Prepare an income statement for June 2010.

b. Prepare a statement of retained earnings for June 2010.

c. Prepare a balance sheet as of 2010 June 30.

d. How solvent does this company appear to be?

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Problem D Little Folks Baseball, Inc., was formed by a group of parents to meet a need for a place

for kids to play baseball. At the beginning of its second year of operations, its balance sheet appeared as

follows: LITTLE FOLKS BASEBALL

Balance Sheet 2010 April 30 Assets

Cash $ 56,000

Accounts Receivable 80,000

Land 600,000

Total assets $ 736,000

Liabilities and Stockholders' Equity

Liabilities:

Accounts payable $ 64,000

Stockholders' Equity:

Capital stock $ 400,000 Retained earnings 272,000 672,000 Total liabilities and stockholders' equity $ 736,000

The summarized transactions for May 2010 are as follows:

a. Issued additional capital stock for cash, USD 200,000.

b. Collected USD 80,000 on accounts receivable.

c. Paid USD 64,000 on accounts payable.

d. Received membership fees from parents (nonrefundable): in cash, USD 260,000; and on

account, USD 120,000.

e. Incurred operating expenses: for cash, USD 60,000; and on account, USD 160,000.

f. Paid dividends of USD 16,000.

g. Purchased more land for cash, USD 96,000.

h. Placed an order for new equipment expected to cost USD 120,000.

a. Prepare a summary of transactions (see Part A of Exhibit 4) using column headings as given in

the balance sheet. Determine balances after each transaction.

b. Prepare an income statement for May 2010.

c. Prepare a statement of retained earnings for May 2010.

d. Prepare a balance sheet as of 2010 May 31.

The balance sheets for 2010 May 31, and 2010 April 30, and the income statement for May of the

Target-Line Golf Driving Range follow. (Common practice is to show the most recent period first.)

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TARGET-LINE GOLF DRIVING RANGE Comparative Balance Sheet

Assets Cash Land Total assets Liabilities and Stockholders' Equity Accounts payable Capital stock Retained earnings Total liabilities and stockholders' equity

TARGET-LINE GOLF DRIVING RANGE Income Statement

For the Month Ended 2010 May 31 Revenues:

Service revenue

Expenses:

Salaries expense Equipment rental expense Net income

All revenues earned are on account.

May 31, April 30,

2010 2010

$56,400 $46,800 163,200 144,000

$219,600 $190,800

$18,000 $27,600 144,000 144,000 57,600 19,200

$219,600 $190,800

$64,000

$16,000 9,600 25,600

$38,400

State the probable cause(s) of the change in each of the balance sheet accounts from April 30 to

2010 May 31.

2.18.6 Alternate problems

Alternate problem A Preston Auto Paint Company had the temporary free use of an old building

and completed the following transactions in September 2010:

Sept. 1 The company was organized and received USD 100,000 cash from the issuance of capital

stock.

5 The company bought painting and sanding equipment for cash at a cost of USD 25,000.

7 The company painted the auto fleet of a customer who agreed to pay USD 8,000 in one week.

The customer furnished the special paint.

14 The company received the USD 8,000 from the transaction of September 7.

20 Additional sanding equipment that cost USD 2,800 was acquired today; payment was postponed

until September 28.

28 USD 2,400 was paid on the liability incurred on September 20.

30 Employee salaries for the month, USD 2,200, were paid.

30 Placed an order for additional painting equipment advertised at USD 20,000.

Prepare a summary of transactions (see Part A of Exhibit 4) for the company for these transactions.

Use money columns headed Cash, Accounts Receivable, Equipment, Accounts Payable, Capital Stock,

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and Retained Earnings. Determine balances after each transaction to show that the basic accounting

equation balances.

Alternate problem B Quick-Start Home Repair Company completed the following transactions

in June 2010:

June 1 The company was organized and received USD 200,000 cash from the issuance of capital

stock.

4 The company paid USD 48,000 cash for a truck.

7 The company borrowed USD 10,000 from its bank on a note.

9 Cash received for repair services performed was USD 4,500.

12 Expenses of operating the business so far this month were paid in cash, USD 3,400.

18 Repair services performed for a customer who agreed to pay within a month amounted to USD

5,400.

25 The company paid USD 4,065 on its loan from the bank, including USD 4,050 of principal and

USD 15 of interest. (The principal is the amount of the loan. Interest is an expense, which reduces

retained earnings.)

30 Miscellaneous expenses incurred in operating the business from June 13 to date were USD 3,825

and were paid in cash.

30 An order (contract) was received from a customer for repair services to be performed tomorrow,

which will be billed at USD 3,000.

a. Prepare a summary of transactions (see Part A of Exhibit 4). Include money columns for Cash,

Accounts Receivable, Trucks, Notes Payable, Capital Stock, and Retained Earnings. Determine

balances after each transaction to show that the basic accounting equation balances.

b. Prepare a balance sheet as of 2010 June 30.

Alternate problem C Following are summarized transaction data for Luxury Apartments, Inc.,

for the year ending 2010 June 30. The company owns and operates an apartment building.

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Rent revenue from building owned USD 150,000

Building repairs 2870

Building cleaning, labor cost 3185

Property taxes on the building 4000

Insurance on the building 1225

Commissions paid to rental agent 5000

Legal and accounting fees (for preparation of 1260

tenant leases)

Utilities expense 8225

Cost of new awnings (installed on June 30, will 5000

last 10 years)

Of the USD 150,000 rent revenue, USD 5,000 was not collected in cash until 2010 July 5.

Prepare an income statement for the year ended 2010 June 30.

Alternate problem D The following data are for Central District Parking Corporation: CENTRAL DISTRICT PARKING CORPORATION

Balance Sheet 2010 October 1

Assets

Cash

Accounts Receivable

Total assets

Liabilities and Stockholders' Equity

Accounts payable

Capital stock

Retained earnings

Total liabilities and stockholders' equity

The summarized transactions for October 2010 are as follows:

$ 344,00

0 18,000

$ 362,00

0

$ 94,000 232,00

0 36,000

$ 362,00

0

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1

Oct.1 The accounts payable owed as of September 30 (USD 94,000) were paid.

The company paid rent for the premises for October, USD 19,200.

7 The company received cash of USD 4,200 for parking by daily customers during the week.

10 The company collected USD 14,400 of the accounts receivable in the balance sheet at September

30.

14 Cash receipts for the week from daily customers were USD 6,600.

15 Parking revenue earned but not yet collected from fleet customers was USD 6,000.

16 The company paid salaries of USD 2,400 for the period October 1–15.

19 The company paid advertising expenses of USD 1,200 for October.

21 Cash receipts for the week from daily customers were USD 7,200.

24 The company incurred miscellaneous expenses of USD 840. Payment will be due November 10.

31 Cash receipts for the last 10 days of the month from daily customers were USD 8,400.

31 The company paid salaries of USD 3,000 for the period October 16–31.

31 Billings to monthly customers totaled USD 21,600 for October.

31 Paid cash dividends of USD 24,000.

a. Prepare a summary of transactions (see Part A of Exhibit 4) using column headings as given in

the preceding balance sheet. Determine balances after each transaction.

b. Prepare an income statement for October 2010.

c. Prepare a statement of retained earnings for October 2010.

d. Prepare a balance sheet as of 2010 October 31.

Alternate problem E The following balance sheets for 2010 June 30, and 2010 May 31, and the

income statement for June are for Beach Camping Trailer Storage, Inc. (Common practice is to show

the most recent period first.) BEACH CAMPING TRAILER STOR AGE, INC

Comparative Balance Sheet

Assets Cash Accounts receivable Land Total assets Liabilities and Stockholders' Accounts payable Capital stock Retained earnings Total liabilities and stockholders' equity

June 30, May 31,

2010 2010

$ 52,000 $ 60,000 24,000 -0- 36,000 36,000

$ 112,000 $ 96,000 Equity

$ 18,000 $ 24,000 60,000 60,000 34,000 12,000

$ 112,000 $ 96,000 BEACH CAMPING TRAILER STORAGE, INC. ,

Income Statement For the Month Ended 2010 June 3 Revenues:

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Service revenue

Expenses:

Salaries expense Supplies bought and used Net income

$ 48,000 24,000

$ 100,000

72,000 $ 28,000

A cash dividend of USD 6,000 was declared and paid in June.

State the probable causes of the changes in each of the balance sheet accounts from May 31 to 2010

June 30.

2.18.7 Beyond the numbers—critical thinking

Business decision case A Upon graduation from high school, Jim Crane went to work for a

builder of houses and small apartment buildings. During the next six years, Crane earned a reputation

as an excellent employee—hardworking, dedicated, and dependable—in the light construction industry.

He could handle almost any job requiring carpentry, electrical, or plumbing skills.

Crane then decided to go into business for himself under the name Jim’s Fix-It Shop, Inc. He

invested cash, some power tools, and a used truck in his business. He completed many repair and

remodeling jobs for homeowners and apartment owners. The demand for his services was so large that

he had more work than he could handle. He operated out of his garage, which he had converted into a

shop, adding several new pieces of power woodworking equipment.

Now, two years after going into business for himself, Crane must decide whether to continue in his

own business or to accept a position as construction supervisor for a home builder. He has been offered

an annual salary of USD 50,000 and a package of fringe benefits (medical and hospitalization

insurance, pension contribution, vacation and sick pay, and life insurance) worth approximately USD

8,000 per year. The offer is attractive to Crane. But he dislikes giving up his business since he has

thoroughly enjoyed being his own boss, even though it has led to an average workweek well in excess of

the standard 40 hours

Suppose Crane comes to you for assistance in gathering the information needed to help him make a

decision. He brings along the accounting records that have been maintained for his business by an

experienced accountant. Using logic and your own life experiences, indicate the nature of the

information Jim needs if he is to make an informed decision. Pay particular attention to the

information likely to be found in his business accounting records. Does the accounting information

available enter directly into the decision? Write a memorandum to Jim describing the information he

will need to make an informed decision. The memo’s headings should include Date, To, From, and

Subject. (See the format in Group Project E below.)

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Annual report analysis B Recall that in this chapter we showed that the equity ratio is calculated

by dividing stockholders’ equity by total equities (or total assets). Another format for analyzing

solvency is to divide total debt by total equities. This latter calculation tells the proportion of assets

financed by debt rather than the proportion of assets financed by stockholders’ equity. These two ratios

are complements and must add to 100 per cent. Thus, if 25 per cent of assets were financed by debt, 75

per cent were financed by stockholders’ equity.

Using the following historical data from Gateway, calculate the “total-debt-to total-capital” ratio for

each year.

2003 2002 2001 2000 1999 1998 1997

Total USD USD USD USD USD USD USD

liabilities 1,772,205 1,937,570 1,546,005 1,109,337 857,870 568,492 394,545

(000's)

Total 2380339 2017118 1344375 930044 815541 555519 376035

stockholder

s equity

Study these amounts and comment on the solvency of the company. Is there a trend in the

company’s solvency over time? Gateway has experienced tremendous growth in stockholders’ equity

during the past six years, but has also increased liabilities significantly. Could Gateway have grown this

much without increasing liabilities?

Annual report analysis C Look at The Limited, Inc., annual report in the Annual report

appendix. In that report you will find a letter outlining Management’s responsibilities concerning the

financial statements, as well as the report of the independent auditors.

Write answers to the following questions:

Who is responsible for preparing the financial statements?

Of what importance is the internal audit?

What is the role of the audit committee?

Why are no officers or employees on the audit committee?

What is the responsibility of the external independent auditor?

Does the independent auditor have absolute assurance that the financial statements are free of

material misstatement?

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To what extent does the independent auditor examine evidence?

Ethics case- writing experience D Refer to “An ethical perspective: State university”. Write a

short essay discussing the alternatives James Stevens could pursue and the likely outcomes of those

alternatives. Which of the alternatives you have discussed would you recommend?

Group project E In teams of two or three students, interview a businessperson in your

community. Ask how that person uses accounting information in making business decisions and obtain

specific examples. Each team should write a memorandum to the instructor summarizing the results of

the interview. Information contained in the memo should include:

Date:

To:

From:

Subject:

Content of the memo must include the name and title of the person interviewed, name of the

company, date of the interview, examples of the use of accounting information for decision

making, and any other pertinent information.

Group project F With a team composed of one or two other students, conceive of a business that

you would like to form after graduation. Then describe approximately 15–20 transactions that the

business might undertake in its first month of operations. Prepare a summary of transactions showing

how each transaction affects the accounting equation. Identify each asset, liability, and stockholders’

equity item in your summary of transactions. For instance, instead of grouping all assets in one

number, show cash, accounts receivable, and so on in your accounting equation.

Group project G With a team of one or two other students and using library sources, write a

paper on the American Institute of Certified Public Accountants, their services to members, and their

activities. Be careful to cite sources for your information. Direct quotes should be labeled as such and

should be single-spaced and indented if relatively long or in quote marks and not indented if relatively

short. To quote without giving the source is plagiarism and should be avoided at all costs.

2.18.8 Using the Internet—A view of the real world

Visit the following website for Nokia:

http://www.nokia.com

Write a short paper describing company information, products and services, and support available

for their products.

Visit the following website for Ford Motor Company:

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http://www.ford.com

When the web page appears, search for Investor Information and then locate the Ford Motor

Company Annual Report. Based on your investigation, write a short paper describing the general

content of the annual report.

2.18.9 Answers to self-test

2.18.9.1 True-False

False. Corporation, not trust, is the third form.

True. The accounting for all three of these is covered in this text.

False. The income statement is dated using a period of time, such as “For the Year Ended

2010 December 31”.

True. In addition, the statement of retained earnings shows dividends declared.

True. Both show assets, liabilities, and stockholders’ equity.

2.18.9.2 Multiple-choice

d. The ending balance in retained earnings is shown in both the statement of retained earnings

and in the balance sheet.

d. This form of the equation would not balance.

b. The inflation accounting concept was not one of the ones discussed. The other two were the

money measurement concept and the periodicity concept.

c. When the stockholders invest cash, assets and stockholders’ equity increase.

c. The performance of services on account increases both accounts receivable and retained

earnings.

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3 Recording business transactions

3.1 Learning objectives

After studying this chapter, you should be able to:

• Use the account as the basic classifying and storage unit for accounting information.

• Express the effects of business transactions in terms of debits and credits to different types of

accounts.

• List the steps in the accounting cycle.

• Record the effects of business transactions in a journal.

• Post journal entries to the accounts in the ledger.

• Prepare a trial balance to test the equality of debits and credits in the journalizing and

posting process.

• Analyze and use the financial results—horizontal and vertical analyses.

3.2 Salary potential of accountants

Selecting a major represents much more than the choice of courses a student takes in college. To a

significant degree, the student's major, along with academic performance, will determine the career

paths available upon graduation. Few professionals would recommend a specific career choice based

solely on salaries. However, as students select their major and map out their career path, it is

important that they make informed decisions with respect to the potential financial rewards of the

various options. Outlined below is information on selected salaries for many accounting-related

careers. These salaries, current as of 2009, should be viewed only as guidelines. Salaries at all levels

can vary significantly between locations. Also, one should add 10 to 15 per cent to the listed salary for

professional certifications (such as the CPA) or for a graduate degree (Masters of Accounting or MBA).

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Salaries for Public Accounting, Non-Partners Position

Large CPA Firms: Salary Range Starting Salaries $35,750 - $42,500 Salary between 1-3 years $41,000 - $51,250 Manager/Director $77,750 - $119,000 Small CPA Firms:

Starting Salaries $29,500 - $36,250 Salary between 1-3 years $33,750 - $42,500 Manager/Director $62,750 - $84,500

Salaries for Corporate Accounting - Large Corporations Position Salary Range Chief Financial Officer/Treasurer $244,500 - $347,000 Vice President, Finance $189,000 - $293,500 Director of Finance $121,500 - $178,250 Director of Accounting $115,250 - $157,500 Controller $105,750 - $147,250 Assistant Controller $89,750 - $114,750 Tax Director $117,000 - $209,750 Tax Manager $78,000 - $113,750 Audit Director $127,750 - $200,750 General Accounting - Manager $61,250 - $83,250 General Accounting - 1-3 years experience $37,500 - $48,750 General Accounting - starting salary $31,750 - $39,750

Students interested in a career in accounting and finance can find detailed information for these

and many other accounting related careers at Robert Half (www.roberthalf.com). Also, accounting

professors are generally familiar with starting salaries and job opportunities for accounting graduates,

so you may want to address more specific questions about potential careers and salaries with them.

In Chapter 1, we illustrated the income statement, statement of retained earnings, balance sheet,

and statement of cash flows. These statements are the end products of the financial accounting process,

which is based on the accounting equation. The financial accounting process quantifies past

management decisions. The results of these decisions are communicated to users—management,

creditors, and investors—and serve as a basis for making future decisions.

The raw data of accounting are the business transactions. We recorded the transactions in Chapter 1

as increases or decreases in the assets, liabilities, and stockholders' equity items of the accounting

equation. This procedure showed you how various transactions affected the accounting equation.

When working through these sample transactions, you probably suspected that listing all transactions

as increases or decreases in the transactions summary columns would be too cumbersome in practice.

Most businesses, even small ones, enter into many transactions every day. Chapter 2 teaches you how

to actually record business transactions in the accounting process.

To explain the dual procedure of recording business transactions with debits and credits, we

introduce you to some new tools: the T-account, the journal, and the ledger. Using these tools, you can

follow a company through its various business transactions. Like accountants, you can use a trial

balance to check the equality of your recorded debits and credits. This is the double-entry accounting

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system that the Franciscan monk, Luca Pacioli, described centuries ago. Understanding this system

enables you to better understand the content of financial statements so you can use the information

provided to make informed business decisions.

3.3 The account and rules of debit and credit

A business may engage in thousands of transactions during a year. An accountant classifies and

summarizes the data in these transactions to create useful information.

Steps in recording business transactions

Look at Exhibit 5 to see the steps in recording and posting the effects of a business transaction. Note

that source documents provide the evidence that a business transaction occurred. These source

documents include such items as bills received from suppliers for goods or services received, bills sent

to customers for goods sold or services performed, and cash register tapes. The information in the

source document serves as the basis for preparing a journal entry. Then a firm posts (transfers) that

information to accounts in the ledger.

You can see from Exhibit 5 that after you prepare the journal entry, you post it to the accounts in

the ledger. However, before you can record the journal entry, you must understand the rules of debit

and credit. To teach you these rules, we begin by studying the nature of an account.

Fortunately, most business transactions are repetitive. This makes the task of accountants

somewhat easier because they can classify the transactions into groups having common characteristics.

For example, a company may have thousands of receipts or payments of cash during a year. As a result,

a part of every cash transaction can be recorded and summarized in a single place called an account.

An account is a part of the accounting system used to classify and summarize the increases,

decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and

expense. Firms set up accounts for each different business element, such as cash, accounts receivable,

and accounts payable. Every business has a Cash account in its accounting system because knowledge

of the amount of cash on hand is useful information.

Accountants may differ on the account title (or name) they give the same item. For example, one

accountant might name an account Notes Payable and another might call it Loans Payable. Both

account titles refer to the amounts borrowed by the company. The account title should be logical to

help the accountant group similar transactions into the same account. Once you give an account a title,

you must use that same title throughout the accounting records.

The number of accounts in a company's accounting system depends on the information needs of

those interested in the business. The main requirement is that each account provides information

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useful in making decisions. Thus, one account may be set up for all cash rather than having a separate

account for each form of cash (coins on hand, currency on hand, and deposits in banks). The amount of

cash is useful information; the form of cash often is not.

To illustrate recording the increases and decreases in an account, texts use the T-account, which

looks like a capital letter T. The name of the account, such as Cash, appears across the top of the T. We

record increases on one side of the vertical line of the T and decreases on the other side. A T-account

appears as follows:

An accounting perspective: Business insight

Have you ever considered starting your own business? If so, you will need to

understand accounting to successfully run your business. To know how well your

business is doing, you must understand and analyze financial statements. Accounting

information also tells you why you are performing as reported. If you are in business

to sell or develop a certain product or perform a specific service, you cannot operate

profitably or consider expanding unless you base your business decisions on

accounting information.

Exhibit 5: The steps in recording and posting the effects of a business transaction

In Chapter 1, you saw that each business transaction affects at least two items. For example, if you—

an owner—invest cash in your business, the company's assets increase and its stockholders' equity

increases. This result was illustrated in the summary of transactions in Exhibit 1.3. In the following

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sections, we use debits and credits and the double-entry procedure to record the increases and

decreases caused by business transactions.

Accountants use the term debit instead of saying, "Place an entry on the left side of the T-account".

They use the term credit for "Place an entry on the right side of the T-account". Debit (abbreviated

Dr.) simply means left side; credit (abbreviated Cr.) means right side.1 Thus, for all accounts a debit

entry is an entry on the left side, while a credit entry is an entry on the right side. Any Account Left, or Right, or debit, side credit, side

After recognizing a business event as a business transaction, we analyze it to determine its increase

or decrease effects on the assets, liabilities, stockholders' equity items, dividends, revenues, or

expenses of the business. Then we translate these increase or decrease effects into debits and credits.

In each business transaction we record, the total dollar amount of debits must equal the total dollar

amount of credits. When we debit one account (or accounts) for USD 100, we must credit another

account (or accounts) for a total of USD 100. The accounting requirement that each transaction be

recorded by an entry that has equal debits and credits is called double-entry procedure, or duality.

This double-entry procedure keeps the accounting equation in balance.

The dual recording process produces two sets of accounts—those with debit balances and those with

credit balances. The totals of these two groups of accounts must be equal. Then, some assurance exists

that the arithmetic part of the transaction recording process has been properly carried out. Now, let us

actually record business transactions in T-accounts using debits and credits.

3.4 Recording changes in assets, liabilities, and stockholders' equity

While recording business transactions, remember that the foundation of the accounting process is

the following basic accounting equation: Assets=Liabilities+Stockholders 'Equity

Recording transactions into the T-accounts is easier when you focus on the equal sign in the

accounting equation. Assets, which are on the left of the equal sign, increase on the left side of the T-

accounts. Liabilities and stockholders' equity, to the right of the equal sign, increase on the right side of

the T-accounts. You already know that the left side of the T-account is the debit side and the right side

1The abbreviations “Dr.” and “Cr.” are based on the Latin words “debere” and “credere”. A synonym

for debit an account is charge an account.

p. 81 of 433

is the credit side. So you should be able to fill in the rest of the rules of increases and decreases by

deduction, such as: Assets = Liabilities + Stockholders' Equity Debit for Credit for Debit for Credit for Debit for Credit for increases decreases decreases increases decreases increases

To summarize:

• Assets increase by debits (left side) to the T-account and decrease by credits (right side) to the T-

account.

• Liabilities and stockholders' equity decrease by debits (left side) to the T-account and increase

by credits (right side) to the T-account.

Applying these two rules keeps the accounting equation in balance. Now we apply the debit and

credit rules for assets, liabilities, and stockholders' equity to business transactions.

Assume a corporation issues shares of its capital stock for USD 10,000 in transaction 1. (Note the

figure in parentheses is the number of the transaction and ties the two sides of the transaction

together.) The company records the receipt of USD 10,000 as follows: (Dr.) Cash (Cr) (Dr.) Capital Stock (Cr (1) 10,000 (1) 10,000

This transaction increases the asset, cash, which is recorded on the left side of the Cash account.

Then, the transaction increases stockholders' equity, which is recorded on the right side of the Capital

Stock account.

Assume the company borrowed USD 5,000 from a bank on a note (transaction 2). A note is an

unconditional written promise to pay to another party (the bank) the amount owed either when

demanded or at a specified date, usually with interest at a specified rate. The firm records this

transaction as follows: (Dr.) Cash (Cr) (Dr.) Notes Payable (Cr) (1) (2)

5,000 (2)

10,000 5,000

Observe that liabilities, Notes Payable, increase with an entry on the right (credit) side of the

account.

Recording changes in revenues and expenses In Chapter 1, we recorded the revenues and

expenses directly in the Retained Earnings account. However, this is not done in practice because of

the volume of revenue and expense transactions. Instead, businesses treat the expense accounts as if

they were subclassifications of the debit side of the Retained Earnings account, and the revenue

accounts as if they were subclassifications of the credit side. Since firms need the amounts of revenues

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and expenses to prepare the income statement, they keep a separate account for each type of revenue

and expense. The recording rules for revenues and expenses are:

• Record increases in revenues on the right (credit) side of the T-account and decreases on the

left (debit) side. The reasoning behind this rule is that revenues increase retained earnings, and

increases in retained earnings are recorded on the right side.

• Record increases in expenses on the left (debit) side of the T-account and decreases on the

right (credit) side. The reasoning behind this rule is that expenses decrease retained earnings,

and decreases in retained earnings are recorded on the left side.

To illustrate these rules, assume the same company received USD 1,000 cash from a customer for

services rendered (transaction 3). The Cash account, an asset, increases on the left (debit) side of the T-

account; and the Service Revenue account, an increase in retained earnings, increases on the right

(credit) side. (Dr.) Cash (Cr) (Dr.) Service Revenue (Cr) (1) 10,000 (3) 1,000

(2) 5,000

(3) 1,000

Now assume this company paid USD 600 in salaries to employees (transaction 4). The Cash

account, an asset, decreases on the right (credit) side of the T-account; and the Salaries Expense

account, a decrease in retained earnings, increases on the left (debit) side.2

(Dr) Cash (Cr) (Dr.) Salaries Expense (Cr) (1) 10,000 (4) 600 (4) 600

(2) 5,000 (3) 1,000

Recording changes in dividends Since dividends decrease retained earnings, increases appear on the left side of the

Dividends account and decreases on the right side. Thus, the firm records payment of a USD 2,000 cash dividend (transaction

5) as follows: (Dr) Cash (Cr) (Dr.) (Cr) Dividends3

(1) 10,000 (4) 600 (5) 2,000

(2) 5,000 (5) 2,000

(3) 1,000

2Certain deductions are normally taken out of employees' pay for social security taxes, federal and

state withholding, and so on. Those deductions are ignored here.

p. 83 of 433

3

At the end of the accounting period, the accountant transfers any balances in the expense, revenue,

and Dividends accounts to the Retained Earnings account. This transfer occurs only after the

information in the expense and revenue accounts has been used to prepare the income statement. We

discuss and illustrate this step in Chapter 4.

To determine the balance of any T-account, total the debits to the account, total the credits to the

account, and subtract the smaller sum from the larger. If the sum of the debits exceeds the sum of the

credits, the account has a debit balance. For example, the following Cash account uses information

from the preceding transactions. The account has a debit balance of USD 13,400, computed as total

debits of USD 16,000 less total credits of USD 2,600. (Dr.) (1) (2) (3)

Cash 10,000 5,000 1,000

16,000

Dr. bal 13,400

(Cr) (4) 600 (5) 2,000

2,600

If, on the other hand, the sum of the credits exceeds the sum of the debits, the account has a credit

balance. For instance, assume that a company has an Accounts Payable account with a total of USD

10,000 in debits and USD 13,000 in credits. The account has a credit balance of USD 3,000, as shown

in the following T-account: (Dr.) Accounts Payable (Cr) 10,000 7,000

6,000

10,000 13,000

Cr. bal 3,000

Normal balances Since debits increase asset, expense, and dividend accounts, they normally have

debit (or left-side) balances. Conversely, because credits increase liability, capital stock, retained

earnings, and revenue accounts, they normally have credit (or right-side) balances.

The following chart shows the normal balances of the seven accounts we have used: Normal Balances

Types of Accounts Debit Credit Assets X

Liabilities X

3As we illustrate later in the text, some companies debt dividends directly to the Retained Earnings

account rather than to a Dividends account.

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Stockholders' Equity

Capital Stock X

Retained earnings X

Dividends X

Expenses X

Revenues X

At this point, you should memorize the six rules of debit and credit. Later, as you proceed in your

study of accounting, the rules will become automatic. Then, you will no longer ask yourself, "Is this

increase a debit or credit?"

Asset accounts increase on the debit side, while liability and stockholders' equity accounts increase

on the credit side. When the account balances are totaled, they conform to the following independent

equations:

Assets = Liabilities + Stockholders' Equity

Debits = Credits

The arrangement of these two formulas gives the first three rules of debit and credit:

• Increases in asset accounts are debits; decreases are credits.

• Decreases in liability accounts are debits; increases are credits.

• Decreases in stockholders' equity accounts are debits; increases are credits. Assets Liabilities + Stockholder's Equity

Stockholders' Equity Account(s)

Asset Accounts = Liability Accounts + (Capital Stock and Retained Earnings) Debit* Credit

+ -

Debit Credit

for for

increase decrease

Debits

1. Increase assets.

2. Decrease liabilities.

3. Decrease

stockholders' equity.

4. Decrease revenues.

5. Increase expenses.

6. Increase dividends.

Debit

-

Debit

for

decrease

Credits

Credit*

+

Credit

for

increase

1. Decreases assets.

2 Increase liabilities.

3. Increase

stockholders' equity.

4. Increase revenues.

5. Decrease expenses.

6. Decrease dividends.

Debit

Debit

for

decrease

Expense Accounts

and Dividends Account

Debit*

+

Debit

for

increase

Credit

-

Credit

for

decrease

Credit*

+

Credit

for

increase

Revenue Accounts

Debit Credit*

- +

Debit Credit

for for

decrease increase

Exhibit 6: Rules of debit and credit

The debit and credit rules for expense and Dividends accounts and for revenue accounts follow

logically if you remember that expenses and dividends are decreases in stockholders' equity and

revenues are increases in stockholders' equity. Since stockholders' equity accounts decrease on the

p. 85 of 433

debit side, expense and Dividend accounts increase on the debit side. Since stockholders' equity

accounts increase on the credit side, revenue accounts increase on the credit side. The last three debit

and credit rules are:

• Decreases in revenue accounts are debits; increases are credits.

• Increases in expense accounts are debits; decreases are credits.

• Increases in Dividends accounts are debits; decreases are credits.

In Exhibit 6, we depict these six rules of debit and credit. Note first the treatment of expense and

Dividends accounts as if they were subclassifications of the debit side of the Retained Earnings

account. Second, note the treatment of the revenue accounts as if they were subclassifications of the

credit side of the Retained Earnings account. Next, we discuss the accounting cycle and indicate where

steps in the accounting cycle are discussed in Chapters 2 through 4.

3.5 The accounting cycle

The accounting cycle is a series of steps performed during the accounting period (some

throughout the period and some at the end) to analyze, record, classify, summarize, and report useful

financial information for the purpose of preparing financial statements. Before you can visualize the

eight steps in the accounting cycle, you must be able to recognize a business transaction. Business

transactions are measurable events that affect the financial condition of a business. For example,

assume that the owner of a business spilled a pot of coffee in her office or broke her leg while skiing.

These two events may briefly interrupt the operation of the business. However, they are not

measurable in terms that affect the solvency and profitability of the business.

Business transactions can be the exchange of goods for cash between the business and an external

party, such as the sale of a book, or they can involve paying salaries to employees. These events have

one fundamental criterion: They must have caused a measurable change in the amounts in the

accounting equation, Assets = Liabilities + Stockholders' Equity. The evidence that a business event

has occurred is a source document such as a sales ticket, check, and so on. Source documents are

important because they are the ultimate proof of business transactions.4

After you have determined that an event is a measurable business transaction and have adequate

proof of this transaction, mentally analyze the transaction's effects on the accounting equation. You

4Many companies send and receive source documents electronically, rather than on paper. In such

an electronic computer environment, source documents might exist only in the computer databases

of the two parties involved in the transaction.

p. 86 of 433

learned how to do this in Chapter 1. This chapter and Chapters 3 and 4 describe the other steps in the

accounting cycle. The eight steps in the accounting cycle and the chapters that discuss them are:

• Analyze transactions by examining source documents (Chapters 1 and 2).

• Journalize transactions in the journal (Chapter 2).

• Post journal entries to the accounts in the ledger (Chapter 2).

• Prepare a trial balance of the accounts (Chapter 2) and complete the work sheet (Chapter 4).

(This step includes adjusting entries from Chapter 3.)

• Prepare financial statements (Chapter 4).

• Journalize and post adjusting entries (Chapters 3 and 4).

• Journalize and post closing entries (Chapter 4).

• Prepare a post-closing trial balance (Chapter 4).

This listing serves as a preview of what you will study in Chapters 2-4. Notice that firms perform the

last five steps at the end of the accounting period. Step 5 precedes steps 6 and 7 because management

needs the financial statements at the earliest possible date. After the statements have been delivered to

management, the adjusting and closing entries can be journalized and posted. In Exhibit 7, we diagram

the eight steps in the accounting cycle.

You can perform many of these steps on a computer with an accounting software package. However,

you must understand a manual accounting system and all of the steps in the accounting cycle to

understand what the computer is doing. This understanding removes the mystery of what the

computer is doing when it takes in raw data and produces financial statements.

3.6 The journal

In explaining the rules of debit and credit, we recorded transactions directly in the accounts. Each

ledger (general ledger) account shows only the increases and decreases in that account. Thus, all the

effects of a single business transaction would not appear in any one account. For example, the Cash

account contains only data on changes in cash and does not show how the cash was generated or how it

was spent. To have a permanent record of an entire transaction, the accountant uses a book or record

known as a journal.

A journal is a chronological (arranged in order of time) record of business transactions. A journal

entry is the recording of a business transaction in the journal. A journal entry shows all the effects of a

business transaction as expressed in debit(s) and credit(s) and may include an explanation of the

transaction. A transaction is entered in a journal before it is entered in ledger accounts. Because each

p. 87 of 433

transaction is initially recorded in a journal rather than directly in the ledger, a journal is called a book

of original entry.

A business usually has more than one journal. Chapter 4 briefly describes several special journals.

In this chapter, we use the basic form of journal, the general journal. As shown in Exhibit 8, a general

journal contains the following columns:

Exhibit 7: Steps in the accounting cycle

p. 88 of 433

MICROTRAIN COMPANY General Journal

Date Account Titles and Explanation Post. Ref.

Debit Credit

2010 Nov. 28 Cash (+A) 100 5 0 0 0 0

Capital Stock (+SE) 300 5 0 0 0 0

Stockholders invested $50,000 cash in business.

Exhibit 8: Journal entry

• Date column. The first column on each journal page is for the date. For the first journal

entry on a page, this column contains the year, month, and day (number). For all other journal

entries on a page, this column contains only the day of the month, until the month changes.

• Account titles and explanation column. The first line of an entry shows the account

debited. The second line shows the account credited. Notice that we indent the credit account

title to the right. For instance, in Exhibit 8 we show the debit to the Cash account and then the

credit to the Capital Stock account. Any necessary explanation of a transaction appears on the

line(s) below the credit entry and is indented halfway between the accounts debited and

credited. A journal entry explanation should be concise and yet complete enough to describe

fully the transaction and prove the entry's accuracy. When a journal entry is self-explanatory,

we omit the explanation.

• Posting reference column. This column shows the account number of the debited or

credited account. For instance, in Exhibit 8, the number 100 in the first entry means that the

Cash account number is 100. No number appears in this column until the information has

been posted to the appropriate ledger account. We discuss posting later in the chapter.

• Debit column. In the debit column, the amount of the debit is on the same line as the title

of the account debited.

• Credit column. In the credit column, the amount of the credit is on the same line as the

title of the account credited.

An account perspective: Uses of technology

Preparing journal entries in a computerized system is different than in a manual

system. The computer normally asks for the number of the account to be debited. After

you type the account number, the computer shows the account title in its proper

position. The cursor then moves to the debit column and waits for you to enter the

p. 89 of 433

amount of the debit. Then it asks if there are more debits. If not, the computer

prompts you for the account number of the credit. After you type the account number,

the computer supplies the account name of the credit and enters the same amount

debited as the credit. When there is more than one credit, you can override the

amount and enter the correct amount. Then you would enter the other credit in the

same way. If your debits and credits are not equal, the computer warns you and makes

you correct the error. You can supply an explanation for the entry from a standard list

or type it in. As you enter the journal entries, the computer automatically posts them

to the ledger accounts. At any time, you can have the computer print a trial balance.

A summary of the functions and advantages of using a journal follows:

The journal—

• Records transactions in chronological order.

• Shows the analysis of each transaction in debits and credits.

• Supplies an explanation of each transaction when necessary.

• Serves as a source for future reference to accounting transactions.

• Eliminates the need for lengthy explanations from the accounts.

• Makes possible posting to the ledger at convenient times.

• Assists in maintaining the ledger in balance because the debit(s) must always equal the credit(s)

in each journal entry.

• Aids in tracing errors when the ledger is not in balance.

3.7 The ledger

A ledger (general ledger) is the complete collection of all the accounts of a company. The ledger

may be in loose-leaf form, in a bound volume, or in computer memory.

Accounts fall into two general groups: (1) balance sheet accounts (assets, liabilities, and

stockholders' equity) and (2) income statement accounts (revenues and expenses). The terms real

accounts and permanent accounts also refer to balance sheet accounts. Balance sheet accounts are real

accounts because they are not subclassifications or subdivisions of any other account. They are

permanent accounts because their balances are not transferred (or closed) to any other account at

the end of the accounting period. Income statement accounts and the Dividends account are nominal

accounts because they are merely subclassifications of the stockholders' equity accounts. Nominal

literally means "in name only". Nominal accounts are also called temporary accounts because they

p. 90 of 433

temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the

Retained Earnings account at the end of the accounting period.

The chart of accounts is a complete listing of the titles and numbers of all the accounts in the

ledger. The chart of accounts can be compared to a table of contents. The groups of accounts usually

appear in this order: assets, liabilities, stockholders' equity, dividends, revenues, and expenses.

Individual accounts are in sequence in the ledger. Each account typically has an identification

number and a title to help locate accounts when recording data. For example, a company might

number asset accounts, 100-199; liability accounts, 200-299; stockholders' equity accounts and

Dividends account, 300-399; revenue accounts, 400-499; and expense accounts, 500-599. We use this

numbering system in this text. The uniform chart of accounts used in the first 11 chapters appears in a

separate file at the end of the text. You should print that file and keep it handy for working certain

problems and exercises. Companies may use other numbering systems. For instance, sometimes a

company numbers its accounts in sequence starting with 1, 2, and so on. The important idea is that

companies use some numbering system.

Now that you understand how to record debits and credits in an account and how all accounts

together form a ledger, you are ready to study the accounting process in operation.

3.8 The accounting process in operation

MicroTrain Company is a small corporation that provides on-site personal computer software

training using the clients' equipment. The company offers beginning through advanced training with

convenient scheduling. A small fleet of trucks transports personnel and teaching supplies to the clients'

sites. The company rents a building and is responsible for paying the utilities.

We illustrate the capital stock transaction that occurred to form the company (in November) and

the first month of operations (December). The accounting process used by this company is similar to

that of any small company. The ledger accounts used by MicroTrain Company are:

p. 91 of 433

Acct. Account Title No. Description

100 Cash Bank deposits and cash on hand.

103 Accounts Receivable Amounts owed to the company by customers.

107 Supplies on Hand Items such as paper, envelopes, writing materials, and other materials used in performing training services for customers or in doing administrative

Assets and clerical office work.

108 Prepaid Insurance Insurance policy premiums paid in advance of the periods for which the insurance coverage applies.

112 Prepaid Rent Rent paid in advance of the periods for which the rent payment applies.

150 Trucks Trucks used to transport personnel and training supplies to clients' locations.

200 Accounts Payable Amounts owed to creditors for items purchased

Liabilities 216 Unearned Service Fees from them. Amounts received from customers before the training services have been performed for them.

Stockholders' 300 Capital Stock Retained The stockholders' investment in the business. The earnings equity 310 Earnings retained in the business. Dividends 320 Dividends The amount of dividends declared to stockholders. Revenues 400 Service Revenue Amounts earned by performing training services for customers.

505 Advertising Expense The cost of advertising incurred in the current period.

506 Gas and Oil Expense The cost of gas and oil used in trucks in the

Expenses current period.

] 507 Salaries Expense The amount of salaries incurred in the current period.

511 Utilities Expense The cost of utilities incurred in the current period.

Notice the gaps left between account numbers (100, 103, 107, etc.). These gaps allow the firm to

later add new accounts between the existing accounts.

To begin, a transaction must be journalized. Journalizing is the process of entering the effects of a

transaction in a journal. Then, the information is transferred, or posted, to the proper accounts in the

ledger. Posting is the process of recording in the ledger accounts the information contained in the

journal. We explain posting in more detail later in the chapter.

In the following example, notice that each business transaction affects two or more accounts in the

ledger. Also note that the transaction date in both the general journal and the general ledger accounts

is the same. In the ledger accounts, the date used is the date that the transaction was recorded in the

general journal, even if the entry is not posted until several days later. Our example shows the journal

entries posted to T-accounts. In practice, firms post journal entries to ledger accounts, as we show later

in the chapter.

Accountants use the accrual basis of accounting. Under the accrual basis of accounting, they

recognize revenues when the company makes a sale or performs a service, regardless of when the

company receives the cash. They recognize expenses as incurred, whether or not the company has paid

out cash. Chapter 3 discusses the accrual basis of accounting in more detail.

p. 92 of 433

In the following MicroTrain Company example, transaction 1 increases (debits) Cash and increases

(credits) Capital Stock by USD 50,000. First, MicroTrain records the transaction in the general

journal; second, it posts the entry to the accounts in the general ledger. Transaction 1:2010 Nov. 28 Stockholders invested $50,000 and formed MicroTrain Company. General Journal Date Account Titles and Explanation Post.

Ref. Debit Credit

2010 Nov. 28 Cash (+A) 100 5 0 0 0 0

Capital Stock (+SE) 300 5 0 0 0 0

Stockholders invested $50,000 cash in business.

General Ledger

Cash Capital Stock

(Dr.) Acct. No. 100 (Cr.) (Dr.) Acct. No. 300 (Cr.)

2010 2010

Nov. 28 50,000 Nov. 28 50,000

No other transactions occurred in November. The company prepares financial statements at the

end of each month. Exhibit 9 shows the company's balance sheet at 2010 November 30.

The balance sheet reflects ledger account balances as of the close of business on 2010 November 30.

These closing balances are the beginning balances on 2010 December 1. The ledger accounts show

these closing balances as beginning balances (Beg. bal.).

Now assume that in December 2010, MicroTrain Company engaged in the following transactions.

We show the proper recording of each transaction in the journal and then in the ledger accounts (in T-

account form), and describe the effects of each transaction. MICROTRAIN COMPANY Balance Sheet 2010 November 30

Assets Liabilities and Stockholders' Equity

Cash $50,000 Stockholders' equity:

Capital stock $50,000

Total Assets $50,000 Total liabilities and stockholders' equity $50,000

Exhibit 9: Balance sheet

p. 93 of 433

Transaction 2: Dec. 1 Paid cash for four small trucks, $40,000. General Journal

Date Account Titles and Explanation

1 Trucks (+A)

Cash (-A)

To record the purchase of four trucks.

2010 Dec.

General Ledger

Trucks

(Dr.) Acct. No. 150 (Cr.)

2010 Dec. 1 (A)40,000

Cash

(Dr.) Acct. No. 100 (Cr.)

2010 50,000 2010 Dec. Dec. 1 Beg. bal. 1 (B)40,0

00

Post. Debit Credit Ref. 150 4 0 0 0 0 (A)

100 4 0 0 0 0 (B)

Transaction 3: Dec. 1 Paid cash for insurance on the trucks to cover a one-year period from this date.

General Journal

Date

2010 Dec. 1

Account Titles and Explanation

Prepaid Insurance (+A)

Cash (-A)

Purchased truck insurance to cover a one-year period.

General Ledger

Prepaid Insurance

(Dr) Acct. No. 108 (Cr)

2010 2,400 Dec. 1

Cash

(Dr) Acct. No. 100 (Cr.)

2010 50,000 2010 40,000 Dec. 1 Beg. Bal Dec. 1 Dec. 1 2,40

Post. Debit Credit Ref. 108 2 4 0 0

100 2 4 0 0

Effects of transaction

An asset, prepaid insurance, increases (debited); and an asset, cash, decreases (credited) by USD

2,400. The debit is to Prepaid Insurance rather than Insurance Expense because the policy covers

more than the current accounting period of December (insurance policies are usually paid one year in

advance). As you will see in Chapter 3, prepaid items are expensed as they are used. If this insurance

p. 94 of 433

policy was only written for December, the entire USD 2,400 debit would have been to Insurance

Expense. Transaction 4: Dec. 1 Rented a building and paid $1,200 to cover a three-month period from this date. General Journal

Date

2010 Dec. 1

Account Titles and Explanation

Prepaid Rent (+A)

Cash (-A)

Paid three months' rent on a building.

General Ledger

Prepaid Rent

Post. Debit Credit Ref. 112 1 2 0 0

100 1 2 0 0

(Dr.) Acct. No. 112 (Cr) 2010

Dec. 1 1,200

Cash

(Dr.) Acct. No. 100 (Cr.) 2010 2010

Dec. 1 Beg. Bal. 50,000 Dec. 1 40,000 Dec. 1 2,400

Dec. 1 1,200

Effects of transaction

An asset, prepaid rent, increases (debited); and another asset, cash, decreases (credited) by USD

1,200. The debit is to Prepaid Rent rather than Rent Expense because the payment covers more than

the current month. If the payment had just been for December, the debit would have been to Rent

Expense.

p. 95 of 433

Transaction 5: Dec. 4 Purchased $1,400 of training supplies on account to be used over the next several months. General Journal Date

2010 Dec.

Account Titles and Explanation Post. Ref.

Debit Credit

4 Supplies on Hand (+A) 107 1 4 0 0

Accounts Payable (+L) 200 1 4 0 0

To record the purchases of training supplies for future use.

General Ledger

Supplies on Hand

(Dr.) Acct. No. 107 (Cr)

2010

Dec. 4 1,400

Accounts Payable

(Dr.) Acct. No. 200 (Cr.)

2010

Dec. 4 1,400

Effects of transaction

An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases

(credited) by USD 1,400. The debit is to Supplies on Hand rather than Supplies Expense because the

supplies are to be used over several accounting periods.

In each of the three preceding entries, we debited an asset rather than an expense. The reason is

that the expenditure applies to (or benefits) more than just the current accounting period. Whenever a

company will not fully use up an item such as insurance, rent, or supplies in the period when

purchased, it usually debits an asset. In practice, however, sometimes the expense is initially debited in

these situations.

Companies sometimes buy items that they fully use up within the current accounting period. For

example, during the first part of the month a company may buy supplies that it intends to consume

fully during that month. If the company fully consumes the supplies during the period of purchase, the

best practice is to debit Supplies Expense at the time of purchase rather than Supplies on Hand. This

same advice applies to insurance and rent. If a company purchases insurance that it fully consumes

during the current period, the company should debit Insurance Expense at the time of purchase rather

than Prepaid Insurance. Also, if a company pays rent that applies only to the current period, Rent

Expense should be debited at the time of purchase rather than Prepaid Rent. As illustrated in Chapter

3, following this advice simplifies the procedures at the end of the accounting period.

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Transaction 6: Dec. 7 Received $4,500 from a customer in payment for future training services. General Journal Date Account Titles and Explanation

2010 Dec. 7 Cash (+A)

Unearned Service Fees (+L)

To record the receipt of cash from a customer in payment

for future training services.

General Ledger Cash

(Dr.) Acct. No. 100 (Cr)

2010 2010

Dec. 1 Beg Bal 50,000 Dec. 1 40,000

Dec. 7 4,500 Dec. 1 2,400

Dec. 1 1,200

Unearned Service Fees

(Dr.) Acct. No. 216 (Cr.)

2010

Dec. 7 4,500

Effects of transaction

Post. Debit Credit Ref. 100 4 5 0 0

216 4 5 0 0

An asset, cash, increases (debited); and a liability, unearned service revenue, increases (credited) by

USD 4,500. The credit is to Unearned Service Fees rather than Service Revenue because the USD

4,500 applies to more than just the current accounting period. Unearned Service Fees is a liability

because, if the services are never performed, the USD 4,500 will have to be refunded. If the payment

had been for services to be provided in December, the credit would have been to Service Revenue.

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Transaction 7: Dec. 15 Performed training services for a customer for cash, $5,000. General Journal

Date

2010 Dec.

Account Titles and Explanation

15 Cash (+A)

Service Revenue (+SE)

To record the receipt of cash for performing training

services for a customer.

Post. Debit Credit Ref. 100 5 0 0 0

400 5 0 0 0

General Ledger

Cash

(Dr.) Acct. No. 100

2010

Dec. 1 Beg Bal. 50,000

Dec. 7 4,500

Dec. 15 5,000

Service Revenue

(Dr.) Acct. No. 400

(Cr)

2010

Dec. 1 40,000

Dec. 1 2,400

Dec. 1 1,200

(Cr.)

2010

Dec. 15 5,000

Effects of transaction

An asset, cash, increases (debited); and a revenue, service revenue, increases (credited) by USD

5,000.

Transaction 8: Dec. 17 Paid the $1,400 account payable resulting from the transaction of December 4. General Journal Date Account Titles and Explanation

2010 Dec. 17 Accounts Payable (-L)

Cash (-A)

Paid the account payable arising from the purchase of

Supplies on December 4.

General Ledger

Accounts Payable

(Dr.) Acct. No. 200 (Cr)

Post. Debit Credit Ref. 200 1 4 0 0

100 1 4 0 0

p. 98 of 433

2010

Dec. 17 1,400

Cash

(Dr.) Acct. No. 100

2010

Dec. 1 Beg Bal. 50,000

Dec. 7 4,500

Dec. 15 5,000

2010

Dec. 4 1,400

2010

Dec. 1

Dec. 1

Dec. 1

Dec 17

(Cr.)

40,000

2,400

1,200

1,400

Effects of transaction

A liability, accounts payable, decreases (debited); and an asset, cash, decreases (credited) by USD

1,400. Transaction 9: Dec. 20 Billed a customer for training services performed, $5,700. General Journal

Date Account Titles and Explanation

2010 Dec. 20 Accounts Receivable (+A)

Service Revenue (+SE)

To record the performance of training services on account

for which a customer was billed.

General Ledger

Accounts Receivable

(Dr.) Acct. No. 103 (Cr)

2010

Dec. 20 5,700

Service Revenue

(Dr.) Acct. No. 400 (Cr.)

2010

Dec. 15 5,000

Dec. 20 5,700

Effects of transaction

Post. Debit Credit Ref. 103 5 7 0 0

400 5 7 0 0

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An asset, accounts receivable, increases (debited); and a revenue, service revenue, increases

(credited) by USD 5,700.

Transaction 10: Dec. 24 Received a bill for advertising in a local newspaper in December, $50.

General Journal

Date Account Titles and Explanation

2010 Dec. 24 Advertising Expense (-SE)

Accounts Payable (+L)

Received a bill for advertising for the month of December.

General Ledger

Advertising Expense

(Dr.) Acct. No. 505 (Cr)

2010

Dec. 24 50

(Dr.) Accounts Payable (Cr.) Acct. No. 200

2010 2010

Dec. 17 1,400 Dec. 4 1,400

Dec. 24 50

Effects of transaction

Post. Debit Credit Ref. 505 5 0

200 5 0

An expense, advertising expense, increases (debited); and a liability, accounts payable, increases

(credited) by USD 50. The reason for debiting an expense rather than an asset is because all the cost

pertains to the current accounting period, the month of December. Otherwise, Prepaid Advertising (an

asset) would have been debited.

p. 100 of 433

Transaction 11: Dec. 26 Received $500 on accounts receivable from a customer. General Journal

Date Account Titles and Explanation

2010 Dec. 26 Cash (+A)

Accounts Receivable (-A)

Received $500 from a customer on accounts receivable

Post. Debit Credit Ref. 100 5 0 0

103 5 0 0

General Ledger Cash (Dr.) Acct. No. 100

2010

Dec. 1 Beg Bal. 50,000

Dec. 7 4,500

Dec. 15 5,000

Dec. 26 500 Accounts (Dr.) Acct. N

2010

Dec. 20 5,700

(Cr)

2010

Dec. 1 40,000

Dec. 1 2,400

Dec. 1 1,200

Dec. 17 1,400 Receivable o. 103 (Cr.)

2010

Dec. 26 500

Effects of transaction

One asset, cash, increases (debited); and another asset, accounts receivable, decreases (credited) by

USD 500. Transaction 12: Dec. 28 Paid salaries of $3,600 to training personnel for the first four weeks of December. (Payroll and other deductions are to be ignored since they have not yet been discussed.)

General Journal

Date Account Titles and Explanation

2010 Dec. 28 Salaries Expense (-SE)

Cash (-A)

Paid training personnel salaries for the first four weeks of

December.

General Ledger

Salaries Expense

(Dr.) Acct. No. 507 (Cr)

2010

Dec. 3,600 28

Cash

(Dr.) Acct. No. 100 (Cr.)

Post. Ref. 507

Debit

3 6 0 0

Credit

100 3 6 0 0

p. 101 of 433

2010

Dec. 50,000 1 Dec. 4,500 7 Dec. 5,000 15 Dec. 500 26

2010

Dec. 1 40,000

Dec. 1 2,400

Dec. 1 1,200

Dec. 17 1,400

Dec. 28 3,600

Effects of transaction

An expense, salaries expense, increases (debited); and an asset, cash, decreases (credited) by USD

3,600. Transaction 13: Dec. 29 Received and paid the utilities bill for December, $150. General Journal

Date Account Titles and Explanation

2010 Dec. 29 Utilities Expense (-SE)

Cash (+A)

Paid the utilities bill for December.

General Ledger

Utilities Expense

Post. Debit Credit Ref. 511 1 5 0

100 1 5 0

(Dr.) Acct. No. 511

2010

Dec. 29

150

Cash

(Dr.) Acct. No. 100

2010

Dec. 1 Dec. 7 Dec. 15 Dec. 26

50,000

4,500

5,000

500

(Cr)

(Cr.)

2010

Dec. 40,000 1 Dec. 2,400 1 Dec. 1,200 1 Dec. 1,400 17 Dec. 3,600 28 Dec. 29 150

Effects of transaction

An expense, utilities expense, increases (debited); and an asset, cash, decreases (credited) by USD

150.

p. 102 of 433

Transaction 14: Dec. 30 Received a bill for gas and oil used in the trucks for December, $680. General Journal

Date Account Titles and Explanation

2010 Dec. 30 Gas and Oil Expense (-SE)

Accounts Payable (+L)

Received a bill for gas and oil used in the trucks for

December.

General Ledger

Gas and Oil Expense

(Dr.) Acct. No. 506 (Cr)

2010

Dec. 680 30

Accounts Payable

(Dr.) Acct. No. 200 (Cr.)

2010 2010

Dec. 1,400 Dec. 4 1,400 17

Dec.24 50

Post. Debit Credit Ref. 506 6 8 0

200 6 8 0

p. 103 of 433

Dec. 30 680

Effects of transaction

An expense, gas and oil expense, increases (debited); and a liability, accounts payable, increases

(credited) by USD 680. Transaction 15: Dec. 31 A dividend of $3,000 was paid to stockholders. General Journal

Date Account Titles and Explanation

2010 Dec. 31 Dividends (-SE)

Cash (-A)

Dividends were paid to stockholders.

General Ledger

Dividends

(Dr.) Acct. No. 320 (Cr)

2010

Dec. 31 3,000

Cash

(Dr.) Acct. No. 100 (Cr.)

Post. Debit Credit Ref. 320 3 0 0 0

100 3 0 0 0

2010

Dec. 1 Beg Bal. 50,000

Dec. 7 4,500

Dec. 15 5,000

Dec. 26 500

2010

Dec. 1 40,000

Dec. 1 2,400

Dec. 1 1,200

Dec. 17 1,400

Dec. 28 3,600

Dec. 29 150

Dec. 31 3,000

Effects of transaction

The Dividends account increases (debited); and an asset, cash, decreases (credited) by USD 3,000.

Transaction 15 concludes the analysis of the MicroTrain Company transactions. The next section

discusses and illustrates posting to ledger accounts and cross-indexing.

An accounting perspective: Uses of technology

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The concept of the Internet dates to the 1960s when the military tied together several

computers forming a "network" that allowed users to communicate with each other

instantaneously on their computers over many miles.

Then universities and scientific institutions connected to the network to meet their

research and communication needs. More and more organizations hooked up to the

network over time. Today many companies seek customers and employees over the

Internet. Students and faculty use the Internet to perform research, communicate with

their colleagues (using e-mail), and search distant libraries. Accountants in practice

are heavy users of the Internet to locate company data, tax regulations, and almost any

other information they need. You will find that learning to use the Internet effectively

is essential to your future success.

3.9 The use of ledger accounts

A journal entry is like a set of instructions. The carrying out of these instructions is known as

posting. As stated earlier, posting is recording in the ledger accounts the information contained in the

journal. A journal entry directs the entry of a certain dollar amount as a debit in a specific ledger

account and directs the entry of a certain dollar amount as a credit in a specific ledger account. Earlier,

we posted the journal entries for MicroTrain Company to T-accounts. In practice, however, companies

post these journal entries to ledger accounts.

Using a new example, Jenks Company, we illustrate posting to ledger accounts. Later, we show you

how to post the MicroTrain Company journal entries to ledger accounts.

In Exhibit 10, the first journal entry for the Jenks Company directs that USD 10,000 be posted in

the ledger as a debit to the Cash account and as a credit to the Capital Stock account. We post the debit

in the general ledger Cash account by using the following procedure: Enter in the Cash account the

date, a short explanation, the journal designation ("G" for general journal) and the journal page

number from which the debit is posted, and the USD 10,000 in the Debit column. Then, enter the

number of the account to which the debit is posted in the Posting Reference column of the general

journal. Post the credit in a similar manner but as a credit to Account No. 300. The arrows in Exhibit

10 show how these amounts were posted to the correct accounts.

Exhibit 10 shows the ledger account. In contrast to the two-sided T-account format shown so far,

the three-column format has columns for debit, credit, and balance. The three-column form has the

p. 105 of 433

advantage of showing the balance of the account after each item has been posted. In addition, in this

chapter, we indicate whether each balance is a debit or a credit. In later chapters and in practice, the

nature of the balance is usually not indicated since it is understood. Also, notice that we give an

explanation for each item in the ledger accounts. Often accountants omit these explanations because

each item can be traced back to the general journal for the explanation.

Posting is always from the journal to the ledger accounts. Postings can be made (1) at the time the

transaction is journalized; (2) at the end of the day, week, or month; or (3) as each journal page is

filled. The choice is a matter of personal taste. When posting the general journal, the date used in the

ledger accounts is the date the transaction was recorded in the journal, not the date the journal entry

was posted to the ledger accounts.

Frequently, accountants must check and trace the origin of their transactions, so they provide cross-

indexing. Cross-indexing is the placing of (1) the account number of the ledger account in the

general journal and (2) the general journal page number in the ledger account. As shown in Exhibit 10,

the account number of the ledger account to which the posting was made is in the Posting Reference

column of the general journal. Note the arrow from Account No. 100 in the ledger to the 100 in the

Posting Reference column beside the first debit in the general journal. Accountants place the number

of the general journal page from which the entry was posted in the Posting Reference column of the

ledger account. Note the arrow from page 1 in Exhibit 10 the general journal to G1 in the Posting

Reference column of the Cash account in the general ledger. The notation "G1" means general journal,

page 1. The date of the transaction also appears in the general ledger. Note the arrows from the date in

the general journal to the dates in the general ledger.

JENKS COMPANY

Date General Journal

Account Titles and Explanation

2010 Jan. 1(B) Cash (+A)

Capital Stock (+SE)

Stockholders invested $10,000 cash in the business.

5 Cash (+A)

Notes Payable (+L)

Borrowed $5,000 from the bank on a note.

:- General Ledger Cash

Page 1

Post. Debit Credit Ref. (C)100 1 0 0 0 0 (A)

300 1 0 0 0 0 (D)

100 5 0 0 0

201 5 0 0 0

Account No 100(C)

Explanation

2010 -Jan. (B)1 Stockholders investment

5 Bank loan

Post Ref. G1

G1

Debt

(A) 1 0 0 0 0

5 0 0 0

Credit Balance

1 0 0 0 0 Dr

1 5 0 0 0 Dr

p. 106 of 433

Notes Payable Account No. 201

Date

2010 Jan. 5

Explanation

Borrowed cash

Post Ref. G1

Debt Credit

5 0 0 0

Balance

5 0 0 0 Cr

Capital Stock Explanation

(B)1 Cash from stockholders 2010 " Jan.

Post Ref. G1

Debt Credit

( 1 0 0 0 0 D )

Account No. 300 Balance

1 0 0 0 0 Cr

Exhibit 10: General journal and general ledger; posting and cross-indexing

Cross-indexing aids the tracing of any recorded transaction, either from general journal to general

ledger or from general ledger to general journal. Normally, they place cross-reference numbers in the

Posting Reference column of the general journal when the entry is posted. If this practice is followed,

the cross-reference numbers indicate that the entry has been posted.

p. 107 of 433

MICROTRAIN COMPANY General Journal

Page1

Date Account Titles and Explanation

2010 Nov. 28 Cash (+A)

Capital Stock (+SE)

Stockholders invested $50,000 cash in the business.

Dec 1 Truck (+A)

Cash (-A)

To record the purchase of four trucks.

1 Prepaid Insurance (+A)

Cash (-A)

Purchased truck insurance to cover a one-year period.

1 Prepaid Rent (+A)

Cash (-A)

Paid three months' rent on a building.

4 Supplies on Hand (+A)

Accounts Payable (+L)

To record the purchase of training supplies for future use.

7 Cash (+A)

Unearned Service Fees (+L)

To record the receipt of cash from a customer in payment

for future training services.

15 Cash (+A)

Service Revenue (+SE)

To record the receipt of cash for performing training

services for a customer.

17 Accounts Payable (-L)

Cash (-A)

Paid the account payable arising from the purchase of

supplies on December 4.

General Journal

Post. Ref. 100*

300

150

100

108

100

112

100

107

200

100

216

100

400

200

100

Debit Credit

5 0 0 0 0

5 0 0 0 0

4 0 0 0 0

4 0 0 0 0

2 4 0 0

2 4 0 0

1 2 0 0

1 2 0 0

1 4 0 0

1 4 0 0

4 5 0 0

4 5 0 0

5 0 0 0

5 0 0 0

1 4 0 0

1 4 0 0

Page 2

Date

2010 Dec. 20

Account Titles and Explanation

Accounts Receivable (+A)

Post. Ref. 103

Debit

5 7 0 0

Credit

p. 108 of 433

Service Revenue (+SE)

To record the performance of training services on account

for which a customer was billed.

24 Advertising Expense (-SE)

Accounts Payable (+L)

Received a bill for advertising for the month of December.

26 Cash (+A)

Accounts Receivable (-A)

Received $500 from a customer on accounts receivable.

28 Salaries Expense (-SE)

Cash (-A)

Paid training personnel salaries for the first four weeks

of December.

29 Utilities Expense (-SE)

Cash (-A)

Paid the utilities bill for December.

30 Gas and Oil Expense (-SE)

Accounts Payable (-A)

Received a bill for gas and oil used in the trucks for

December.

31 Dividends (-SE)

Cash (-A)

Dividends were paid to stockholders.

Exhibit 11: General journal (after posting)

400

505

200

100

103

507

100

511

100

506

200

320

100

5 7 0 0

5 0

5 0

5 0 0

5 0 0

3 6 0 0

3 6 0 0

1 5 0

1 5 0

6 8 0

6 8 0

3 0 0 0

3 0 0 0

To understand the posting and cross-indexing process, trace the entries from the general journal to

the general ledger. The ledger accounts need not contain explanations of all the entries, since any

needed explanations can be obtained from the general journal.

Look at Exhibit 11 to see how all the November and December transactions of MicroTrain Company

would be journalized. As shown in Exhibit 11, you skip a line between journal entries to show where

one journal entry ends and another begins. This procedure is standard practice among accountants.

Note that no dollar signs appear in journals or ledgers. When amounts are in even dollar amounts,

accountants leave the cents column blank or use zeros or a dash. When they use lined accounting work

p. 109 of 433

papers, commas or decimal points are not needed to record an amount. When they use unlined paper,

they add both commas and decimal points.

Next, observe Exhibit 12, the three-column general ledger accounts of MicroTrain Company after

the journal entries have been posted. Each ledger account would appear on a separate page in the

ledger. Trace the postings from the general journal to the general ledger to make sure you know how to

post journal entries.

All the journal entries illustrated so far have involved one debit and one credit; these journal entries

are called simple journal entries. Many business transactions, however, affect more than two

accounts. The journal entry for these transactions involves more than one debit and/or credit. Such

journal entries are called compound journal entries.

As an illustration of a compound journal entry, assume that on 2011 January 2, MicroTrain

Company purchased USD 8,000 of training equipment from Wilson Company. See below. MICROTRAIN COMPANY

General Ledger Cash

Account No. 100

Date Explanation

2010 Dec. 1 Beginning balance*

1 Trucks

1 Prepaid insurance

1 Prepaid rent

7 Unearned service fees

15 Service revenue

17 Paid account payable

26 Collected account receivable

28 Salaries

29 Utilities

31 Dividends

Accounts Receivable

Post Ref.

G1

G1

G1

G1

G1

G1

G2

G2

G2

G2

Debit

4 5 0 0

5 0 0 0

5 0 0

Credit

Account No. 103

4 0 0 0 0

2 4 0 0

1 2 0 0

1 4 0 0

3 6 0 0

1 5 0

3 0 0 0

Balance

5 0 0 0 0 Dr

1 0 0 0 0 Dr

7 6 0 0 Dr

6 4 0 0 Dr

1 0 9 0 0 Dr

1 5 9 0 0 Dr

1 4 5 0 0 Dr

1 5 0 0 0 Dr

1 1 4 0 0 Dr

1 1 2 5 0 Dr

8 2 5 0 Dr

Date Explanation Post Debit Credit Balance Ref.

2010 Dec. 20 Service revenue G2 5 7 0 0 5 7 0 0 Dr

26 Collections G2 5 0 0 5 2 0 0 Dr

Supplies on Hand Account No. 107

Date

2010 Dec. 4

Explanation

Purchased on account

Post Ref. G1

Debit

1 4 0 0

Credit Balance

1 4 0 0 Dr

p. 110 of 433

Prepaid Insurance Account No. 108

Date

2010 Dec. 1

Explanation

One-year policy on trucks

Post Ref. G1

Debit

2 4 0 0

Credit Balance

2 4 0 0 Dr

Date

2010 Dec. 1

Explanation

Three-month payment

General Ledger Prepaid Rent

Post Ref. G1

Debit

1

Page 1 Account No. 112

Credit

2 0 0

Balance

1 2 0 0 Dr

Trucks Account No. 150

Date Explanation Post Debit Credit Balance Ref.

2010 Dec. 1 Paid cash G1 4 0 0 0 0 4 0 0 0 0 Dr

Accounts Payable Account No. 200

Date Explanation

2010 Dec. 4 Supplies

17 Paid for supplies

24 Advertising

30 Gas and oil

Unearned Service Fees

Post Ref. G1

G1

G2

G2

Debit

1

Credit

4 0 0

1 4

6

Account No. 216

Balance

0 0 1 4 0 0 Cr

- 0 -

5 0 5 0 Cr

8 ) 7 3 0 Cr

Date Explanation Post Debit Credit Balance Ref.

2010 Dec. 7 Received cash G1 4 5 0 0 4 5 0 0 Cr

Capital Stock Account No. 300

Date Explanation Post Debit Credit Balance Ref.

2010 Dec. 1 Beginning balance 5 0 0 0 0 Cr

General Ledger Page 3 Dividends Account No. 320

Date Explanation Post Debt Credit Balance Ref.

2010 Dec. 31 Cash G2 3 0 0 0 3 0 0 0 Dr

Service Revenue Account No. 400

Date

2010 Dec. 15

Explanation

Cash

Post Ref. G1

Debt Credit

5 0 0 0

Balance

5 0 0 0 Cr

p. 111 of 433

20 On account G2 5 7 0 0 1 0 7 0 0 Cr

Advertising Expense Account No. 505

Date Explanation Post Debt Credit Balance Ref.

2010 Dec. 24 On account G2 5 0 5 0 Dr

Gas and Oil Expense Account No. 506

Date Explanation Post Debt Credit Balance Ref.

2010 Dec. 30 On account G2 6 8 0 6 8 0 Dr

Salaries Expense Account No. 507

Date Explanation Post Debt Credit Balance Ref.

2010 Dec. 28 Cash paid G2 3 6 0 0 3 6 0 0 Dr

Utilities Expense Account No. 511

Date Explanation Post Debt Credit Balance Ref.

2010 Dec. 29 Cash paid G2 1 5 0 1 5 0 Dr

Exhibit 12: General ledger - Extended illustration MICROTRAIN COMPANY

Trial Balance December 31, 2010

Acct.

No. Account Title Debits Credits 100 Cash $ 8,250

103 Accounts Receivable 5,200

107 Supplies on Hand 1,400

108 Prepaid Insurance 2,400

112 Prepaid Rent 1,200

150 Trucks 40,000

200 Accounts Payable $ 730

216 Unearned Service Fees 4,500

300 Capital Stock 50,000

320 Dividends 3,000

400 Service Revenue 10,700

505 Advertising Expense 50

506 Gas and Oil Expense 680

507 Salaries Expense 3,600

511 Utilities Expense 150

Exhibit 13: Trail balance

p. 112 of 433

MicroTrain paid USD 2,000 cash with the balance due on 2011 March 3. The general journal entry

for MicroTrain Company is: Debit Credit

2011

Jan. 2 Equipment (+A) 8,000

Cash (-A) 2,000

Accounts Payable (+L) 6,000

Training equipment purchased from Wilson Company.

Note that the firm credits two accounts, Cash and Accounts Payable, in this one entry. However, the

dollar totals of the debits and credits are equal.

Periodically, accountants use a trial balance to test the equality of their debits and credits. A trial

balance is a listing of the ledger accounts and their debit or credit balances to determine that debits

equal credits in the recording process. The accounts appear in this order: assets, liabilities,

stockholders' equity, dividends, revenues, and expenses. Within the assets category, the most liquid

(closest to becoming cash) asset appears first and the least liquid appears last. Within the liabilities,

those liabilities with the shortest maturities appear first. Study Exhibit 13, the trial balance for

MicroTrain Company. Note the listing of the account numbers and account titles on the left, the

column for debit balances, the column for credit balances, and the equality of the two totals.

When the trial balance does not balance, try re-totaling the two columns. If this step does not locate

the error, divide the difference in the totals by 2 and then by 9. If the difference is divisible by 2, you

may have transferred a debit-balanced account to the trial balance as a credit, or a credit-balanced

account as a debit. When the difference is divisible by 2, look for an amount in the trial balance that is

equal to one-half of the difference. Thus, if the difference is USD 800, look for an account with a

balance of USD 400 and see if it is in the wrong column.

If the difference is divisible by 9, you may have made a transposition error in transferring a balance

to the trial balance or a slide error. A transposition error occurs when two digits are reversed in an

amount (e.g. writing 753 as 573 or 110 as 101). A slide error occurs when you place a decimal point

incorrectly (e.g. USD 1,500 recorded as USD 15.00). Thus, when a difference is divisible by 9, compare

the trial balance amounts with the general ledger account balances to see if you made a transposition

or slide error in transferring the amounts.

p. 113 of 433

An ethical perspective: Financial Deals, Inc. Larry Fisher was captain of the football team at Prestige University. Later, he earned a

master's degree in business administration with a concentration in accounting.

Upon graduation, Larry accepted a position with Financial Deals, Inc., in the

accounting and finance division. At first, things were going smoothly. He was tall, good

looking, and had an outgoing personality. The president of the company took a liking to

him. However, Larry was somewhat bothered when the president started asking him to

do some things that were slightly unethical. When he protested mildly, the president

said: "Come on, son, this is the way the business world works. You have great potential

if you don't let things like this get in your way."

As time went on, Larry was asked to do things that were more unethical, and finally he

was performing illegal acts. When he resisted, the president appealed to his loyalty and

asked him to be a team player. The president also promised Larry great wealth

sometime in the future. Finally, when he was told to falsify some financial statements

by making improper entries and to sign some documents containing material errors,

the president supported his request by stating: "You are in too deep now to refuse to

cooperate. If I go down, you are going with me." Through various company schemes,

Larry had convinced some friends and relatives to invest about USD 10 million. Most of

this would be lost if the various company schemes were revealed.

Larry could not sleep at night and began each day with a pain in his stomach and by

becoming physically ill. He was under great strain and believed that he could lose his

mind. He also heard that the president had a shady past and could become violent in

retaliating against his enemies. If Larry blows the whistle, he believes he will go to

prison for his part in the schemes. (Note: This scenario is based on an actual situation

with some facts changed to protect the guilty.)

If you still cannot find the error, it may be due to one of the following causes:

• Failing to post part of a journal entry.

• Posting a debit as a credit, or vice versa.

• Incorrectly determining the balance of an account.

• Recording the balance of an account incorrectly in the trial balance.

• Omitting an account from the trial balance.

p. 114 of 433

• Making a transposition or slide error in the accounts or the journal.

Usually, you should work backward through the steps taken to prepare the trial balance. Assuming

you have already re-totaled the columns and traced the amounts appearing in the trial balance back to

the general ledger account balances, use the following steps: Verify the balance of each general ledger

account, verify postings to the general ledger, verify general journal entries, and then review the

transactions and possibly the source documents.

The equality of the two totals in the trial balance does not necessarily mean that the accounting

process has been error-free. Serious errors may have been made, such as failure to record a

transaction, or posting a debit or credit to the wrong account. For instance, if a transaction involving

payment of a USD 100 account payable is never recorded, the trial balance totals still balance, but at an

amount that is USD 100 too high. Both cash and accounts payable would be overstated by USD 100.

You can prepare a trial balance at any time—at the end of a day, a week, a month, a quarter, or a

year. Typically, you would prepare a trial balance before preparing the financial statements.

An accounting perspective: Uses of technology

The computers of persons in a given department or building are frequently connected

in a Local Area Network (LAN). These persons can then access simultaneously the

programs and databases stored in the LAN and can communicate with all other

persons in the LAN through email. A more advanced type of computer network is

called Client/Server Computing. Under this structure, any computer in the network

can be used to update the information stored elsewhere in the network. For example,

accounting information stored in one computer could be updated by authorized

persons from a number of other computers in the system. The use of networks is

designed to improve efficiency and to reduce software and hardware costs.

3.10 Analyzing and using the financial results— Horizontal and vertical analyses

The calculation of dollar and/or percentage changes from one year to the next in an item on

financial statements is horizontal analysis. For instance, in the following data taken from the 2000

annual report of Hewlett-Packard Company, the amount of inventory increased by USD 836 million

from 1999 October 31, to 2000 October 31. This amount represented a 17 per cent increase. To find the

p. 115 of 433

amount of the increase or decrease, subtract the 1999 amount from the 2000 amount. To find the

percentage change, divide the increase or decrease by the 1999 amount.

Knowing the dollar amount and percentage of change in an amount is much more meaningful than

merely knowing the amount at one point in time. By analyzing the data, we can see that cash and cash

equivalents declined in 2000. Their decline at least partially explains the increases in some of the other

current assets. We can also see that the company invested in property, plant and equipment. Any terms

in Hewlett-Packard's list of assets that you do not understand are explained in later chapters. At this

point, all we want you to understand is the nature of horizontal and vertical analyses.

Vertical analysis shows the percentage that each item in a financial statement is of some

significant total such as total assets or sales. For instance, in the Hewlett-Packard data we can see that

cash and cash equivalents were 15.3 per cent of total assets as of 1999 October 31, and had declined to

10.0 per cent of total assets by 2000 October 31. Total current assets (cash plus other amounts that will

become cash or be used up within one year) increased from 61.3 per cent of total assets to 68.3 per cent

during 2000. Long-term investments and other non-current assets accounted for 18.4 per cent of total

assets as of 2000 October 31. Increase or Percent of

(Decrease) Total Assets

2000 over 1999 October 31

2000 1999 Dollars Percent 2000 1999

Assets (in millions)

Current assets:

Cash and cash equivalents $ 3,415 $ 5,411 $ (1,996) -37% 10.0% 15.3% Short-term investments 592 179 413 231% 1.7% 0.5% Accounts receivable 6,394 5,958 436 7% 18.8% 16.9% Financing receivables 2,174 1,889 285 15% 6.4% 5.4% Inventory 5,699 4,863 836 17% 16.8% 13.8% Other current assets 4,970 3,342 1,628 49% 14.6% 9.5% Total current assets $ 23,244 $ 21,642 $ 1,602 7% 68.3% 61.3% Property, plant and equipment:

Property, plant and equipment, net 4,500 4,333 167 4% 13.2% 12.3% Long-term investments and

other non-current assets 6,265 9,322 (3,057) -33% 18.4% 26.4% Total assets $ 34,009 $ 35,297 $ (1,288) -4% 100.0% 100.0%

Management performs horizontal and vertical analyses along with other forms of analysis to help

evaluate the wisdom of its past decisions and to plan for the future. Other data would have to be

examined before decisions could be made regarding the assets shown. For instance, if you discovered

the liabilities that would have to be paid within a short time by Hewlett-Packard were more than USD

30 billion, you might conclude that the company is short of cash even though current assets increased

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substantially during 2000. We illustrate horizontal and vertical analyses to a much greater extent later

in the text.

An accounting perspective: Business insight

Many companies have been restructuring their organizations and reducing the

number of employees to cut expenses. General Motors, AT&T, IBM, and numerous

other companies have taken this action. One could question whether companies place

as much value on their employees as in the past. In previous years it was common to

see the following statement in the annual reports of companies: "Our employees are

our most valuable asset". Companies are not permitted to show employees as assets on

their balance sheets. Do you think they should be allowed to do so?

What you have learned in this chapter is basic to your study of accounting. The entire process of

accounting is based on the double-entry concept. Chapter 3 explains that adjustments bring the

accounts to their proper balances before accurate financial statements are prepared.

3.10.1 Understanding the learning objectives

• An account is a storage unit used to classify and summarize money measurements of business

activities of a similar nature.

• A firm sets up an account whenever it needs to provide useful information about a particular

business item to some party having a valid interest in the business.

• A T-account resembles the letter T.

• Debits are entries on the left side of a T-account.

• Credits are entries on the right side of a T-account.

• Debits increase asset, expense, and Dividends accounts.

• Credits increase liability, stockholders' equity, and revenue accounts.

• Analyze transactions by examining source documents.

• Journalize transactions in the journal.

• Post journal entries to the accounts in the ledger.

• Prepare a trial balance of the accounts and complete the work sheet.

• Prepare financial statements.

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• Journalize and post adjusting entries.

• Journalize and post closing entries. Prepare a post-closing trial balance.

• A journal contains a chronological record of the transactions of a business. An example of a

general journal is shown in Exhibit 11. Journalizing is the process of entering a transaction in a

journal.

• Posting is the process of transferring information recorded in the journal to the proper places

in the ledger.

• Cross-indexing is the placing of (1) the account number of the ledger account in the general

journal and (2) the general journal page number in the ledger account.

• An example of cross-indexing appears in Exhibit 10.

• A trial balance is a listing of the ledger accounts and their debit or credit balances.

• If the trial balance does not balance, an accountant works backward to discover the error.

• A trial balance is shown in Exhibit 13.

• Horizontal analysis involves calculating the dollar and/or percentage changes in an item from

one year to the next.

• Vertical analysis shows the percentage that each item in a financial statement is of some

significant total.

3.10.2 Demonstration problem

Green Hills Riding Stable, Incorporated, had the following balance sheet on 2010 June 30: GREEN HILLS RIDING STABLE, INCORPORATED

Balance Sheet 2010 June 30

Assets

Cash $ 7,500

Accounts receivable 5,400

Land 40,000

Total assets $ 52,900

Liabilities and Stockholders' Equity Liabilities:

Accounts payable $ 800

Notes payable 40,000

Total liabilities $ 40,800

Stockholders' equity:

Capital stock $ 10,000

Retained earnings 2,100

Total stockholders' equity 12,100

Total liabilities and stockholders' equity $52,900

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a. Prepare the journal entries to record the transactions for July 2010.

b. Post the journal entries to the ledger accounts after entering the beginning balances in those

accounts. Insert cross-indexing references in the journal and ledger. Use the following chart of

accounts:

100 Cash 320 Dividends 103 Accounts Receivable 402 Horse Boarding Fees Revenue 130 Land 404 Riding and Lesson Fees Revenue 140 Buildings 507 Salaries Expense 200 Accounts Payable 513 Feed Expense 201 Notes Payable 540 Interest Expense 300 Capital Stock 568 Miscellaneous Expense 310 Retained Earnings

c. Prepare a trial balance.

3.10.3 Solution to demonstration problem

a. GREEN HILLS RIDING STABLE, INCORPORATED

General Journal

Date Account Titles and Explanation

2010 July 1 Cash (+A)

Capital Stock (+SE)

Additional capital stock issued.

1 Buildings (+A)

Cash (-A)

Paid for building.

8 Account Payable (-L)

Cash (-A)

Paid accounts payable.

10 Cash (+A)

Accounts Receivable (-A)

Collected accounts receivable.

12 Feed Expense (-SE)

Accounts Payable (+L)

Purchased feed on account

15 Accounts Receivable (+A)

Horse Boarding Fee Revenue (+SE)

Billed boarding fees for July.

Post. Ref. 100

300

140

100

200

100

100

103

513

200

103

402

Page1 Debit Credit

2 5 0 0 0

2 5 0 0 0

2 4 0 0 0

2 4 0 0 0

8 0 0

8 0 0

5 4 0 0

5 4 0 0

1 1 0 0

1 1 0 0

4 5 0 0

4 5 0 0

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24 Miscellaneous Expense (-SE)

Cash (-A)

Paid miscellaneous expenses for July.

31 Interest Expense (-SE)

Cash (-A)

Paid interest

31 Salaries Expense (-SE)

Cash (-A)

Paid salaries for July.

31 Accounts Receivable (+A)

Riding and Lesson Fee Revenue (+SE)

Billed riding and lesson fees for July.

31 Dividends (-SE)

Cash (-A)

Paid a dividend to stockholders.

568

100

540

100

507

100

103

404

320

100

8 0 0

8 0 0

2 0 0

2 0 0

1 4 0 0

1 4 0 0

3 6 0 0

3 6 0 0

1 0 0 0

1 0 0 0

b. GREEN HILLS RIDING STABLE, INCORPORATED General Ledger

Land Account No. 100

Date Explanation

2010 June 30 Balance

July 1 Stockholders' investment

1 Buildings

8 Accounts payable

10 Accounts receivable

24 Miscellaneous expense

31 Interest expense

31 Salaries expense

31 Dividends

Accounts Receivable

Post Ref.

G1

G1

G1

G1

G1

G1

G1

G1

Debt

2 5 0 0 0

5 4 0 0

Credit Balance

Account No. 103

7 5 0 0 0 Dr

3 2 5 0 0 Dr

2 4 0 0 0 8 5 0 0 Dr

8 0 0 7 7 0 0 Dr

1 3 1 0 0 Dr

8 0 0 1 2 3 0 0 Dr

2 0 0 1 2 1 0 0 Dr

1 4 0 0 1 0 7 0 0 Dr

1 0 0 0 9 7 0 0 Dr

Date Explanation

2010 June 30 Balance

July 10 Cash

15 Horse boarding fees

31 Riding and lessons fees

Post Ref.

G1

G1

G1

Debt

4 5 0 0

3 6 0 0

Credit Balance

5 4 0 0 Dr

5 4 0 0 - 0 -

4 5 0 0 Dr

8 1 0 0 Dr

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Land Account No. 130

Date Explanation Post Debt Credit Balance Ref.

2010 June 30 Balance 4 0 0 0 0 Dr

Buildings Account No. 140

Date

2010 July 1

Explanation

Cash

Post Ref. G1

Debt

2 4 0 0 0

Credit Balance

2 4 0 0 0 Dr

Accounts Payable Account No. 200

Date Explanation

2010 June 30 Balance

July 8 Cash

12 Feed expense

Post Debt Credit Balance Ref.

8 0 0 Cr

G1 8 0 0 - 0 -

G1 1 1 0 0 1 1 0 0 Cr

General Ledger (continued) Notes Payable Account No. 201

Date Explanation Post Debt Credit Balance Ref.

2010 June 30 Balance 4 0 0 0 0 Cr

Capital Stock Account No. 300

Date Explanation Post Debt Credit Balance Ref.

2010 June 30 Balance 1 0 0 0 0 Cr

July 1 Cash G1 2 5 0 0 0 3 5 0 0 0 Cr

Retained Earnings Account No. 310

Date Explanation Post Debt Credit Balance Ref.

2010 June 30 Balance 2 1 0 0 Cr

Dividends Account No. 320

Date

2010 July 31

Explanation

Cash

Post Ref. G1

Debt

1 0 0 0

Credit Balance

1 0 0 0 Dr

Horse Boarding Fee Revenue Account No. 402

Date

2010 July 15

Explanation

Accounts receivable

Post Ref. G1

Debt Credit

4 5 0 0

Balance

4 5 0 0 Cr

Riding and Lesson Fee Revenue Account No. 404

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Date Explanation Post Debt Credit Balance Ref.

2010 July 31 Accounts receivable G1 3 6 0 0 3 6 0 0 Cr

Date

2010 July 31

Explanation

Cash

General Ledger (concluded) Salaries Expense Account No. 507

Post Debt Credit Ref. G1 1 4 0 0

Balance

1 4 0 0 Dr

Feed Expense Account No. 513

Date

2010 July 12

Explanation

Accounts payable

Post Ref. G1

Debt

1 1 0 0

Credit Balance

1 1 0 0 Dr

Interest Expense Account No. 540

Date

2010 July 31

Explanation

Cash

Post Ref. G1

Debt

2 0 0

Credit Balance

2 0 0 Dr

Miscellaneous Expense Account No. 568

Date Explanation Post Debt Credit Balance Ref.

2010 July 24 Cash G1 8 0 0 8 0 0 Dr

GREEN HILLS RIDING STABLE, INCORPORATED c. Trial Balance

2010 July 31

Acct.

No. Account Title Debits Credits

100 Cash $ 9,700

103 Accounts Receivable 8,100

130 Land 40,000

140 Buildings 24,000

200 Accounts Payable $ 1,100

201 Notes Payable 40,000

300 Capital Stock 35,000

310 Retained Earnings 2,100

320 Dividends 1,000

402 Horse Boarding Fee Revenue 4,500

404 Riding and Lesson Fee Revenue 3,600

507 Salaries Expense 1,400

513 Feed Expense 1,100

540 Interest Expense 200

568 Miscellaneous Expense 800

$86,300 $86,300

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3.11 Key terms Account A part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and expense. The three-column account is normally used. It contains columns for debit, credit, and balance. Accounting cycle A series of steps performed during the accounting period (some throughout the period and some at the end) to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements. Accrual basis of accounting Recognizes revenues when sales are made or services are performed, regardless of when cash is received. Recognizes expenses as incurred, whether or not cash has been paid out. Business transactions Measurable events that affect the financial condition of a business. Chart of accounts The complete listing of the account titles and account numbers of all of the accounts in the ledger; somewhat comparable to a table of contents. Compound journal entry A journal entry with more than one debit and/or credit. Credit The right side of any account; when used as a verb, to enter a dollar amount on the right side of an account; credits increase liability, stockholders' equity, and revenue accounts and decrease asset, expense, and Dividends accounts. Credit balance The balance in an account when the sum of the credits to the account exceeds the sum of the debits to that account. Cross-indexing The placing of (1) the account number of the ledger account in the general journal and (2) the general journal page number in the ledger account. Debit The left side of any account; when used as a verb, to enter a dollar amount on the left side of an account; debits increase asset, expense, and Dividends accounts and decrease liability, stockholders' equity, and revenue accounts. Debit balance The balance in an account when the sum of the debits to the account exceeds the sum of the credits to that account. Double-entry procedure The accounting requirement that each transaction must be recorded by an entry that has equal debits and credits. Horizontal analysis The calculation of dollar and/or percentage changes in an item on the financial statements from one year to the next. Journal A chronological (arranged in order of time) record of business transactions; the simplest form of journal is the two-column general journal. Journal entry Shows all of the effects of a business transaction as expressed in debit(s) and credit(s) and may include an explanation of the transaction. Journalizing A step in the accounting recording process that consists of entering the effects of a transaction in a journal. Ledger The complete collection of all of the accounts of a company; often referred to as the general ledger. Nominal accounts See temporary accounts. Note An unconditional written promise to pay to another party the amount owed either when demanded or at a certain specified date.

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Permanent accounts (real accounts) Balance sheet accounts; their balances are not transferred (or closed) to any other account at the end of the accounting period. Posting Recording in the ledger accounts the information contained in the journal. Real accounts See permanent accounts. Simple journal entry An entry with one debit and one credit. T-account An account resembling the letter T, which is used for illustrative purposes only. Debits are entered on the left side of the account, and credits are entered on the right side of the account. Temporary accounts (nominal accounts) They temporarily contain the revenue, expense, and dividend information that is transferred (or closed) to a stockholders' equity account (Retained Earnings) at the end of the accounting period. Trial balance A listing of the ledger accounts and their debit or credit balances to determine that debits equal credits in the recording process. Vertical analysis Shows the percentage that each item in a financial statement is of some significant total such as total assets or sales.

3.12 Self-test

3.12.1 True-false

Indicate whether each of the following statements is true or false.

All of the steps in the accounting cycle are performed only at the end of the accounting period.

A transaction must be journalized in the journal before it can be posted to the ledger accounts.

The left side of any account is the credit side.

Revenues, liabilities, and capital stock accounts are increased by debits.

The dividends account is increased by debits.

If the trial balance has equal debit and credit totals, it cannot contain any errors.

3.12.2 Multiple-choice

Select the best answer for each of the following questions.

When the stockholders invest cash in the business:

a. Capital Stock is debited and Cash is credited.

b. Cash is debited and Dividends is credited.

c. Cash is debited and Capital Stock is credited.

d. None of the above.

Assume that cash is paid for insurance to cover a three-year period. The recommended debit and

credit are:

a. Debit Insurance Expense, credit Cash.

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b. Debit Prepaid Insurance, credit Cash.

c. Debit Cash, credit Insurance Expense.

d. Debit Cash, credit Prepaid Insurance.

A company received cash from a customer in payment for future delivery services. The correct debit

and credit are:

a. Debit Cash, credit Unearned Delivery Fees.

b. Debit Cash, credit Delivery Fee Revenue.

c. Debit Accounts Receivable, credit Delivery Fee Revenue.

d. None of the above.

A company performed delivery services for a customer for cash. The correct debit and credit are:

a. Debit Cash, credit Unearned Delivery Fees.

b. Debit Cash, credit Delivery Fee Revenue.

c. Debit Accounts Receivable, credit Delivery Fee Revenue.

d. None of the above.

A cash dividend of USD 500 was declared and paid to stockholders. The correct journal entry is:

a. Capital stock 500 Cash 500 b. Cash 500 Dividends 500 c. Dividends 500 Cash 500 d. Cash 500

Capital stock 500

Now turn to “Answers to self-test” at the end of the chapter to check your answers.

3.12.3 Questions

• Describe the steps in recording and posting the effects of a business transaction.

• Give some examples of source documents.

• Define an account. What are the two basic forms (styles) of accounts illustrated in the

chapter?

• What is meant by the term double-entry procedure, or duality?

• Describe how you would determine the balance of a T-account.

• Define debit and credit. Name the types of accounts that are:

• Increased by a debit.

• Decreased by a debit.

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• Increased by a credit.

• Decreased by a credit.

• Do you think this system makes sense? Can you conceive of other possible methods for

recording changes in accounts?

• Which of the steps in the accounting cycle are performed throughout the accounting

period?

• Which of the steps in the accounting cycle are performed only at the end of the

accounting period?

• Why are expense and revenue accounts used when all revenues and expenses could be

shown directly in the Retained Earnings account?

• What is the purpose of the Dividends account and how is it increased?

• Are the following possibilities conceivable in an entry involving only one debit and one

credit? Why?

• Increase a liability and increase an expense.

• Increase an asset and decrease a liability.

• Increase a revenue and decrease an expense.

• Decrease an asset and increase another asset.

• Decrease an asset and increase a liability.

• Decrease a revenue and decrease an asset.

• Decrease a liability and increase a revenue.

• Describe the nature and purposes of the general journal. What does journalizing mean?

Give an example of a compound entry in the general journal.

• Describe a ledger and a chart of accounts. How do these two compare with a book and

its table of contents?

• Describe the act of posting. What difficulties could arise if no cross-indexing existed

between the general journal and the ledger accounts?

• Which of the following cash payments would involve the immediate recording of an

expense? Why?

• Paid vendors for office supplies previously purchased on account.

• Paid an automobile dealer for a new company auto.

• Paid the current month's rent.

• Paid salaries for the last half of the current month.

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• What types of accounts appear in the unadjusted trial balance? What are the purposes of

this trial balance?

• You have found that the total of the Debits column of the trial balance of Burns

Company is USD 200,000, while the total of the Credits column is USD 180,000. What

are some possible causes of this difference? If the difference between the columns is

divisible by 9, what types of errors are possible?

• Store equipment was purchased for USD 2,000. Instead of debiting the Store

Equipment account, the debit was made to Delivery Equipment. Of what help will the

trial balance be in locating this error? Why?

• A student remembered that the side toward the window in the classroom was the debit

side of an account. The student took an examination in a room where the windows were

on the other side of the room and became confused and consistently reversed debits and

credits. Would the student's trial balance have equal debit and credit totals? If there

were no existing balances in any of the accounts to begin with, would the error prevent

the student from preparing correct financial statements? Why?

3.12.4 Exercises

Exercise A A diagram of the various types of accounts follows. Show where pluses (+) or minuses

(-) should be inserted to indicate the effect debits and credits have on each account.

Asset Accounts = Liability Accounts + Stockholders' Equity Accounts Debit Credit Debit Credit Debit Credit

Expense and Dividends Revenue Accounts Accounts Account Debit* Credit Debit Credit*

Exercise B Prepare the journal entry required for each of the following transactions: