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Information for Decisions

Financial & Managerial Accounting

8th edition

JOHN J. WILD KEN W. SHAW

Financial & Managerial Accounting

8thedition

John J. Wild University of Wisconsin at Madison

Ken W. Shaw University of Missouri at Columbia

INFORMATION FOR DECISIONS

To my students and family, especially Kimberly, Jonathan, Stephanie, and Trevor. To my wife Linda and children Erin, Emily, and Jacob.

FINANCIAL AND MANAGERIAL ACCOUNTING: INFORMATION FOR DECISIONS, EIGHTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2018, 2016, and 2013. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-1-260-24785-5 (bound edition) MHID 1-260-24785-6 (bound edition) ISBN 978-1-260-41719-7 (loose-leaf edition) MHID 1-260-41719-0 (loose-leaf edition)

Executive Portfolio Manager: Steve Schuetz Product Developers: Michael McCormick, Christina Sanders Marketing Manager: Michelle Williams Content Project Managers: Lori Koetters, Brian Nacik Buyer: Sandy Ludovissy Design: Debra Kubiak Content Licensing Specialist: Melissa Homer Cover Image: Runner: ©Maridav/Shutterstock; Statistics icons: ©A-spring/Shutterstock; Background image: ©Vector work/Shutterstock Compositor: Aptara®, Inc.

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data Names: Wild, John J., author. | Shaw, Ken W., author. Title: Financial and managerial accounting : information for decisions / John J. Wild, University of Wisconsin at Madison, Ken W. Shaw, University of Missouri at Columbia. Description: 8th Edition. | Dubuque, IA : McGraw-Hill Education, [2018] | Revised edition of Financial and managerial accounting, [2018] | Includes bibliographical references and index. Identifiers: LCCN 2018035310| ISBN 9781260247855 (alk. paper) | ISBN 1260247856 (alk. paper) Subjects: LCSH: Accounting. | Managerial accounting. Classification: LCC HF5636 .W674b 2018 | DDC 658.15/11—dc23 LC record available at https://lccn.loc.gov/2018035310

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

iii

About the Authors JOHN J. WILD is a distinguished pro- fessor of accounting at the University of Wisconsin at Madison. He previously held appointments at Michigan State University and the University of Manchester in England. He received his BBA, MS, and PhD from the University of Wisconsin.

John teaches accounting courses at both the undergraduate and graduate levels. He has received numerous teaching honors, in- cluding the Mabel W. Chipman Excellence-in-

Teaching Award and the departmental Excellence-in-Teaching Award, and he is a two-time recipient of the Teaching Excellence Award from business graduates at the University of Wisconsin. He also received the Beta Alpha Psi and Roland F. Salmonson Excellence-in-Teaching Award from Michigan State University. John has received several research honors, is a past KPMG Peat Marwick National Fellow, and is a recipient of fellowships from the American Accounting Association and the Ernst and Young Foundation.

John is an active member of the American Accounting Association and its sections. He has served on several committees of these organizations, including the Outstanding Accounting Educator Award, Wildman Award, National Program Advisory, Publications, and Research Committees. John is author of Financial Accounting, Managerial Accounting, Fundamental Accounting Principles, and College Accounting, all published by McGraw-Hill Education.

John’s research articles on accounting and analysis appear in The Accounting Review; Journal of Accounting Research; Journal of Accounting and Economics; Contemporary Accounting Research; Journal of Accounting, Auditing and Finance; Journal of Accounting and Public Policy; Accounting Horizons; and other journals. He is past associate editor of Contemporary Accounting Research and has served on several editorial boards including The Accounting Review and the Journal of Accounting and Public Policy.

In his leisure time, John enjoys hiking, sports, boating, travel, people, and spending time with family and friends.

Courtesy of John J. Wild

KEN W. SHAW is an associate profes- sor of accounting and the KPMG/Joseph A. Silvoso Distinguished Professor of Accounting at the University of Missouri. He previously was on the faculty at the University of Maryland at College Park. He has also taught in international programs at the University of Bergamo (Italy) and the University of Alicante (Spain). He received an accounting degree from Bradley University and an MBA and PhD from the

University of Wisconsin. He is a Certified Public Accountant with work experience in public accounting.

Ken teaches accounting at the undergraduate and graduate levels. He has received numerous School of Accountancy, College of Business, and university-level teaching awards. He was voted the “Most Influential Professor” by four School of Accountancy graduating classes and is a two-time recipient of the O’Brien

Excellence in Teaching Award. He is the advisor to his school’s chapter of the Association of Certified Fraud Examiners.

Ken is an active member of the American Accounting Association and its sections. He has served on many committees of these organizations and presented his research papers at na- tional and regional meetings. Ken’s research appears in the Journal of Accounting Research; The Accounting Review; Contemporary Accounting Research; Journal of Financial and Quantitative Analysis; Journal of the American Taxation Association; Strategic Management Journal; Journal of Accounting, Auditing, and Finance; Journal of Financial Research; and other journals. He has served on the editorial boards of Issues in Accounting Education; Journal of Business Research; and Research in Accounting Regulation. Ken is co-author of Fundamental Accounting Principles, Managerial Accounting, and College Accounting, all published by McGraw-Hill Education.

In his leisure time, Ken enjoys tennis, cycling, music, and coaching his children’s sports teams.

Courtesy of Ken W. Shaw

Author Letter Using Learning Science and Data Analytics We use data to make decisions and maximize performance. Like the runner on the cover who uses data to track her progress, we used stu- dent performance data to identify content areas that can be made more direct, concise, and systematic.

Learning science reveals that students do not read large chunks of text, so we streamlined this edition to present it in a more focused, succinct, blocked format to improve student learning and retention. Our new edition delivers the same content in 112 fewer pages. Visual aids and numer- ous videos offer additional learning aids. New summary Cheat Sheets conclude each chapter to visually reinforce key concepts and procedures.

Our new edition has over 1,500 videos to engage students and improve outcomes: • Concept Overview Videos—cover each chapter’s learning objectives with multimedia presentations that include Knowledge Checks to

engage students and assess comprehension. • Need-to-Know Demos—walk-through demonstrations of key procedures and analysis to ensure success with assignments and tests. • Guided Examples (Hints)—step-by-step walk-through of assignments that mimic Quick Studies, Exercises, and General Ledger.

Difference Makers in Teaching . . . Learning Science Learning analytics show that students learn better when material is broken into “blocks” of content. Each chapter opens with a visual preview. Learning objective numbers highlight the location of re- lated content. Each “block” of content concludes with a Need-to-Know (NTK) to aid and reinforce student learning. Visual aids and concise, bullet-point dis- cussions further help students learn.

Learning Objectives

CONCEPTUAL C1 Explain the steps in processing

transactions and the role of source documents.

C2 Describe an account and its use in recording transactions.

C3 Describe a ledger and a chart of accounts.

PROCEDURAL P1 Record transactions in a journal and post

entries to a ledger.

P2 Prepare and explain the use of a trial balance.

P3 Prepare financial statements from business transactions.

C4 Define debits and credits and explain double-entry accounting.

ANALYTICAL A1 Analyze the impact of transactions on

accounts and financial statements.

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Chapter Preview

2 Recording Transactions

NTK 2-4

TRIAL BALANCE

P2 Trial balance preparation and use

Error identification

NTK 2-5

FINANCIAL STATEMENTS

P3 Financial statement preparation

A2 Debt ratio

NTK 2-3

RECORDING TRANSACTIONS

P1 Journalizing and posting

A1 Processing transactions— Examples

NTK 2-1

SYSTEM OF ACCOUNTS

Using financial statements

C1 Source documents

C2 Types of accounts C3 General ledger

NTK 2-2

DEBITS AND CREDITS

T-account

C4 Debits and credits

Normal balance

wiL16960_ch02_044-083.indd 44 5/3/18 2:14 PM

New Revenue Recognition • Wild uses the popular gross method

for merchandising transactions (net method is covered in an appendix). The gross method is widely used in practice and best for student success.

• Adjusting entries for new revenue rec- ognition rules are included in an ap- pendix. Assignments are clearly marked and separated. Wild is GAAP compliant.

154 Chapter 4 Accounting for Merchandising Operations

Z-Mart’s Merchandise Inventory account at the end of the year has a balance of $21,250, but a physical count shows only $21,000 of inventory exists. The adjusting entry to record this $250 shrinkage is

Dec . 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Adjust for $250 shrinkage.

Assets = Liabilities + Equity −250 −250

Sales Discounts, Returns, and Allowances—Adjusting Entries Revenue recognition rules require sales to be reported at the amount expected to be received. This means that period-end adjusting entries are commonly made for Expected sales discounts. Expected returns and allowances (revenue side). Expected returns and allowances (cost side).

These three adjustments produce three new accounts: Allowance for Sales Discounts, Sales Refund Payable, and Inventory Returns Estimated. Appendix 4B covers these accounts and the adjusting entries.

Preparing Financial Statements The financial statements of a merchandiser are similar to those for a service company described in prior chapters. The income statement mainly differs by the addition of cost of goods sold and gross profit. Net sales is affected by discounts, returns and allowances, and some additional expenses such as delivery expense and loss from defective merchandise. The balance sheet dif- fers by the addition of merchandise inventory as part of current assets. (Appendix 4B explains inventory returns estimated as part of current assets and sales refund payable as part of current liabilities.) The statement of retained earnings is unchanged.

Closing Entries for Merchandisers Closing entries are similar for service companies and merchandising companies. The difference is that we close some new temporary accounts that come from merchandising activities. Z-Mart has temporary accounts unique to merchandisers: Sales (of goods), Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. The third and fourth closing entries are identical for a mer- chandiser and a service company. The differences are in red in the closing entries of Exhibit 4.11.

EXHIBIT 4.11 Closing Entries for a Merchandiser

Step 1: Close Credit Balances in Temporary Accounts to Income Summary.

Step 2: Close Debit Balances in Temporary Accounts to Income Summary.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,100 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . 2,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,700 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,800 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,300 Close debit balances in temporary accounts.

Step 3: Close Income Summary.

Dec . 31 Income Summary . . . . . . 12,900 Retained Earnings . . 12,900

Step 4: Close Dividends.

Dec . 31 Retained Earnings . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . 4,000

Dec . 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Close credit balances in temporary accounts.

wiL47856_ch04_142-189.indd 154 9/20/18 9:12 AM

Up-to-Date This book reflects changes in accounting for revenue recognition, investments, leases, and extraordinary items. It is important that students learn GAAP accounting.

Less Is More Wild has markedly fewer pages than competing books covering the same material. • The text is to the point and uses visuals to aid student learning. • Bullet-point discussions and active writing aid learning. • The 8th edition has 112 fewer pages than the 7th edition—a 10% reduction!

Visual Learning • Learning analytics tell us to-

day’s students do not read large blocks of text. Wild has adapted to student needs by having in- formative visual aids through- out. Many visuals and exhibits are new to this edition.

$180 3

= $60 each

2. Last-in, first-out (LIFO) Costs flow in the reverse

order incurred.

3. Weighted average Costs flow at an average

of costs available.

1. First-in, first-out (FIFO) Costs flow in the order

incurred.

× 2× 1

Income Statement Net sales.................... $100

Cost of goods sold.. 45

Gross profit................ $ 55

Balance Sheet Inventory.................... $135

Income Statement Net sales.................... $100

Cost of goods sold.. 70

Gross profit................ $ 30

Balance Sheet Inventory.................... $1 10

Income Statement Net sales.................... $100

Cost of goods sold.. 60

Gross profit................ $ 40

Balance Sheet Inventory.................... $120

$65 May 3

$45 May 1 G

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G o o d s

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G o o d s

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$70 May 6

$65 May 3

$45 May 1

$70 May 6

$65 May 3

$45 May 1

Videos • A growing number of students now learn

accounting online. Wild offers over 1,500 videos designed to increase student en- gagement and improve outcomes.

• Hundreds of hint videos or Guided Examples provide a narrated, animated, step-by-step walk-through of select exer- cises similar to those assigned. These short presentations, which can be turned on or off by instructors, provide reinforcement when students need it most. (Exercise PowerPoints are available for instructors.)

• Concept Overview Videos cover each chapter’s learning objectives with nar- rated, animated presentations that fre- quently assess comprehension. Wild’s concept overview presentations cover learning objectives broken down into over 700 videos.

Chapter 7 Accounting for Receivables 277

Recovering a Bad Debt If an account that was written off is later collected, two en- tries are made. The first is to reverse the write-off and reinstate the customer’s account. The second is to record the collection of the reinstated account. If on March 11 Kent pays in full his account previously written off, the entries are

Exhibit 7.6 portrays the allowance method. It shows the creation of the allowance for future write-offs—adding to a cookie jar. It also shows the decrease of the allowance through write- offs—taking cookies from the jar.

A dj

us tin

g en

tr ie

Adjusting entries add to allowance for doubtful accounts.

Allowance for doubtful accounts

Write-o�s

Allowance for doubtful accounts

Bad debt write-o�s subtract from allowance for doubtful accounts.

Increase Allowance Decrease Allowance

Bad Debts Expense… # Allow. for Doubtful Accts… #

Allow. for Doubtful Accts… # Accts Receivable—J.Kent… #

EXHIBIT 7.6 Increases and Decreases to the Allowance for Doubtful Accounts

Assets = Liabilities + Equity +520 −520

Mar . 11 Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 520

Reinstate account previously written off.

Mar . 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

Accounts Receivable—J . Kent . . . . . . . . . . . . . . . . . . . . . 520

Record full payment of account.

Kent paid the entire amount previously written off, but sometimes a customer pays only a por- tion. If we believe this customer will later pay in full, we return the entire amount owed to accounts receivable (in the first entry only). If we expect no further collection, we return only the amount paid.

A retailer uses the allowance method. Record the following transactions.

Dec. 31 The retailer estimates $3,000 of its accounts receivable are uncollectible at its year-end. Feb. 14 The retailer determines that it cannot collect $400 of its accounts receivable from a customer

named ZZZ Company. Apr. 1 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its

recovery of this bad debt.

Solution

Entries under Allowance Method

NEED-TO-KNOW 7-3

Dec . 31 Bad Debts Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 3,000

Record estimated bad debts.

Feb . 14 Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Write off an account.

Apr . 1 Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Allowance for Doubtful Accounts . . . . . . . . . . . . . . . . . . . 400

Reinstate an account previously written off.

Apr . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Accounts Receivable—ZZZ Co . . . . . . . . . . . . . . . . . . . . . 400

Record cash received on account. Do More: QS 7-4, QS 7-5, E 7-5

wiL47856_ch07_270-301.indd 277 9/21/18 10:06 AM

Need-to-Know Demos Need-to-Know demonstrations are located at key junctures in each chapter. These demonstrations pose questions about the material just presented—content that students “need to know” to learn accounting. Accompanying solutions walk students through key procedures and analysis neces- sary to be successful with homework and test materials. Need-to-Know demonstrations are supplemented with narrated, animated, step-by-step walk- through videos led by an instructor and available via Connect.

Comprehensive Need-to-Know Comprehensive Need-to-Knows are problems that draw on material from the entire chapter. They include a complete solution, allowing students to review the entire problem-solving process and achieve success.

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s net sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase of 0.4 cents in research and development costs, which can be a positive development if these costs lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling, general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that segment’s operating income margin (Operating income/Segment net sales). The Americas seg- ment has a 32% operating income margin. This type of graphic can raise questions about the profitability of each segment and lead to discussion of further expansions into more profitable segments. For example, the Japan segment has an operating margin of 46%. A natural question for management is what potential is there to expand sales into the Japan segment and maintain

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0% Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1 Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7 Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8 Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6 Income before provision for income taxes . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5 Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

Difference Makers in Teaching . . . Driving Decisions Whether we prepare, analyze, or apply accounting infor- mation, one skill remains essential: decision making. To help develop good decision-making habits and to show the relevance of accounting, we use a learning framework. • Decision Insight provides context for business decisions. • Decision Ethics and Decision Maker are role-playing

scenarios that show the relevance of accounting. • Decision Analysis provides key tools to assess company

performance.

260 Chapter 7 Accounting Information Systems

The five components of accounting systems are source documents, input devices, information processors, information storage, and output devices. These components apply whether a system is computerized or manual. Exhibit 7.2 shows these components.

SYSTEM COMPONENTS Point: Computerized systems provide more accuracy and speed than manual.

Output Devices

Source Document

Input Devices

Information Processor

Information Storage

Cloud Storage

AppleApple

EXHIBIT 7.2 Accounting System Components

Source Documents Source documents provide the information processed by an ac- counting system. Examples include bank statements and checks, invoices from suppliers, cus- tomer bills, sales receipts, and employee earnings records. Accurate source documents are crucial to accounting information systems. Input of wrong information damages the reliability of the information system.

Input Devices Input devices take information from source documents and transfer it to information processing. These devices convert data on source documents to a form usable by the system. Journal entries are a type of input device. Keyboards and scanners are the most com- mon input devices in business.

Information Processors Information processors summarize information for use in analysis and reporting. An information processor includes journals, ledgers, working papers, and posting procedures. Each assists in transforming raw data to useful information.

Information Storage Information storage keeps data accessible to information pro- cessors. After being input and processed, data are stored for use in future analyses and reports. Auditors rely on this database when they audit both financial statements and a company’s con- trols. Modern systems depend increasingly on cloud storage.

Output Devices Output devices make accounting information available to users. Common output devices are printers, monitors, and smartphones. Output devices provide users a variety of items including customer bills, financial statements, and internal reports.

Point: Control procedures limit the possibility of entering wrong data.

Point: Controls ensure that only authorized individuals input data into the system.

©Amble Design/Shutterstock

Match each of the numbered descriptions with the principle, component, or descriptor that it best reflects. Indicate your answer by entering the letter A through J in the blank provided.

System Principles and Components

NEED-TO-KNOW 7-1

A. Control principle B. Relevance principle C. Compatibility principle D. Flexibility principle

E. Cost-benefit principle F. Source documents G. Input devices H. Information processors

I. Information storage J. Output devices

System’s Fine Print Nintendo’s stock increased greatly after the huge success of Pokémon Go. However, few investors read Nintendo’s disclosures that said it owned less than one-third of the company that developed the app. When investors realized this, the stock dropped 17%, representing over $6 billion in value. ■

Decision Insight

©Eric Audras/Getty Images

the benefits of producing a specific report must outweigh the costs of time and effort to produce that report. Decisions regarding other system principles (control, relevance, compatibility, and flexibility) are also affected by the cost-benefit principle.

wiL16960_ch07_258-289.indd 260 8/1/18 1:04 PM

When a buyer is responsible for paying transportation costs, the payment is made to a carrier or directly to the seller. The cost principle requires that transportation costs of a buyer (often called transportation-in or freight-in) be part of the cost of merchandise inventory. Z-Mart’s entry to record a $75 freight charge from UPS for merchandise purchased FOB shipping point is

Point: If we place an order online and receive free shipping, we have terms FOB destination.

(d) Nov . 24 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Paid freight costs on goods.

Assets = Liabilities + Equity +75 −75

When a seller is responsible for paying shipping costs, it records these costs in a Delivery Expense account. Delivery expense, also called transportation-out or freight-out, is reported as a selling expense in the seller’s income statement.

Itemized Costs of Purchases In summary, purchases are recorded as debits to Merchandise Inventory (or Inventory). Purchases discounts, returns, and allowances are credited to (subtracted from) Merchandise Inventory. Transportation-in is debited (added) to Merchandise Inventory. Z-Mart’s itemized costs of merchandise purchases for the year are in Exhibit 5.8.

The accounting system described here does not provide separate records (accounts) for total purchases, total pur- chases discounts, total purchases returns and allowances, and total transportation-in. Many companies collect this information in supple- mentary records to evaluate these costs. Supplementary records, or supplemental records, refer to information outside the usual ledger accounts.

Point: INcoming freight costs are charged to INventory. When inventory EXits, freight costs are charged to EXpense.

Itemized Costs of Merchandise Purchases

Invoice cost of merchandise purchases . . . . . . . . . $ 235,800

Less: Purchases discounts received . . . . . . . . . . . . (4,200)

Purchases returns and allowances . . . . . . . . . (1,500)

Add: Costs of transportation-in . . . . . . . . . . . . . . . . 2,300

Total net cost of merchandise purchases . . . . . . $232,400

EXHIBIT 5.8 Itemized Costs of Merchandise Purchases

Point: Some companies have separate accounts for purchases discounts, returns and allowances, and transportation-in. These accounts are then transferred to Merchandise Inventory at period- end. This is a hybrid system of perpetual and periodic. That is, Merchandise Inventory is updated on a perpetual basis but only for purchases and cost of goods sold.

Payables Manager As a new accounts payable manager, you are being trained by the outgoing manager. She explains that the system prepares checks for amounts net of favorable cash discounts, and the checks are dated the last day of the discount period. She tells you that checks are not mailed until five days later, adding that “the company gets free use of cash for an extra five days, and our department looks better.” Do you continue this policy? ■ Answer: One point of view is that the late payment policy is unethical. A deliberate plan to make late payments means the company lies when it pretends to make payment within the discount period. Another view is that the late payment policy is acceptable. Some believe attempts to take discounts through late payments are accepted as “price negotiation.”

Decision Ethics

Prepare journal entries to record each of the following purchases transactions of a merchandising com- pany. Assume a perpetual inventory system using the gross method for recording purchases.

Oct. 1 Purchased $1,000 of goods. Terms of the sale are 4∕10, n∕30, and FOB shipping point; the in- voice is dated October 1.

3 Paid $30 cash for freight charges from UPS for the October 1 purchase. 7 Returned $50 of the $1,000 of goods from the October 1 purchase and received full credit. 11 Paid the amount due from the October 1 purchase (less the return on October 7). 31 Assume the October 11 payment was never made. Instead, payment of the amount due, less the

return on October 7, occurred on October 31.

Solution

P1 Merchandise Purchases

NEED-TO-KNOW 5-2

Oct . 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Purchased goods, terms 4∕10, n∕30. Oct . 3 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Paid freight on purchases FOB shipping point.

[continued on next page]

wiL16960_ch05_166-213.indd 173 8/2/18 7:20 AM

Chapter 2 Analyzing and Recording Transactions 61

sheet lists its assets: cash, supplies, prepaid insurance, and equipment. The upper right side of the balance sheet shows that it owes $6,200 to creditors and $3,000 in services to customers who paid in advance. The equity section shows an ending capital balance of $33,195. Note the link between the ending balance of the statement of owner’s equity and the capital balance. (This presentation of the balance sheet is called the account form: assets on the left and liabili- ties and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity. Either presentation is acceptable.)

Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. Most of your cus- tomers want to buy on credit. How can you use the balance sheets of customers to decide which ones to extend credit to? ■ Answer: We use the accounting equation (Assets = Liabilities + Equity) to identify risky customers to whom we would not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would be to extend credit. A low equity means the business already has many creditor claims to it.

Decision Maker

©REDPIXEL.PL/Shutterstock

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. We usually put dollar signs be- side only the first and last numbers in a column. Apple’s financial statements in Appendix A show this. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level. Apple, like many large companies, rounds its financial statement amounts to the nearest million. This decision is based on the impact of rounding for users’ decisions.

Prepare a trial balance for Apple using the following condensed data from its recent fiscal year ended September 30 ($ in millions).

Preparing Trial Balance

NEED-TO-KNOW 2-4

P2Owner, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . $128,249 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Cost of sales (and other expenses) . . . . . . . . . . 141,048

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289

Revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Owner, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,553

Investments and other assets. . . . . . . . . . . . . . . . . . 303,373

Land and equipment . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Selling and other expense . . . . . . . . . . . . . . . . . . . . 39,835

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Solution ($ in millions)

APPLE Trial Balance

September 30

Do More: E 2-8, E 2-10

APPLE

Debit Credit

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Land and equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Investments and other assets . . . . . . . . . . . . . . . . . . . . . . 303,373

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Owner, Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,249

Owner, Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,553

Revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Cost of sales (and other expenses) . . . . . . . . . . . . . . . . . . 141,048

Selling and other expense . . . . . . . . . . . . . . . . . . . . . . . . . 39,835

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $598,755 $598,755

wiL16960_ch02_044-083.indd 61 5/3/18 2:15 PM

It is important to assess a company’s risk of failing to pay its debts. Companies finance their assets with either liabilities or equity. A company that finances a relatively large portion of its assets with liabilities is said to have higher financial leverage. Higher financial leverage means greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). One measure of the risk associated with liabilities is the debt ratio as defined in Exhibit 2.17.

Costco’s total liabilities, total assets, and debt ratio for the past three years are shown in Exhibit 2.18. Costco’s debt ratio ranges from a low of 0.63 to a high of 0.70. Its ratio exceeds Walmart’s in each of the last three years, suggesting a higher than average risk from financial leverage. So, is financial leverage good or bad for Costco? The answer: If Costco is making more money with this debt than it is paying the lenders, then it is successfully borrowing money to make more money. A company’s use of debt can turn unprofitable quickly if its return from that money drops below the rate it is paying lenders.

This problem extends Need-To-Know 1-6 from Chapter 1: Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month. a. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions. b. 2 Expressions paid $600 cash for furniture for the shop. c. 3 Expressions paid $500 cash to rent space in a strip mall for August. d. 4 Expressions purchased $1,200 of equipment on credit for the shop (recorded as accounts

payable). e. 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. f. 16 Expressions provided $100 of haircutting services on account. g. 17 Expressions received a $100 check for services previously rendered on account. h. 18 Expressions paid $125 to an assistant for hours worked for the grand opening. i. 31 Cash received from services provided during the second half of August was $930. j. 31 Expressions paid $400 cash toward the account payable entered into on August 4. k. 31 Worthy made a $900 cash withdrawal from the company for personal use.

Required

1. Open the following ledger accounts in balance column format (account numbers are in parentheses): Cash (101); Accounts Receivable (102); Furniture (161); Store Equipment (165); Accounts Payable (201); J. Worthy, Capital (301); J. Worthy, Withdrawals (302); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

COMPREHENSIVE

Journalizing and Posting Transactions, Statement Preparation, and Debt Ratio

NEED-TO-KNOW 2-5

EXHIBIT 2.17 Debt Ratio Debt ratio =

Total liabilities Total assets

62 Chapter 2 Analyzing and Recording Transactions

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Debt RatioDecision Analysis

Investor You consider buying stock in Converse. As part of your analysis, you compute the company’s debt ratio for 2017, 2018, and 2019 as 0.35, 0.74, and 0.94, respectively. Based on the debt ratio, is Converse a low-risk investment? Has the risk of buying Converse stock changed over this period? (The industry debt ratio averages 0.40.) ■ Answer: The debt ratio suggests that Converse’s stock is of higher risk than normal and that this risk is rising. The average industry ratio of 0.40 supports this conclusion. The 2019 debt ratio for Converse is twice the industry norm. Also, a debt ratio approaching 1.0 indicates little to no equity.

Decision Maker

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

Company $ millions Current Year 1 Year Ago 2 Years Ago

Costco Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $25,268 $20,831 $22,174 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,347 $33,163 $33,017 Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.70 0.63 0.67 Walmart Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .59 0 .58 0 .58

wiL16960_ch02_044-083.indd 62 7/12/18 5:20 AM

Accounting Analytics New to this edition, Accounting Analysis assignments have students evaluate the most current financial statements from Apple, Google, and Samsung. Students compute key metrics and compare perfor- mance between companies and industry. These assignments are auto-gradable in Connect and are included after Problem Set B in the text.

Chapter 7 Accounting for Receivables 299

Required

1. Prepare the adjusting entry to record bad debts expense on March 31, 2020, under each separate assumption. There is a zero unadjusted balance in the Allowance for Doubtful Accounts at March 31.

a. Bad debts are estimated to be 1% of total revenues. b. Bad debts are estimated to be 2% of accounts receivable. (Round to the dollar.) 2. Assume that Business Solutions’s Accounts Receivable balance at June 30, 2020, is $20,250 and that

one account of $100 has been written off against the Allowance for Doubtful Accounts since March 31, 2020. If Rey uses the method in part 1b, what adjusting journal entry is made to recognize bad debts expense on June 30, 2020?

3. Should Rey consider adopting the direct write-off method of accounting for bad debts expense rather than one of the allowance methods considered in part 1? Explain. ©Alexander Image/Shutterstock

Check (2) Dr. Bad Debts Expense, $48

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in accounting so that the financial professional can focus on the impacts of each transaction on various financial reports and perfor- mance measures.

GL 7-1 General Ledger assignment GL 7-1, based on Problem 7-5A, focuses on transactions related to accounts and notes receivable and highlights the impact each transaction has on interest revenue.

COMPANY ANALYSIS A1

Accounting Analysis

AA 7-1 Use Apple’s financial statements in Appendix A to answer the following. 1. What is the amount of Apple’s accounts receivable as of September 30, 2017? 2. Compute Apple’s accounts receivable turnover as of September 30, 2017. 3. How long does it take, on average, for the company to collect receivables for the fiscal year ended

September 30, 2017? 4. Apple’s most liquid assets include (a) cash and cash equivalents, (b) short-term marketable securities,

(c) accounts receivable, and (d ) inventory. Compute the percentage that these liquid assets (in total) make up of current liabilities as of September 30, 2017, and as of September 24, 2016.

5. Did Apple’s liquid assets as a percentage of current liabilities improve or worsen as of its fiscal 2017 year-end compared to its fiscal 2016 year-end?

APPLE

AA 7-2 Comparative figures for Apple and Google follow.

Apple Google

Current One Year Two Years Current One Year Two Years $ millions Year Prior Prior Year Prior Prior

Accounts receivable, net . . $ 17,874 $ 15,754 $ 16,849 $ 18,336 $14,137 $11,556

Net sales . . . . . . . . . . . . . . . 229,234 215,639 233,715 110,855 90,272 74,989

COMPARATIVE ANALYSIS A1 P2

APPLE GOOGLE

Required

1. Compute the accounts receivable turnover for (a) Apple and (b) Google for each of the two most recent years using the data shown.

2. Compute how many days, on average, it takes to collect receivables for the two most recent years for (a) Apple and (b) Google.

3. Which company more quickly collects its accounts receivable in the current year?

Hint: Average collection period equals 365 divided by the accounts receivable turnover.

wiL47856_ch07_270-301.indd 299 9/21/18 10:06 AM

Keep It Real Research shows that students learn best when using current data from real companies. Wild uses the most current data from real companies for assignments, examples, and analysis in the text. See Chapter 13 for use of real data.

APPLE

Samsung GOOGLE

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

504 Chapter 13 Analysis of Financial Statements

EXHIBIT 13.9 Common-Size Comparative Income Statements

APPLE

as representing one sales dollar, the remaining items show how each revenue dollar is distrib- uted among costs, expenses, and income.

Common-Size Graphics Exhibit 13.10 is a graphic of Apple’s current-year common-size income statement. This pie chart shows the contribution of each cost component of net sales for net income.

Exhibit 13.11 takes data from Apple’s Segments footnote. The exhibit shows the level of net sales for each of Apple’s five operating seg- ments. Its Americas segment gener-

Cost of sales 61.5%

Selling, general, administrative,

and other income 6.7%

Research and development

5.1%

Income taxes 6.9%

Net income, excluding non-

operating income and expenses

19.8%

EXHIBIT 13.10 Common-Size Graphic of Income Statement

N et

S al

es (i

n bi

l.)

$20

$40

$100

$80

$60

35%46%30%32%

$15.2$17.7

$54.9

$96.6

38%

$44.8

Americas Europe China Japan Asia Pacific

Segment percentages based on: Operating income/Net sales

EXHIBIT 13.11 Sales and Operating Income Margin Breakdown by Segment

APPLE INC. Common-Size Comparative Income Statements

Common-Size Percents* $ millions Current Yr Prior Yr Current Yr Prior Yr

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

wiL47856_ch13_496-533.indd 504 9/22/18 3:23 PM

vii

852 Chapter 21 Flexible Budgets and Standard Costs

Refer to the information in QS 21-14. Compute the overhead volume variance for November and classify it as favorable or unfavorable.

QS 21-15 Volume variance P4

Alvarez Company’s output for the current period yields a $20,000 favorable overhead volume variance and a $60,400 unfavorable overhead controllable variance. Standard overhead applied to production for the period is $225,000. What is the actual total overhead cost incurred for the period?

QS 21-16 Overhead cost variances

Refer to the information in QS 21-16. Alvarez records standard costs in its accounts. Prepare the journal entry to charge overhead costs to the Work in Process Inventory account and to record any variances.

QS 21-17A Preparing overhead entries

Refer to the information from QS 21-18. Compute the variable overhead spending variance and the vari- able overhead efficiency variance and classify each as favorable or unfavorable.

QS 21-19A Overhead spending and efficiency variances P5

Farad, Inc., specializes in selling used trucks. During the month, Farad sold 50 trucks at an average price of $9,000 each. The budget for the month was to sell 45 trucks at an average price of $9,500 each. Compute the dealership’s sales price variance and sales volume variance for the month and classify each as favor- able or unfavorable.

QS 21-20 Computing sales price and volume variances A1

AirPro Corp. reports the following for November. Compute the total overhead variance and controllable overhead variance for November and classify each as favorable or unfavorable.

QS 21-14 Controllable overhead variance

P4 Actual total factory overhead incurred . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,175 Standard factory overhead:

Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3 .10 per unit produced

Fixed overhead ($12,000∕12,000 predicted units to be produced) . . . . $1 per unit Predicted units to produce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 units

Actual units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,800 units

QS 21-18A Total variable overhead cost variance

Mosaic Company applies overhead using machine hours and reports the following information. Compute the total variable overhead cost variance and classify it as favorable or unfavorable.

Actual machine hours used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700 hours

Standard machine hours (for actual production) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 hours

Actual variable overhead rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4 .15

Standard variable overhead rate per hour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4 .00

In a recent year, BMW sold 182,158 of its 1 Series cars. Assume the company expected to sell 191,158 of these cars during the year. Also assume the budgeted sales price for each car was $30,000 and the actual sales price for each car was $30,200. Compute the sales price variance and the sales volume variance.

QS 21-21 Sales variances A1

MM Co. uses corrugated cardboard to ship its product to customers. Management believes it has found a more efficient way to package its products and use less cardboard. This new approach will reduce shipping costs from $10.00 per shipment to $9.25 per shipment. (1) If the company forecasts 1,200 shipments this year, what amount of total direct materials costs would appear on the shipping depart- ment’s flexible budget? (2) How much is this sustainability improvement predicted to save in direct materials costs for this coming year?

QS 21-22 Sustainability and standard costs

wiL47856_ch21_820-867.indd 852 9/4/18 9:51 AM

Doing What’s Right Companies increasingly issue sustainability reports, and accountants are being asked to prepare, analyze, and audit them. Wild includes brief sections in the managerial chapters. This material focuses on the importance of sustainability within the context of accounting, including standards from the Sustainability Accounting Standards Board (SASB). Sustainability assign- ments cover chapter material with a social responsibility twist.

Chapter 18 Managerial Accounting Concepts and Principles 667

Value Chain The value chain refers to the series of activities that add value to a company’s products or services. Exhibit 18.18 illustrates a possible value chain for a retail cookie company. Companies can use lean practices across the value chain to increase efficiency and profits.

Acquire raw materials Baking Sales Service

EXHIBIT 18.18 Typical Value Chain (cookie retailer)

How Lean Principles Impact the Value Chain Adopting lean principles can be challenging because systems and procedures that a company follows must be realigned. Managerial account- ing has an important role in providing accurate cost and performance information. Developing such a system is important to measuring the “value” provided to customers. The price that cus- tomers pay for acquiring goods and services is a key determinant of value. In turn, the costs a company incurs are key determinants of price.

Corporate Social Responsibility In addition to maximizing shareholder value, cor- porations must consider the demands of other stakeholders, including employees, suppliers, and society in general. Corporate social responsibility (CSR) is a concept that goes beyond fol- lowing the law. For example, to reduce its impact on the environment, Three Twins Ice Cream uses only cups and spoons made from organic ingredients. United By Blue, an apparel and jewelry company, removes one pound of trash from waterways for every product sold. Many companies extend the concept of CSR to include sustainability, which considers fu- ture generations when making business decisions.

Triple Bottom Line Triple bottom line focuses on three measures: financial (“profits”), social (“people”), and environmental (“planet”). Adopting a triple bottom line impacts how businesses report. In response to a growing trend of such reporting, the Sustainability Accounting Standards Board (SASB) was established to develop report- ing standards for businesses’ sustainability activities. Some of the business sectors for which the SASB has developed reporting standards include health care, nonrenewable re- sources, and renewable resources and alternative energy.

Point: Companies like Microsoft, Google, and Walt Disney, ranked at the top of large multinational companies in terms of CSR, disclose CSR results on their websites.

Economic

EnvironmentalSo ci

Triple Bottom Line

Balanced Scorecard The balanced scorecard aids continuous improvement by augmenting financial measures with information on the “drivers” (indicators) of future financial performance along four dimensions: (1) financial—profitabil- ity and risk, (2) customer—value creation and product and service differentiation, (3) internal business processes— business activities that create customer and owner satisfaction, and (4) learning and growth— organizational change, innovation, and growth. ■

Decision Insight

In creating sustainability accounting standards, the Sustainability Accounting Standards Board (SASB) has created reporting guidelines. The SASB considers sustainability information as material if its disclosure would affect the views of equity investors on a company’s financial condition or operating performance.

Material information can vary across industries; for example, while environmental “planet” issues such as air quality, wastewater management, and biodiversity impacts are important for investments in companies in the nonrenewable resources sectors, such issues are likely not as important for investments in banks. In contrast, “people” issues such as diversity and inclusion, fair labor practices, and employee health are considered material for most sectors, particularly those that use considerable direct labor.

SUSTAINABILITY AND ACCOUNTING

©MoringaConnect

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Cheat Sheets New to this edition, Cheat Sheets are provided at the end of each chapter. Cheat Sheets are roughly one page in length and include key procedures, concepts, journal entries, and formulas.

194 Chapter 5 Accounting for Merchandising Operations

If the invoice is paid on (or before) November 12 within the discount period, it records

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Purchases Discounts . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490

Gross Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Discounts Lost . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

If the invoice is paid after the discount period, it records

SALES—Periodic For sales transactions, the perpetual and periodic entries are identical except that under the periodic system the cost-side entries are not made at the time of each sale nor for any subsequent returns. Instead, the cost of goods sold is computed at period-end based on a physical count of inventory. This entry is shown in Exhibit 5A.1.

APPENDIX

Work Sheet—Perpetual System5D This appendix along with assignments is available online.

MERCHANDISING ACTIVITIES Merchandise: Goods a company buys to resell. Cost of goods sold: Costs of merchandise sold. Gross profit (gross margin): Net sales minus cost of goods sold. Computing net income (service company vs. merchandiser):

EqualsMinusEqualsMinus Expenses Netincome

Net sales

Merchandiser

Expenses NetincomeRevenues

Service Company Minus Equals

Gross profit

Cost of goods sold

Inventory: Costs of merchandise owned, but not yet sold. It is a current asset on the balance sheet. Merchandise Cost Flows:

Net purchases

Merchandise available for sale

Cost of goods sold

Ending inventory

Beginning inventory

Perpetual inventory system: Updates accounting records for each pur- chase and each sale of inventory. Periodic inventory system: Updates accounting records for purchases and sales of inventory only at the end of a period.

Summary: Cheat Sheet

MERCHANDISING PURCHASES Cash discount: A purchases discount on the price paid by the buyer; or, a sales discount on amount received for the seller. Credit terms example: “2/10, n/60” means full payment is due within 60 days, but the buyer can deduct 2% of the invoice amount if payment is made within 10 days. Gross method: Initially record purchases at gross (full) invoice amounts. Purchasing Merchandise for Resale Entries:

Transportation Costs and Ownership Transfer Rules:

Purchasing merchandise Merchandise Inventory . . . . . . . . 500 on credit Accounts Payable . . . . . . . . 500

Paying within discount period Accounts Payable . . . . . . . . . . . . 500 (Inventory reduced by Merchandise Inventory . . . 10 discount taken) Cash . . . . . . . . . . . . . . . . . . 490

Paying outside discount Accounts Payable . . . . . . . . . . . . 500 period Cash . . . . . . . . . . . . . . . . . . 500

Recording purchases Cash or Accounts Payable . . . . . 30 returns or allowances Merchandise Inventory . . . 30

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . . #

wiL16960_ch05_166-213.indd 194 8/2/18 7:20 AM

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▪ Over 210 assignments new to this edition—all available in Connect with algorithmic options. Nearly all are Quick Studies (brief exercises) and Exercises.

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Content Revisions Enhance Learning

Chapter 1 Updated opener—Apple and entrepreneurial assignment. Updated salary info for accountants. Revised business entity section along with adding LLC. Updated section on FASB objectives and accounting constraints. New layout for introducing the expanded accounting equation. New layout for introducing financial statements. Updated Apple numbers for NTK 1-5. New Cheat Sheet reinforces chapter content. Updated return on assets analysis using Nike and Under Armour. Added a new Exercise assignment and Quick Study assignment. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 2 NEW opener—Fitbit and entrepreneurial assignment. New visual for process to get from transactions to financial statements. New layout on four types of accounts that determine equity. Improved presentation of “Double-Entry System” section. Updated Apple data for NTK 2-4. Updated debt ratio analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added three new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 3 NEW opener—Snapchat and entrepreneurial assignment. Revised learning objectives and chapter preview—each type of adjusting entry is assigned its own learning objective. Updated “Recognizing Revenues and Expenses” section. New streamlined “Framework for Adjustments” section. Enhanced Exhibit 3.12 on summary of adjustments. Enhanced Exhibit 3.19 on steps of accounting cycle with images. Streamlined section on classified balance sheet. Updated profit margin analysis using Visa and Mastercard. Updated current ratio analysis using Costco and Walmart. Improved layouts for Exhibits 3A.1 through 3A.5. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 4 NEW opener—Build-A-Bear and entrepreneurial assignment. Updated introduction for servicers vs. merchandisers using Liberty Tax and Nordstrom. Revised NTK 4-1 covers basics of merchandising. Reorganized “Purchases” section to aid learning. New Decision Insight on growing number of returns for businesses. Enhanced entries on payment of purchases within discount period vs. after discount period. Improved discussion of entries for sales with discounts vs. sales without discounts. Color-coded Exhibit 4.12 highlights different merchandising transactions. Updated acid-test ratio and gross margin analysis using Nike and Under Armour. Appendix 4B explains adjusting entries for future sales discounts, returns, and allowances. Appendix 4C covers the net method. Appendix 4D moved to online only. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 5 NEW opener—Shake Shack and entrepreneurial assignment. New Ethical Risk on the alleged fraud of Homex. Simplified introduction to inventory costing. Shortened explanation for specific identification. Enhanced layout to explain effects of inventory errors across years. Updated inventory turnover and days’ sales in inventory analysis using Costco and Walmart. Added colored arrow lines to Exhibits 5A.3 and 5A.4 to show cost flows from purchases to sales. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 6 NEW opener—Care.com and entrepreneurial assignment. New COSO framework to guide internal control, including COSO cube. New discussion of internal control failure at Amazon that cost customers $150 million. Simplified bank statement for learning. Revised “Bank Reconciliation” section to separate bank balance adjustments and book balance adjustments.

New summary image on adjustments for bank balance and for book balance. Removed collection expenses and NSF fees—most are immaterial and covered in advanced courses. Updated days’ sales uncollected analysis using Starbucks and Jack in the Box. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added eight new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 7 NEW opener—Facebook and entrepreneurial assignment. Updated company data in Exhibit 7.1. Streamlined direct write-off method. Enhanced Exhibit 7.6 showing allowances set aside for future bad debts along with journal entries. New calendar graphic added as learning aid with Exhibit 7.12. New Excel demo to compute maturity dates. Updated accounts receivable analysis using Visa and Mastercard. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 8 NEW opener—New Glarus Brewery and entrepreneurial assignment. Updated company data in Exhibit 8.1. Added entry with Exhibit 8.3 and Exhibit 8.4. Simplified “Partial-Year Depreciation” section. Added margin table to Exhibit 8.14 as a learning aid. New Decision Insight box on extraordinary repairs to SpaceX’s reusable orbital rocket. New simple introduction to finance leases and operating leases for the new standard. Updated asset turnover analysis using Starbucks and Jack in the Box. Simplified Appendix 8A by postponing exchanges without commercial substance to advanced courses. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added one new Exercise. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 9 NEW opener—Pandora and entrepreneurial assignment. Updated data in Exhibit 9.2. Streamlined “Short-Term Notes Payable” section. Simplified explanation of FICA taxes.

Updated payroll tax rates and explanations. Revised NTK 9-4. New W-4 form added to Appendix 9A. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 10 NEW opener—e.l.f. Cosmetics and entrepreneurial assignment. Updated IBM bond quote data. Simplified numbers in Exhibit 10.7. Simplified Exhibit 10.10 on premium bonds. Simplified numbers in Exhibit 10.11. Bond pricing moved to Appendix 10A. Simplified Exhibit 10.12 for teaching the note amortization schedule. Updated debt-to-equity analysis using Nike and Under Armour. New Excel computations for bond pricing in Appendix 10A. Simplified numbers in Exhibits 10B.1 and 10B.2. Revised Appendix 10C for new standard on finance leases and operating leases. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added four new Exercises. Added four new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 11 NEW opener—Yelp and entrepreneurial assignment. New Decision Insight on bots investing in stocks based on erroneous news. New AT&T stock quote explanation. New graphic visually depicting cash dividend dates. New table summarizing differences between small stock dividends, large stock dividends, and stock splits. Updated Apple statement of equity in Exhibit 11.10. Updated PE ratio and dividend yield using Amazon, Altria, Visa, and Mastercard. Simplified book value per share explanation and computations. New Cheat Sheet reinforces chapter content. Added six new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 12 NEW opener—Vera Bradley and entrepreneurial assignment. Slightly revised infographics on cash flows from operating, investing, and financing. Streamlined sections on analyzing the cash account and noncash accounts.

Instructors and students guided this edition’s revisions. Revisions include ∙ New Accounting Analysis assignments—all available in Connect—

using real-world data from Apple, Google, and Samsung. ∙ Many new and revised General Ledger and Excel assignments. ∙ New assignments that focus on financial statement preparation. ∙ Updated videos for each learning objective in new Concept Overview Video format. ∙ Many new Need-to-Know (NTK) demos and accompanying videos to reinforce

learning.

∙ New Cheat Sheets at each chapter-end visually reinforce key chapter concepts. ∙ More concise text covering the same content. New 8th edition has 112 fewer

pages than 7th edition. ∙ Over 210 new assignments—all available in Connect with algorithmic options. ∙ Gross method is used for merchandising transactions, reflecting practice—adjusting

entries for new revenue recognition rules are set in an appendix. ∙ Revised Investments chapter for the new standard.

xiii

New presentation to aid learning of indirect adjustments to income. Simplified T-accounts to reconstruct cash flows. New box on Tesla’s cash outflows and growing market value. Simplified reconstruction entries to help compute cash flows. Updated cash flow on total assets analysis using Nike and Under Armour. New Cheat Sheet reinforces chapter content. Added ten new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 13 Updated opener—Morgan Stanley and entrepreneurial assignment. Updated data for all analyses of Apple using horizontal, vertical, and ratio analysis. Updated comparative analysis using Google and Samsung. Streamlined section on ratio analysis. Streamlined the “Analysis Reporting” section. Shortened Appendix 13A. New Cheat Sheet reinforces chapter content. Added eight new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 14 NEW opener—MoringaConnect and entrepreneurial assignment. Added discussion on role of managerial accounting for nonaccounting and nonbusiness majors. New margin exhibit showing product and period cost flows. Added equation boxes for total manufacturing costs and cost of goods manufactured. Added lists of common selling and administrative expenses. Updated and edited several exhibits for clarity. New Cheat Sheet reinforces chapter content. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 15 NEW opener—HoopSwagg and entrepreneurial assignment. Revised discussions of manufacturing costs and link between job cost sheets and general ledger. Added graphic linking job cost sheets and general ledger accounts. Enhanced exhibit of 4-step overhead process. Added formula for computing applied overhead. New short discussion of cost-plus pricing. Added margin T-accounts and calculations for clarity.

New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 16 NEW opener—Azucar Ice Cream and entrepreneurial assignment. Revised discussion comparing process and job order costing systems. Added cost flow graphic. New margin graphic illustrating EUP. Revised discussion of weighted-average versus FIFO method of process costing. Revised discussion of using the process cost summary. New graphic on FIFO goods flow. Added margin T-accounts and calculations for clarity. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 17 NEW opener—Sycamore Brewing and entrepreneurial assignment. New graphic showing activities for service businesses. Added examples to discussion of ABC for service businesses. New Cheat Sheet reinforces chapter content. Added one new Discussion Question. Added one new Quick Study. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 18 NEW opener—Ellis Island Tropical Tea and entrepreneurial assignment. Added margin graphs of fixed, variable, and mixed costs. New Excel steps to create a line chart. Moved details of creating scatter plot to Appendix 18A, with Excel steps. Revised discussion of scatter plots. Moved details of creating a CVP chart to Appendix 18C, with Excel steps. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 19 NEW opener—Lantern Inn B&B and entrepreneurial assignment. New Cheat Sheet reinforces chapter content. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 20 NEW opener—Misfit Juicery and entrepreneurial assignment.

Added T-accounts and steps to exhibit margins. Added numbered steps to several exhibits. Expanded discussion of cost of goods sold budgeting. New exhibit for calculation of cash paid for interest. Expanded discussion with bulleted list on use of a master budget. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added one new Exercise. New assignment on CMA exam budgeting coverage. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 21 NEW opener—Away and entrepreneurial assignment. Added graph to flexible budget exhibit. Revised discussion of flexible budget. New exhibit and discussion of computing total cost variance. Edited discussion of direct materials cost variance. Edited discussion of evaluating labor variances. Edited discussion of overhead variance reports. New exhibit for summary of variances. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 22 NEW opener—Jibu and entrepreneurial assignment. Updated Walt Disney ROI example. New Decision Analysis on cash conversion cycle. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 23 NEW opener—Solugen and entrepreneurial assignment. Organized decision scenarios into three types: production, capacity, and pricing. Expanded discussion of product pricing. Added other pricing methods: value-based, auction-based, and dynamic. New Decision Insight on blockchain technology. New Decision Analysis on time and materials pricing of services. New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added one new Exercise.

Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 24 NEW opener—Fellow Robots and entrepreneurial assignment. Added example of investment in robotics. New discussion of postaudit of investment decisions. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Appendix A New financial statements for Apple, Google, and Samsung.

Appendix B New Decision Maker on postponed retail pricing. Continued Excel demos for PV and FV of lump sums. Continued Excel demos for PV and FV of annuities.

Appendix C New learning objective P4 for new category of stock investments. Revised and simplified Exhibit C.2 for new standard on investments. Reorganized text to first explain debt securities and then stock securities. Revised trading and available-for-sale securities to cover only debt securities given the new standard. New section on stock investments with insignificant influence. New Exhibit C.6 to describe accounting for equity securities by ownership level. Updated component-returns analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added four new Exercises. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Appendix D NEW appendix on lean principles and accounting. Describes lean business principles. Measures production efficiency. Illustrates how to account for product costs using lean accounting. New: 13 Discussion Questions, 14 Quick Studies, 14 Exercises, and 3 Problems.

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Darlene Adkins, University of Tennessee–Martin Peter Aghimien, Indiana University South Bend Janice Akao, Butler Community College Nathan Akins, Chattahoochee Technical College John Alpers, Tennessee Wesleyan University Sekhar Anantharaman, Indiana University of Pennsylvania Karen Andrews, Lewis-Clark State College Chandra D. Arthur, Cuyahoga Community College Steven Ault, Montana State University Victoria Badura, Metropolitan Community College Felicia Baldwin, City College of Chicago Reb Beatty, Anne Arundel Community College Robert Beebe, Morrisville State College George Henry Bernard, Seminole State College of Florida Cynthia Bird, Tidewater Community College, Virginia Beach Pascal Bizarro, Bowling Green State University Amy Bohrer, Tidewater Community College, Virginia Beach John Bosco, North Shore Community College Nicholas Bosco, Suffolk County Community College Jerold K. Braun, Daytona State College Doug Brown, Forsyth Technical Community College Tracy L. Bundy, University of Louisiana at Lafayette Marci Butterfield, University of Utah Ann Capion, Scott Community College Amy Cardillo, Metropolitan State University of Denver Anne Cardozo, Broward College Crystal Carlson-Myer, Indian River State College Julie Chasse, Des Moines Area Community College Patricia Chow, Grossmont College Maria Coclin, Community College of Rhode Island Michael Cohen, Lewis-Clark State College Jerilyn Collins, Herzing University Scott Collins, Penn State University, University Park William Conner, Tidewater Community College Erin Cornelsen, University of South Dakota

Mariah Dar, John Tyler Community College Nichole Dauenhauer, Lakeland Community College Donna DeMilia, Grand Canyon University Tiffany DeRoy, University of South Alabama Susan Dickey, Motlow State Community College Erin Dischler, Milwaukee Area Technical College–West Allis Holly Dixon, State College of Florida Vicky Dominguez, College of Southern Nevada David Doyon, Southern New Hampshire University Chester Drake, Central Texas College Christopher Eller, Appalachian State University Cynthia Elliott, Southwest Tennessee Community College–Macon Kim Everett, East Carolina University Corinne Frad, Eastern Iowa Community College Krystal Gabel, Southeast Community College Harry Gallatin, Indiana State University Rena Galloway, State Fair Community College Rick Gaumer, University of Wisconsin–Green Bay Tammy Gerszewski, University of North Dakota Pradeep Ghimire, Rappahannock Community College Marc Giullian, Montana State University, Bozeman Nelson Gomez, Miami Dade College–Kendall Robert Goodwin, University of Tampa Steve G. Green, U.S. Air Force Academy Darryl Greene, Muskegon Community College Lisa Hadley, Southwest Tennessee Community College–Macon Penny Hahn, KCTCS Henderson Community College Yoon Han, Bemidji State University Becky Hancock, El Paso Community College Amie Haun, University of Tennessee–Chattanooga Michelle Hays, Kalamazoo Valley Community College Rhonda Henderson, Olive Harvey College Lora Hines, John A. Logan College

Acknowledgments John J. Wild, Ken W. Shaw, and McGraw-Hill Education recognize the following instructors for their valuable feedback and involvement in the development of Financial and Managerial Accounting. We are thankful for their suggestions, counsel, and encouragement.

Rob Hochschild, Ivy Tech Community College of Indiana– South Bend John Hoover, Volunteer State Community College Roberta Humphrey, Southeast Missouri State University Carley Hunzeker, Metro Community College, Elkhorn Kay Jackson, Tarrant County College South Elizabeth Jennison, Saddleback College Mary Jepperson, Saint John’s University Vicki Jobst, Benedictine University Odessa Jordan, Calhoun Community College Susan Juckett, Victoria College Amanda Kaari, Central Georgia Technical College Ramadevi Kannan, Owens Community College Jan Klaus, University of North Texas Aaron P. Knape, The University of New Orleans Cedric Knott, Henry Ford Community College Robin Knowles, Texas A&M International University Kimberly Kochanny, Central Piedmont Community College Sergey Komissarov, University of Wisconsin–La Crosse Stephanie Lareau Kroeger, Ocean County College Joseph Krupka, Lander University Tara Laken, Joliet Junior College Suzanne Lay, Colorado Mesa University Brian Lazarus, Baltimore City Community College Kevin Leifer, Long Island University, CW Post Campus Harold Levine, Los Angeles Valley College Yuebing Liu, University of Tampa Philip Lee Little, Coastal Carolina University Delores Loedel, Miracosta College Rebecca Lohmann, Southeast Missouri State University Ming Lu, Santa Monica Community College Annette C. Maddox, Georgia Highlands College Natasha Maddox, KCTCS Maysville Community and Technical College Rich Mandau, Piedmont Technical College Robert Maxwell, College of the Canyons Karen McCarron, Georgia Gwinnett College Michael McDonald, College of Southern Nevada Gwendolyn McFadden-Wade, North Carolina A&T University Allison McLeod, University of North Texas

Kate McNeil, Johnson County Community College Jane Medling, Saddleback College Heidi H. Meier, Cleveland State University Tammy Metzke, Milwaukee Area Technical College Jeanine Metzler, Northampton Community College Michelle Meyer, Joliet Junior College Pam Meyer, University of Louisiana at Lafayette Deanne Michaelson, Pellissippi State Community College Susan Miller, County College of Morris Carmen Morgan, Oregon Tech Karen Satterfield Mozingo, Pitt Community College Haris Mujahid, South Seattle College Andrea Murowski, Brookdale Community College Jaclynn Myers, Sinclair Community College Micki Nickla, Ivy Tech Community College of Indiana–Gary Dan O’Brien, Madison College–Truax Jamie O’Brien, South Dakota State University Grace Odediran, Union County College Ashley Parker, Grand Canyon University Pamela Parker, NOVA Community College Alexandria Margaret Parrish, John Tyler Community College Reed Peoples, Austin Community College Rachel Pernia, Essex County College Brandis Phillips, North Carolina A&T University Debbie Porter, Tidewater Community College–Virginia Beach M. Jeff Quinlan, Madison Area Technical College James E. Racic, Lakeland Community College Ronald de Ramon, Rockland Community College Robert J. Rankin, Texas A&M University–Commerce Robert Rebman, Benedictine University Jenny Resnick, Santa Monica Community College DeAnn Ricketts, York Technical College Renee Rigoni, Monroe Community College Kevin Rosenberg, Southeastern Community College David Rosser, University of Texas at Arlington Michael J. Rusek, Eastern Gateway Community College Alfredo Salas, El Paso Community College Carolyn Satz, Tidewater Community College–Chesapeake Kathy Saxton, Bryant & Stratton College

xvi

Many talented educators and professionals have worked hard to create the materials for this product, and for their efforts, we’re grateful. We extend a special thank you to our contributing and technology supplement authors, who have worked so diligently to support this product.

Contributing Author, Connect Content, General Ledger Problems, and Exercise PowerPoints: Kathleen O’Donnell, Onondaga Community College

Text and Supplements Accuracy Checkers: Dave Krug, Johnson County Community College; Mark McCarthy, East Carolina University; Kate McNeil, Johnson County Community College; Wanda Wong, Chabot College; and Beth Kobylarz

Test Bank Authors and Accuracy Checkers: Melodi Bunting, Madison College; Brian Schmoldt, Madison College; M. Jeff Quinlan, Madison College; and Teri Zuccaro, Clarke University

LearnSmart Author, Concept Overview Videos, PowerPoint Presentations, and Instructor Resource Manual: April Mohr, Jefferson Community and Technical College, SW

Wilson Seda, Lehman College–CUNY Perry Sellers, Lonestar College–North Harris James Shimko, Ferris State University Philip Slater, Forsyth Technical Community College Clayton Smith, Columbia College Chicago Patricia Smith, DePaul University Jane Stam, Onondaga Community College Natalie Strouse, Notre Dame College Erica Teague-Friend, Gwinnett Technical College Louis Terrero, Lehman College Geoff Tickell, Indiana University of Pennsylvania Judith A. Toland, Bucks County Community College Debra Touhey, Ocean County College Jim Ulmer, Angelina College Bob Urell, Irvine Valley College Kevin Veneskey, Ivy Tech Community College

Teresa Walker, North Carolina A&T University Terri Walsh, Seminole State College of Florida Eric Weinstein, Suffolk County Community College, Brentwood Andy Welchel, Greenville Technical College Joe Welker, College of Western Idaho Jean Wells, Howard University Denise White, Austin Community College Jonathan M. Wild, Oklahoma State University Kenneth Wise, Wilkes Community College Shondra Woessner, Holyoke Community College Mindy Wolfe, Arizona State University Jan Workman, East Carolina University Lori Zaher, Bucks County Community College Jessie Zetnick, Texas Woman’s University Laurence Zuckerman, Fulton-Montgomery Community College

Special recognition extends to the entire team at McGraw-Hill Education: Tim Vertovec, Steve Schuetz, Natalie King, Michelle Williams, Julie Wolfe, Michele Janicek, Christina Sanders, Michael McCormick, Lori Koetters, Xin Lin, Kevin Moran, Debra Kubiak, Brian Nacik, and Daryl Horrocks. We could not have published this new edition without your efforts.

John J. Wild Ken W. Shaw

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Brief Contents 1 Accounting in Business 2 2 Accounting for Business

Transactions 44

3 Adjusting Accounts for Financial Statements 84

4 Accounting for Merchandising Operations 142

5 Inventories and Cost of Sales 190 6 Cash, Fraud, and Internal Control 234 7 Accounting for Receivables 270 8 Accounting for Long-Term Assets 302 9 Accounting for Current Liabilities 340 10 Accounting for Long-Term Liabilities 380 11 Corporate Reporting and Analysis 416 12 Reporting Cash Flows 452 13 Analysis of Financial Statements 496 14 Managerial Accounting Concepts and

Principles 534

15 Job Order Costing and Analysis 570 16 Process Costing and Analysis 610

17 Activity-Based Costing and Analysis 656 18 Cost Behavior and Cost-Volume-Profit

Analysis 696

19 Variable Costing and Analysis 738 20 Master Budgets and Performance

Planning 770

21 Flexible Budgets and Standard Costs 820

22 Performance Measurement and Responsibility Accounting 868

23 Relevant Costing for Managerial Decisions 912

24 Capital Budgeting and Investment Analysis 946

A Financial Statement Information A-1 B Time Value of Money B C Investments C D Lean Principles and Accounting D-1 CA Chart of Accounts CA BR Brief Review BR-1

xviii

Preface iv

1 Accounting in Business 2 Importance of Accounting 3

Users of Accounting Information 4 Opportunities in Accounting 4

Fundamentals of Accounting 6 Ethics—A Key Concept 6 Generally Accepted Accounting Principles 7 Conceptual Framework 7

Business Transactions and Accounting 9 Accounting Equation 10 Transaction Analysis 11 Summary of Transactions 14

Communicating with Users 15 Income Statement 15 Statement of Retained Earnings 17 Balance Sheet 17 Statement of Cash Flows 17

Decision Analysis—Return on Assets 18 Appendix 1A Return and Risk 21 Appendix 1B Business Activities 22

2 Accounting for Business Transactions 44 Basis of Financial Statements 45

Source Documents 45 The “Account” Underlying Financial Statements 45 Ledger and Chart of Accounts 48

Double-Entry Accounting 49 Debits and Credits 49 Double-Entry System 49

Analyzing and Processing Transactions 51 Journalizing and Posting Transactions 51 Processing Transactions—An Example 52 Summarizing Transactions in a Ledger 57

Trial Balance 58 Preparing a Trial Balance 58 Financial Statements Prepared from Trial Balance 58

Decision Analysis—Debt Ratio 62

3 Adjusting Accounts for Financial Statements 84

Timing and Reporting 85 The Accounting Period 85 Accrual Basis versus Cash Basis 86 Recognizing Revenues and Expenses 86 Framework for Adjustments 87

Deferral of Expense 87 Prepaid Insurance 87 Supplies 88 Other Prepaid Expenses 89 Depreciation 89

Deferral of Revenue 91 Unearned Consulting Revenue 91

Accrued Expense 93 Accrued Salaries Expense 93 Accrued Interest Expense 94 Future Cash Payment of Accrued

Expenses 94

Accrued Revenue 95 Accrued Services Revenue 96 Accrued Interest Revenue 96 Future Cash Receipt of Accrued Revenues 96 Links to Financial Statements 97

Trial Balance and Financial Statements 98 Adjusted Trial Balance 98 Preparing Financial Statements 99

Closing Process 100 Temporary and Permanent Accounts 101 Recording Closing Entries 101 Post-Closing Trial Balance 104

Accounting Cycle 104 Classified Balance Sheet 105

Classification Structure 105 Classification Categories 106

Decision Analysis—Profit Margin and Current Ratio 108

Appendix 3A Alternative Accounting for Prepayments 111

Appendix 3B Work Sheet as a Tool 113 Appendix 3C Reversing Entries 115

Contents

Contents xix

Valuing Inventory at LCM and the Effects of Inventory Errors 200 Lower of Cost or Market 200 Financial Statement Effects of Inventory

Errors 201

Decision Analysis—Inventory Turnover and Days’ Sales in Inventory 203

Appendix 5A Inventory Costing under a Periodic System 209

Appendix 5B Inventory Estimation Methods 214

6 Cash, Fraud, and Internal Control 234 Fraud and Internal Control 235

Purpose of Internal Control 235 Principles of Internal Control 236 Technology, Fraud, and Internal Control 237 Limitations of Internal Control 237

Control of Cash 238 Cash, Cash Equivalents, and Liquidity 238 Cash Management 238 Control of Cash Receipts 239 Control of Cash Payments 241

Banking Activities as Controls 245 Basic Bank Services 245 Bank Statement 246 Bank Reconciliation 247

Decision Analysis—Days’ Sales Uncollected 250 Appendix 6A Documentation and

Verification 252

7 Accounting for Receivables 270 Valuing Accounts Receivable 271 Direct Write-Off Method 274 Allowance Method 275 Estimating Bad Debts 278

Percent of Sales Method 278 Percent of Receivables Method 278 Aging of Receivables Method 279

Notes Receivable 281 Computing Maturity and Interest 282 Recording Notes Receivable 283 Valuing and Settling Notes 283 Disposal of Receivables 285

Decision Analysis—Accounts Receivable Turnover 285

4 Accounting for Merchandising Operations 142

Merchandising Activities 143 Reporting Income for a Merchandiser 143 Reporting Inventory for a Merchandiser 144 Operating Cycle for a Merchandiser 144 Inventory Systems 144

Accounting for Merchandise Purchases 145 Purchases without Cash Discounts 145 Purchases with Cash Discounts 145 Purchases with Returns and Allowances 147 Purchases and Transportation Costs 148

Accounting for Merchandise Sales 150 Sales without Cash Discounts 150 Sales with Cash Discounts 151 Sales with Returns and Allowances 151

Adjusting and Closing for Merchandisers 153 Adjusting Entries for Merchandisers 153 Preparing Financial Statements 154 Closing Entries for Merchandisers 154 Summary of Merchandising Entries 155

More on Financial Statement Formats 156 Multiple-Step Income Statement 156 Single-Step Income Statement 157 Classified Balance Sheet 158

Decision Analysis—Acid-Test and Gross Margin Ratios 159

Appendix 4A Periodic Inventory System 163 Appendix 4B Adjusting Entries under New Revenue

Recognition Rules 167 Appendix 4C Net Method for Merchandising 168

5 Inventories and Cost of Sales 190 Inventory Basics 191

Determining Inventory Items 191 Determining Inventory Costs 192 Internal Controls and Taking

a Physical Count 192

Inventory Costing under a Perpetual System 193 Inventory Cost Flow Assumptions 193 Inventory Costing Illustration 194 Specific Identification 194 First-In, First-Out 195 Last-In, First-Out 195 Weighted Average 196 Financial Statement Effects of Costing Methods 197 Tax Effects of Costing Methods 198

xx Contents

Warranty Liabilities 350 Multi-Period Estimated Liabilities 351

Contingent Liabilities 352 Accounting for Contingent Liabilities 352 Applying Rules of Contingent Liabilities 353 Uncertainties That Are Not Contingencies 353

Decision Analysis—Times Interest Earned Ratio 353

Appendix 9A Payroll Reports, Records, and Procedures 356

Appendix 9B Corporate Income Taxes 361

10 Accounting for Long-Term Liabilities 380 Basics of Bonds 381

Bond Financing 381 Bond Issuing 382 Bond Trading 382

Par Bonds 382 Discount Bonds 383

Bond Discount or Premium 383 Issuing Bonds at a Discount 384

Premium Bonds 386 Issuing Bonds at a Premium 386 Bond Retirement 388

Long-Term Notes Payable 390 Installment Notes 390 Mortgage Notes and Bonds 391

Decision Analysis—Debt Features and the Debt-to-Equity Ratio 392

Appendix 10A Bond Pricing 395 Appendix 10B Effective Interest

Amortization 397 Appendix 10C Leases and Pensions 398

11 Corporate Reporting and Analysis 416 Corporate Form of Organization 417

Corporate Advantages 417 Corporate Disadvantages 417 Corporate Organization and Management 418 Corporate Stockholders 418 Corporate Stock 419

Common Stock 420 Issuing Par Value Stock 420 Issuing No-Par Value Stock 421 Issuing Stated Value Stock 421 Issuing Stock for Noncash Assets 421

8 Accounting for Long-Term Assets 302 SECTION 1—PLANT ASSETS 303 Cost Determination 304

Machinery and Equipment 304 Buildings 304 Land Improvements 304 Land 304 Lump-Sum Purchase 305

Depreciation 305 Factors in Computing Depreciation 305 Depreciation Methods 305 Partial-Year Depreciation 309 Change in Estimates 310 Reporting Depreciation 310

Additional Expenditures 311 Ordinary Repairs 312 Betterments and Extraordinary Repairs 312

Disposals of Plant Assets 312 Discarding Plant Assets 313 Selling Plant Assets 313

SECTION 2—NATURAL RESOURCES 315 Cost Determination and Depletion 315 Plant Assets Tied into Extracting 316

SECTION 3—INTANGIBLE ASSETS 317 Cost Determination and Amortization 317 Types of Intangibles 317

Decision Analysis—Total Asset Turnover 320 Appendix 8A Exchanging Plant Assets 323

9 Accounting for Current Liabilities 340 Known Liabilities 341

Characteristics of Liabilities 341 Examples of Known Liabilities 342 Accounts Payable 343 Sales Taxes Payable 343 Unearned Revenues 343 Short-Term Notes Payable 343

Payroll Liabilities 346 Employee Payroll and Deductions 346 Employer Payroll Taxes 347 Internal Control of Payroll 348 Multi-Period Known Liabilities 348

Estimated Liabilities 349 Health and Pension Benefits 349 Vacation Benefits 350 Bonus Plans 350

Contents xxi

13 Analysis of Financial Statements 496 Basics of Analysis 497

Purpose of Analysis 497 Building Blocks of Analysis 497 Information for Analysis 498 Standards for Comparisons 498 Tools of Analysis 498

Horizontal Analysis 498 Comparative Statements 498 Trend Analysis 501

Vertical Analysis 502 Common-Size Statements 502 Common-Size Graphics 504

Ratio Analysis 506 Liquidity and Efficiency 506 Solvency 508 Profitability 509 Market Prospects 510 Summary of Ratios 511

Decision Analysis—Analysis Reporting 512 Appendix 13A Sustainable Income 515

14 Managerial Accounting Concepts and Principles 534

Managerial Accounting Basics 535 Purpose of Managerial Accounting 535 Nature of Managerial Accounting 536 Fraud and Ethics in Managerial Accounting 537 Career Paths 538

Managerial Cost Concepts 539 Types of Cost Classifications 539 Identification of Cost Classifications 541 Cost Concepts for Service Companies 541

Managerial Reporting 542 Manufacturing Costs 542 Nonmanufacturing Costs 542 Prime and Conversion Costs 543 Costs and the Balance Sheet 543 Costs and the Income Statement 543

Cost Flows and Cost of Goods Manufactured 546 Flow of Manufacturing Activities 546 Schedule of Cost of Goods Manufactured 547 Trends in Managerial Accounting 550

Decision Analysis—Raw Materials Inventory Turnover and Days’ Sales in Raw Materials Inventory 552

Dividends 422 Cash Dividends 422 Stock Dividends 423 Stock Splits 425 Financial Statement Effects of Dividends and

Splits 425

Preferred Stock 426 Issuance of Preferred Stock 426 Dividend Preference of Preferred Stock 427 Reasons for Issuing Preferred Stock 427

Treasury Stock 429 Purchasing Treasury Stock 429 Reissuing Treasury Stock 429

Reporting of Equity 431 Statement of Retained Earnings 431 Statement of Stockholders’ Equity 432

Decision Analysis—Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share 432

12 Reporting Cash Flows 452 Basics of Cash Flow Reporting 453

Purpose of the Statement of Cash Flows 453 Importance of Cash Flows 453 Measurement of Cash Flows 453 Classification of Cash Flows 454 Noncash Investing and Financing 455 Format of the Statement of Cash Flows 455 Preparing the Statement of Cash Flows 456

Cash Flows from Operating 457 Indirect and Direct Methods of Reporting 457 Applying the Indirect Method 457 Summary of Adjustments for Indirect Method 460

Cash Flows from Investing 461 Three-Step Analysis 461 Analyzing Noncurrent Assets 461

Cash Flows from Financing 463 Three-Step Analysis 463 Analyzing Noncurrent Liabilities 463 Analyzing Equity 464 Proving Cash Balances 464

Summary Using T-Accounts 466 Decision Analysis—Cash Flow Analysis 467 Appendix 12A Spreadsheet Preparation of the

Statement of Cash Flows 470 Appendix 12B Direct Method of Reporting

Operating Cash Flows 472

xxii Contents

Decision Analysis—Hybrid Costing System 627

Appendix 16A FIFO Method of Process Costing 631

17 Activity-Based Costing and Analysis 656 Assigning Overhead Costs 657

Alternative Methods of Overhead Allocation 657

Plantwide Overhead Rate Method 658 Departmental Overhead Rate Method 660 Assessing Plantwide and Departmental

Overhead Rate Methods 662

Activity-Based Costing 663 Steps in Activity-Based Costing 663 Applying Activity-Based Costing 664 Assessing Activity-Based Costing 668

Activity-Based Management 669 Activity Levels and Cost Management 669 Costs of Quality 670 Lean Manufacturing 671 ABC for Service Providers 671

Decision Analysis—Customer Profitability 673

18 Cost Behavior and Cost-Volume-Profit Analysis 696

Identifying Cost Behavior 697 Fixed Costs 698 Variable Costs 698 Graphing Fixed and Variable Costs against

Volume 698 Mixed Costs 698 Step-wise Costs 699 Curvilinear Costs 700

Measuring Cost Behavior 701 Scatter Diagram 701 High-Low Method 702 Regression 702 Comparing Cost Estimation Methods 702

Contribution Margin and Break-Even Analysis 703 Contribution Margin and Its Measures 703 Break-Even Point 704 Cost-Volume-Profit Chart 706 Changes in Estimates 706

Applying Cost-Volume-Profit Analysis 707 Margin of Safety 707 Computing Income from Sales and Costs 708

15 Job Order Costing and Analysis 570 Job Order Costing 571

Cost Accounting System 571 Job Order Production 571 Job Order vs. Process Operations 572 Production Activities in Job Order Costing 572 Cost Flows 573 Job Cost Sheet 573

Materials and Labor Costs 574 Materials Cost Flows and Documents 574 Labor Cost Flows and Documents 577

Overhead Costs 578 Set Predetermined Overhead Rate 579 Apply Estimated Overhead 579 Record Actual Overhead 581 Summary of Cost Flows 582 Using Job Cost Sheets for Managerial

Decisions 583 Schedule of Cost of Goods Manufactured 584

Adjusting Overhead 585 Factory Overhead Account 585 Adjust Underapplied or Overapplied

Overhead 585 Job Order Costing of Services 586

Decision Analysis—Pricing for Services 587

16 Process Costing and Analysis 610 Process Operations 611

Organization of Process Operations 611 Comparing Process and Job Order Costing

Systems 612 Equivalent Units of Production 613

Process Costing Illustration 614 Overview of GenX Company’s Process

Operation 614 Pre-Step: Collect Production and Cost Data 615 Step 1: Determine Physical Flow of Units 616

Step 2: Compute Equivalent Units

of Production 616 Step 3: Compute Cost per Equivalent Unit 617 Step 4: Assign and Reconcile Costs 617 Process Cost Summary 619

Accounting for Process Costing 620 Accounting for Materials Costs 621 Accounting for Labor Costs 622 Accounting for Factory Overhead 623 Accounting for Transfers 624 Trends in Process Operations 626

Contents xxiii

Investing and Financing Budgets 781 Capital Expenditures Budget 781 Cash Budget 781

Budgeted Financial Statements 785 Budgeted Income Statement 785 Budgeted Balance Sheet 786 Using the Master Budget 786 Budgeting for Service Companies 786

Decision Analysis—Activity-Based Budgeting 787

Appendix 20A Merchandise Purchases Budget 795

21 Flexible Budgets and Standard Costs 820 Fixed and Flexible Budgets 821

Fixed Budget Reports 822 Budget Reports for Evaluation 823 Flexible Budget Reports 823

Standard Costing 827 Standard Costs 827 Setting Standard Costs 827 Cost Variance Analysis 828

Materials and Labor Variances 830 Materials Variances 830 Labor Variances 832

Overhead Standards and Variances 833 Flexible Overhead Budgets 833 Standard Overhead Rate 833 Computing Overhead Cost Variances 835 Standard Costing—Management

Considerations 838

Decision Analysis—Sales Variances 839 Appendix 21A Expanded Overhead Variances and

Standard Cost Accounting System 844

22 Performance Measurement and Responsibility Accounting 868

Responsibility Accounting 869 Performance Evaluation 869 Controllable versus Uncontrollable Costs 870 Responsibility Accounting for Cost Centers 870

Profit Centers 872 Direct and Indirect Expenses 872 Expense Allocations 873 Departmental Income Statements 874 Departmental Contribution to Overhead 877

Computing Sales for a Target Income 709 Evaluating Strategies 710 Sales Mix and Break-Even 711 Assumptions in Cost-Volume-Profit Analysis 713

Decision Analysis—Degree of Operating Leverage 714

Appendix 18A Using Excel for Cost Estimation 716 Appendix 18B Variable Costing and Performance

Reporting 717 Appendix 18C Preparing a CVP Chart 720

19 Variable Costing and Analysis 738 Introducing Variable Costing and Absorption

Costing 739 Computing Unit Product Cost 740

Income Reporting Implications 741 Units Produced Equal Units Sold 741 Units Produced Exceed Units Sold 743 Units Produced Are Less Than Units Sold 744 Summarizing Income Reporting 745 Converting Income under Variable Costing to

Absorption Costing 746

Comparing Variable Costing and Absorption Costing 746 Planning Production 746 Setting Prices 748 Controlling Costs 748 CVP Analysis 749 Variable Costing for Service Firms 749

Decision Analysis—Pricing Special Orders 751

20 Master Budgets and Performance Planning 770

Budget Process and Administration 771 Budgeting Process 771 Benefits of Budgeting 772 Budgeting and Human Behavior 772 Budget Reporting and Timing 773 Master Budget Components 773

Operating Budgets 773 Sales Budget 775 Production Budget 775 Direct Materials Budget 776 Direct Labor Budget 777 Factory Overhead Budget 778 Selling Expense Budget 779 General and Administrative Expense Budget 780

xxiv Contents

24 Capital Budgeting and Investment Analysis 946

Capital Budgeting 947 Capital Budgeting Process 947 Capital Investment Cash Flows 948

Methods Not Using Time Value of Money 948 Payback Period 948 Accounting Rate of Return 951

Methods Using Time Value of Money 952 Net Present Value 952 Internal Rate of Return 956 Comparison of Capital Budgeting Methods 958 Postaudit 958

Decision Analysis—Break-Even Time 960 Appendix 24A Using Excel to Compute Net Present

Value and Internal Rate of Return 962

Appendix A Financial Statement Information A-1 Apple A-2 Google A-10 Samsung A-14 Appendix B Time Value of Money B Appendix C Investments C Appendix D Lean Principles and Accounting D-1 Index IND-1 Chart of Accounts CA Brief Review Managerial Analyses and Reports BR-1 Financial Reports and Tables BR-2 Selected Transactions and

Relations BR-3 Fundamentals and Analyses BR-4

Investment Centers 878 Return-on-Investment and Residual Income 878 Investment Center Profit Margin and Investment

Turnover 880

Nonfinancial Performance Evaluation Measures 881 Balanced Scorecard 881 Transfer Pricing 883

Decision Analysis—Cash Conversion Cycle 884 Appendix 22A Cost Allocations 887 Appendix 22B Transfer Pricing 889 Appendix 22C Joint Costs and Their Allocation 890

23 Relevant Costing for Managerial Decisions 912

Decisions and Information 913 Decision Making 913 Relevant Costs and Benefits 914

Production Decisions 914 Make or Buy 915 Sell or Process Further 916 Sales Mix Selection When Resources Are

Constrained 917

Capacity Decisions 919 Segment Elimination 919 Keep or Replace Equipment 920

Pricing Decisions 921 Normal Pricing 921 Special Offers 923

Decision Analysis—Time and Materials Pricing 925

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Financial & Managerial Accounting

Learning Objectives

CONCEPTUAL C1 Explain the purpose and importance of

accounting.

C2 Identify users and uses of, and opportunities in, accounting.

C3 Explain why ethics are crucial to accounting.

C4 Explain generally accepted accounting principles and define and apply several accounting principles.

PROCEDURAL P1 Analyze business transactions using the

accounting equation.

P2 Identify and prepare basic financial statements and explain how they interrelate.

C5 Appendix 1B—Identify and describe the three major activities of organizations.

ANALYTICAL A1 Define and interpret the accounting

equation and each of its components.

A2 Compute and interpret return on assets.

A3 Appendix 1A—Explain the relation between return and risk.

Chapter Preview

1 Accounting in Business

FINANCIAL STATEMENTS

P2 Income statement Statement of retained earnings

Balance sheet

Statement of cash flows

A2 Financial analysis

NTK 1-5

TRANSACTION ANALYSIS

A1 Accounting equation and its components

Expanded accounting equation

P1 Transaction analysis— Illustrated

NTK 1-3, 1-4

ETHICS AND ACCOUNTING

C3 Ethics C4 Generally accepted

accounting principles

Conceptual framework

NTK 1-1

ACCOUNTING USES

C1 Purpose of accounting

C2 Accounting information users

Opportunities in accounting

Learning Objectives are classified as conceptual, analytical, or procedural

Chapter Preview is organized by “blocks” of key content and learning objectives followed by Need-to-Know (NTK) guided video examples

NTK 1-2

“We ran the business . . . with just a few hundred bucks”—Steve Wozniak

Big Apple

CUPERTINO, CA—“When I designed the Apple stuff,” says Steve Wozniak, “I never thought in my life I would have enough money to fly to Hawaii or make a down payment on a house.” But some dreams do come true. Woz, along with Steve Jobs and Ron Wayne, founded Apple (Apple.com) when Woz was 25 and Jobs was 21.

The young entrepreneurs faced challenges, including how to read and interpret accounting data. They also needed to finance the company, which they did by selling Woz’s HP calcu- lator and Jobs’s Volkswagen van. The $1,300 raised helped them purchase the equipment Woz used to build the first Apple computer.

In setting up their company, the owners chose between a part- nership and a corporation. They decided on a partnership that in- cluded Ron as a third partner with 10% ownership. Days later, Ron withdrew when he considered the unlimited liability of a partner- ship. He sold his 10% share to Woz and Jobs for $800. Within nine months, Woz and Jobs converted Apple to a corporation.

As Apple grew, Woz and Jobs had to learn more accounting, along with details of preparing and interpreting financial state- ments. Important questions involving transaction analysis and financial reporting arose, and the owners took care to do things

right. “Everything we did,” asserts Woz, “we were setting the tone for the world.”

Woz and Jobs focused their accounting system to provide information for Apple’s business decisions. Today, Woz believes that Apple is key to the language of technology, just as account- ing is the language of business. In retrospect, Woz says, “Every dream I have ever had in life has come true ten times over.”

Sources: Apple website, January 2019; Woz.org, January 2019; Apple 2016 Sustainability Report, April 2016; Greenbiz, October 2014; iWoz: From Computer Geek to Cult Icon, W.W. Norton & Co., 2006; Founders at Work, Apress, 2007

©Miguel Medina/AFP/Getty Images

Why is accounting so popular on campus? Why are there so many openings for accounting jobs? Why is accounting so important to companies? The answer is that we live in an informa- tion age in which accounting information impacts us all.

Accounting is an information and measurement system that identifies, records, and commu- nicates an organization’s business activities. Exhibit 1.1 shows these accounting functions.

IMPORTANCE OF ACCOUNTING

Our most common contact with accounting is through credit checks, checking accounts, tax forms, and payroll. These experiences focus on recordkeeping, or bookkeeping, which is the recording of transactions and events. This is just one part of accounting. Accounting also includes analysis and interpretation of information.

Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur; Entrepreneurial Decision assignment returns to this feature with a mini-case

C1 Explain the purpose and importance of accounting.

Select transactions and events Input, measure, and log Prepare, analyze, and interpret

Identifying Recording Communicating

Examples are Apple’s sale of iPhones and TicketMaster’s receipt of ticket money.

Examples are dated logs of transactions measured in dollars.

Examples are reports that we analyze and interpret.

EXHIBIT 1.1 Accounting Functions

4 Chapter 1 Accounting in Business

Technology plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving accuracy. As technology makes more information available, the demand for accounting knowledge increases. Consulting, planning, and other financial services are closely linked to accounting.

Users of Accounting Information Accounting is called the language of business because it communicates data that help people make better decisions. People using accounting information are divided into two groups: exter- nal users and internal users. Financial accounting focuses on the needs of external users, and managerial accounting focuses on the needs of internal users.

External Users External users of accounting information do not directly run the organi- zation and have limited access to its accounting information. These users get accounting infor- mation from general-purpose financial statements. Following is a partial list of external users and decisions they make with accounting information. Lenders (creditors) loan money or other resources to an organization. Banks, savings and

loans, and mortgage companies are lenders. Lenders use information to assess if an organiza- tion will repay its loans.

Shareholders (investors) are the owners of a corporation. They use accounting reports to de- cide whether to buy, hold, or sell stock.

Boards of directors oversee organizations. Directors use accounting information to evaluate the performance of executive management.

External (independent) auditors examine financial statements to verify that they are prepared according to generally accepted accounting principles.

Nonmanagerial and nonexecutive employees and labor unions use external information to bargain for better wages.

Regulators have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) requires accounting reports for computing taxes.

Voters and government officials use information to evaluate government performance. Contributors to nonprofits use information to evaluate the use and impact of donations. Suppliers use information to analyze a customer before extending credit. Customers use financial reports to assess the stability of potential suppliers.

Internal Users Internal users of accounting information directly manage the organiza- tion. Internal reports are designed for the unique needs of managerial or executive employees, such as the chief executive officer (CEO). Following is a partial list of internal users and deci- sions they make with accounting information. Purchasing managers need to know what, when, and how much to purchase. Human resource managers need information about employees’ payroll, benefits, and performance. Production managers use information to monitor costs and ensure quality. Distribution managers need reports for timely and accurate delivery of products and services. Marketing managers use reports to target consumers, set prices, and monitor consumer needs. Service managers use reports to provide better service to customers. Research and development managers use information on projected costs and revenues of

innovations.

Opportunities in Accounting Accounting has four areas of opportunities: financial, managerial, taxation, and accounting- related. Exhibit 1.2 lists selected opportunities in each area.

C2 Identify users and uses of, and opportunities in, accounting.

23.90 15.00 15.34 17.89 19.45 13.67 13.60 25.65 15.45 18.85 23.56 18.85 17.23

+3.58% +12.3% +5.34% +5.94% +2.13% +6.43% -11.6% +23.1% +5.56% -3.67% +11.3% +2.54% +12.3%

400.20 253.95 285.32 248.20 989.26 320.34 208.98 432.62 765.23 564.23 256.25 524.65 754.62

530.000 320.000 430.000 900.000 600.000 380.000 220.000 750.000 250.000 120.000 158.000 245.000 658.000

Annual Repor t

–4% 2009 2007

2005 2003 2001

–2%

10%

12%

Circuit City Best Buy

Return on Assets:

• Managers

• Officers and directors

• Internal auditors

• Sales sta ff

• Budget officers

• Controllers

Annual Budge t

–4% 2009 2007

2005 2003 2001

–2%

10%

12%

Circuit City Best Buy

Return on Assets:

• Managers

• Officers and directors

• Internal auditors

• Sales sta ff

• Budget officers

• Controllers

Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting.

Chapter 1 Accounting in Business 5

• Preparation • Analysis • External auditing • Regulatory • Consulting • Planning • Criminal investigation

• Preparation • Planning • Regulatory • Investigations • Consulting • Enforcement • Legal services • Estate plans

• General accounting • Cost accounting • Budgeting • Internal auditing • Consulting • Controller • Treasurer • Strategy

• Lenders • Consultants • Analysts • Traders • Directors • Underwriters • Planners • Appraisers

• FBI investigators • Market researchers • Systems designers • Merger services • Business valuation • Forensic accounting • Litigation support • Entrepreneurs

Opportunities in Accounting

Financial Taxation Accounting-relatedManagerial

EXHIBIT 1.2 Accounting Opportunities

Exhibit 1.3 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting involves accounting services such as auditing and taxation. Opportunities also exist in government and not-for-profit agen- cies, including business regulation and law enforcement.

Accounting specialists are highly regarded, and their professional standing is often denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements, pass an exam, and be ethical. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), certified fraud examiner (CFE), and certified foren- sic accountant (CrFA).

Accounting specialists are in demand. Exhibit 1.4 reports average annual salaries for several accounting positions. Salaries vary based on location, company size, and other factors.

Public accounting

24%

Government and

not-for-profit 22%

Private accounting

54%

EXHIBIT 1.3 Accounting Jobs by Area

Point: The largest accounting firms are EY, KPMG, PwC, and Deloitte.

Point: Higher education yields higher pay: Master’s degree $73,738 Bachelor’s degree 56,665 Associate’s degree 39,771 High school degree 30,627 No high school degree 20,241

EXHIBIT 1.4 Accounting Salaries

Public Accounting Salary

Partner . . . . . . . . . . . . . . . . . . . . . . $245,000

Manager (6–8 years) . . . . . . . . . . 112,000

Senior (3–5 years) . . . . . . . . . . . . 90,000

Junior (0–2 years) . . . . . . . . . . . . 62,500

Private Accounting Salary

CFO . . . . . . . . . . . . . . . . . . . . . . . . $290,000

Controller/Treasurer . . . . . . . . . . . 180,000

Manager (6–8 years) . . . . . . . . . . 98,500

Senior (3–5 years) . . . . . . . . . . . . 81,500

Junior (0–2 years) . . . . . . . . . . . . . 58,000

Recordkeeping Salary

Full-charge bookkeeper . . . . . . . . $60,500

Accounts manager . . . . . . . . . . . . 58,000

Payroll manager . . . . . . . . . . . . . . 59,500

Accounting clerk (0–2 years) . . . . 39,500

Identify the following users of accounting information as either an (a) external or (b) internal user.

C1 C2 Accounting Users

NEED-TO-KNOW 1-1 1. Regulator 2. CEO 3. Shareholder

4. Marketing manager 5. Executive employee 6. External auditor

7. Production manager 8. Nonexecutive employee 9. Bank lender

Solution

1. a 2. b 3. a 4. b 5. b 6. a 7. b 8. a 9. a. Do More: QS 1-1, QS 1-2, E 1-1,

E 1-2, E 1-3

NEED-TO-KNOWs highlight key procedures and concepts in learning accounting; instructional audio/video recordings accompany each one

6 Chapter 1 Accounting in Business

Ethics—A Key Concept For information to be useful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that separate right from wrong. They are accepted standards of good and bad behavior.

Accountants face ethical choices as they prepare financial reports. These choices can affect the salaries and bonuses paid to workers. They even can affect the success of products and ser- vices. Misleading information can lead to a bad decision that harms workers and the business. There is an old saying: Good ethics are good business. Exhibit 1.5 gives a three-step process for making ethical decisions.

C3 Explain why ethics are crucial to accounting.

FUNDAMENTALS OF ACCOUNTING

Use ethics to recognize an ethical concern.

Consider all consequences.

Choose best option after weighing all consequences.

1. Identify ethical concerns 2. Analyze options 3. Make ethical decisionEXHIBIT 1.5 Ethical Decision Making

Point: A Code of Conduct is available at AICPA.org.

Fraud Triangle: Ethics under Attack The fraud triangle shows that three factors push a person to commit fraud. Opportunity. A person must be able to commit fraud with a low risk of getting caught. Pressure, or incentive. A person must feel pressure or have incentive to commit fraud. Rationalization, or attitude. A person justifies fraud or does not see its criminal nature.

The key to stopping fraud is to focus on prevention. It is less expensive and more effective to prevent fraud from happening than it is to detect it.

To help prevent fraud, companies set up internal controls. Internal controls are procedures to protect assets, ensure reliable accounting, promote efficiency, and uphold company policies. Examples are good records, physical controls (locks), and independent reviews.

Enforcing Ethics In response to major accounting scandals, like those at Enron and WorldCom, Congress passed the Sarbanes-Oxley Act, also called SOX, to help stop financial abuses. SOX requires documentation and verification of internal controls and emphasizes effec- tive internal controls. Management must issue a report stating that internal controls are effective. Auditors verify the effectiveness of internal controls. Ignoring SOX can lead to penalties and criminal prosecution of executives. CEOs and CFOs who knowingly sign off on bogus account- ing reports risk millions of dollars in fines and years in prison.

Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank, has two important provisions. Clawback Mandates recovery (clawback) of excessive pay. Whistleblower SEC pays whistleblowers 10% to 30% of sanctions exceeding $1 million.

O pp

or tu

nit y

Rationalization

Pressure

Point: An audit examines whether financial statements are prepared using GAAP.

Point: SOX requires a business that sells stock to disclose a code of ethics for its executives.

Ethics Pay The $100 million mark in total payments made by the SEC to whistleblowers was recently surpassed. Since the SEC began awarding whistleblowers a percentage of money from sanctions, over 14,000 tips have been reported. Many of the tips come from accountants. ■

Ethical Risk

Ethical Risk boxes highlight ethical issues from practice

Chapter 1 Accounting in Business 7

Generally Accepted Accounting Principles Financial accounting is governed by concepts and rules known as generally accepted account- ing principles (GAAP). GAAP wants information to have relevance and faithful representa- tion. Relevant information affects decisions of users. Faithful representation means information accurately reflects the business results.

The Financial Accounting Standards Board (FASB) is given the task of setting GAAP from the Securities and Exchange Commission (SEC). The SEC is a U.S. government agency that oversees proper use of GAAP by companies that sell stock and debt to the public.

International Standards Our global economy demands comparability in accounting re- ports. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. These standards are similar to, but sometimes different from, U.S. GAAP. The FASB and IASB are working to reduce differences between U.S. GAAP and IFRS.

Conceptual Framework The FASB conceptual framework in Exhibit 1.6 consists of the following. Objectives—to provide information useful to investors, creditors,

and others. Qualitative characteristics—to require information that has rele-

vance and faithful representation. Elements—to define items in financial statements. Recognition and measurement—to set criteria for an item to be

recognized as an element; and how to measure it.

Principles, Assumptions, and Constraint There are two types of accounting principles (and assumptions). General principles are the assumptions, concepts, and guidelines for preparing financial statements; these are shown in purple font in Exhibit 1.7, along with key as- sumptions in red font. Specific principles are de- tailed rules used in reporting business transactions and events; they are described as we encounter them.

Accounting Principles There are four general principles. Measurement principle (cost principle)

Accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. Information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence. Later chapters cover adjust- ments to market and introduce fair value.

Revenue recognition principle Revenue is recognized (1) when goods or services are pro- vided to customers and (2) at the amount expected to be received from the customer. Revenue (sales) is the amount received from selling products and services. The amount received is usually in cash, but it also can be a customer’s promise to pay at a future date, called credit sales. (To recognize means to record it.)

C4 Explain generally accepted accounting principles and define and apply several accounting principles.

Point: CPAs who audit financial statements must disclose if they do not comply with GAAP.

Objectives of financial accounting

Recognition and measurement

Qualitative characteristics Elements

EXHIBIT 1.6 Conceptual Framework

GAAPGAAP

Measurement

Full disclosure

Revenue recognition

Expense recognition

sepExpExpen tiogrecogrec tionionoongnitr

Business entity

Time period

F lFul sclosuuurescdiscd ssd clos

Monetary unit

Going concern

Cost-benefit

Principles

Assumptions

Constraint

EXHIBIT 1.7 Building Blocks for GAAP

Point: A company pays $500 for equipment. The cost principle requires it be recorded at $500. It makes no difference if the owner thinks this equipment is worth $700.

Example: A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded? Answer: It is recorded over time as it is earned; record $400 revenue for June and $400 for July.

8 Chapter 1 Accounting in Business

Expense recognition principle (matching principle) A company records the expenses it incurred to generate the revenue reported. An example is rent costs of office space.

Full disclosure principle A company reports the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Example: Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded? Answer: If revenue is earned over time, record $100 expense in June and $100 in July.

Measurement and Recognition Revenues for the Seattle Seahawks, Atlanta Falcons, Green Bay Packers, and other professional football teams include ticket sales, television broadcasts, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they are a liability until the NFL team plays the game for which the ticket was sold. At that point, the liability is removed and revenues are reported. ■

Decision Insight

©Shane Roper/CSM/REX/Shutterstock

Accounting Assumptions There are four accounting assumptions. Going-concern assumption Accounting information presumes that the business will con-

tinue operating instead of being closed or sold. This means, for example, that property is re- ported at cost instead of liquidation value.

Monetary unit assumption Transactions and events are expressed in monetary, or money, units. Examples of monetary units are the U.S. dollar and the Mexican peso.

Time period assumption The life of a company can be divided into time periods, such as months and years, and useful reports can be prepared for those periods.

Business entity assumption A business is accounted for separately from other business entities and its owner. Exhibit 1.8 describes four common business entities.

EXHIBIT 1.8 Attributes of Businesses

Sole Proprietorship Partnership Corporation Limited Liability Company (LLC)

Number of owners 1 owner; easy to set up . 2 or more, called partners; easy to set up .

1 or more, called stockholders; can get many investors by selling stock or shares of corporate ownership .*

1 or more, called members .

Business taxation No additional business income tax .

No additional business income tax .

Additional corporate income tax . No additional business income tax .

Owner liability Unlimited liability . Owner is per- sonally liable for proprietorship debts .

Unlimited liability . Partners are jointly liable for partnership debts .

Limited liability . Owners, called stock- holders (or shareholders), are not liable for corporate acts and debts .

Limited liability . Owners, called mem- bers, are not personally liable for LLC debts .

Legal entity Not a separate legal entity . Not a separate legal entity . A separate entity with the same rights and responsibilities as a person .

A separate entity with the same rights and responsibilities as a person .

Business life Business ends with owner death or choice .

Business ends with a partner death or choice .

Indefinite . Indefinite .

*When a corporation issues only one class of stock, it is called common stock (or capital stock).

Tax Services

Accounting Constraint The cost-benefit constraint, or cost constraint, says that infor- mation disclosed by an entity must have benefits to the user that are greater than the costs of providing it. Materiality, or the ability of information to influence decisions, is also sometimes mentioned as a constraint. Conservatism and industry practices are sometimes listed as well.

Point: Proprietorships, partner- ships, and LLCs are managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who hire managers to run the business.

Chapter 1 Accounting in Business 9

Entrepreneur You and a friend develop a new design for ice skates that improves speed. You plan to form a busi- ness to manufacture and sell the skates. You and your friend want to minimize taxes, but your big concern is potential lawsuits from customers who might be injured on these skates. What form of organization do you set up? ■ Answer: You should probably form an LLC. An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject to an additional business income tax. You also must examine the ethical and social aspects of starting a business where injuries are expected.

Decision Ethics Decision Ethics boxes are role-playing exercises that stress ethics in accounting

Solution

a. no b. no c. no d. no e. yes f. yes g. yes h. yes i. no j. yes k. yes l. yes

Part 1: Identify each of the following terms/phrases as either an accounting (a) principle, (b) assumption, or (c) constraint.

C3 C4 Accounting Guidance

NEED-TO-KNOW 1-2 1. Cost-benefit 2. Measurement 3. Business entity

4. Going-concern 5. Full disclosure 6. Time period

7. Expense recognition 8. Revenue recognition

Solution

1. c 2. a 3. b 4. b 5. a 6. b 7. a 8. a

Part 2: Complete the following table with either a yes or a no regarding the attributes of a partnership, corporation, and LLC.

Attribute Present Partnership Corporation LLC

Business taxed . . . . . . . . . . . a . e . i .

Limited liability . . . . . . . . . . . b . f . j .

Legal entity . . . . . . . . . . . . . . c . g . k .

Unlimited life . . . . . . . . . . . . d . h . l .

Do More: QS 1-3, QS 1-4, QS 1-5, QS 1-6, E 1-4, E 1-5,

E 1-6, E 1-7

Accounting shows two basic aspects of a company: what it owns and what it owes. Assets are resources a company owns or controls. The claims on a company’s assets—what it owes—are separated into owner (equity) and nonowner (liability) claims. Together, liabilities and equity are the source of funds to acquire assets.

Assets Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are web servers for an online services company, musical instru- ments for a rock band, and land for a vegetable grower. Assets include cash, supplies, equip- ment, land, and accounts receivable. A receivable is an asset that promises a future inflow of resources. A company that provides a service or product on credit has an account receivable from that customer.

Liabilities Liabilities are creditors’ claims on assets. These claims are obligations to pro- vide assets, products, or services to others. A payable is a liability that promises a future out- flow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes (loans) payable to banks, and taxes payable.

Equity Equity is the owner’s claim on assets and is equal to assets minus liabilities. Equity is also called net assets or residual equity.

Point: “On credit” and “on account” mean cash is paid at a future date.

BUSINESS TRANSACTIONS AND ACCOUNTING A1 Define and interpret the accounting equation and each of its components.

Point: Double taxation means that (1) the corporation income is taxed and (2) any dividends to owners are taxed as part of the owners’ personal income.

10 Chapter 1 Accounting in Business

Accounting Equation The relation of assets, liabilities, and equity is shown in the following accounting equation. The accounting equation applies to all transactions and events, to all companies and orga- nizations, and to all points in time.

Assets = Liabilities + Equity

We can break down equity to get the expanded accounting equation. Point: This equation can be rearranged. Example: Assets − Liabilities = Equity

Big Data The SEC keeps an online database called EDGAR (sec.gov/edgar) that has accounting information for thousands of companies, such as Columbia Sportswear, that issue stock to the public. The annual report filing for most publicly traded U.S. companies is known as Form 10-K, and the quarterly filing is Form 10-Q. Information ser- vices such as Finance.Yahoo.com offer online data and analysis. ■

Decision Insight

©Greg Epperson/Shutterstock

Part 1: Use the accounting equation to compute the missing financial statement amounts.

Accounting Equation

NEED-TO-KNOW 1-3

Company Assets Liabilities Equity

Bose $150 $ 30 $ (a)

Vogue $ (b) $100 $300

Solution

a. $120 b. $400

Part 2: Use the expanded accounting equation to compute the missing financial statement amounts.

Company Assets Liabilities Common Stock Dividends Revenues Expenses

Tesla $200 $ 80 $100 $5 $ (a) $40

YouTube $400 $160 $220 $ (b) $ 120 $90

Solution

a. $65 b. $10 Do More: QS 1-7, QS 1-8,

E 1-8, E 1-9

We see that equity increases from owner investments, called stock issuances, and from reve- nues. It decreases from dividends and from expenses. Equity consists of four parts.

Equity

Assets = Liabilities + Contributed Capital + Retained Earnings

= Liabilities + Common Stock − Dividends + Revenues − Expenses

Common Stock

Common stock reflects inflows of cash and other net assets from stockholders in exchange for stock (stock is part of contributed capital and covered in later chapters).

Dividends Dividends are outflows of cash and other assets to stockholders that reduce equity.

Revenues

Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consulting services provided, facilities rented to others, and commissions from services.

Expenses

Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees.

+ − + −

Contributed capital

Retained earnings

Chapter 1 Accounting in Business 11

Transaction Analysis Business activities are described in terms of transactions and events. External transactions are exchanges of value between two entities, which cause changes in the accounting equation. An example is the sale of the AppleCare Protection Plan by Apple. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An example is Target’s use of its supplies, which are reported as expenses when used. Events are happen- ings that affect the accounting equation and are reliably measured. They include business events such as changes in the market value of certain assets and liabilities and natural events such as fires that destroy assets and create losses.

This section uses the accounting equation to analyze 11 transactions and events of FastFor- ward, a start-up consulting (service) business, in its first month of operations. Remember that after each transaction and event, assets always equal liabilities plus equity.

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consult- ing business named FastForward and set up as a corporation. FastForward evaluates the performance of footwear and accessories. Taylor owns and manages the business, which will publish online re- views and consult with clubs, athletes, and others who purchase Nike and Adidas products.

Taylor invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, cash (an asset) and stockholders’ equity each equals $30,000. Equity is increased by the owner’s investment (stock issuance), which is included in the column titled Common Stock. The effect of this transaction on FastForward is shown in the accounting equation as follows (we label the equity entries).

P1 Analyze business transac- tions using the accounting equation.

FASTForward

Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of Nike and Adidas footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It simply changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of footwear are assets because of the expected future benefits from the test results of their performance.

Assets = Liabilities + Equity

Cash = Common Stock (1) +$30,000 = +$30,000 Owner investment

Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to acquire equipment for testing footwear. Like Transaction 2, Transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected fu- ture benefits from testing footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.

Assets = Liabilities + Equity

Cash + Supplies = Common Stock Old Bal . $30,000 = $30,000 (2) − 2,500 + $2,500 ________ ________ ________ New Bal . $27,500 + $ 2,500 = $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Common Stock Old Bal . $27,500 + $2,500 = $30,000 (3) −26,000 + $26,000 _________ _______ ___________ ________ New Bal . $ 1,500 + $2,500 + $ 26,000 = $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

In vo

ic e

B ill

In vo

ic e

B ill Lones

Bes t Bu

y St ock

BANK

Assets Liabilities + Equity=

Real company names are in bold magenta

12 Chapter 1 Accounting in Business

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of footwear and accessories are needed. These additional supplies cost $7,100, but FastForward has only $1,500 in cash. Taylor arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount.

Example: If FastForward pays $500 cash in Transaction 4, how does this partial payment affect the liability to CalTech? Answer: The liability to CalTech is reduced to $6,600 and the cash balance is reduced to $1,000.

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common + Revenues Payable Stock Old Bal . $1,500 + $9,600 + $26,000 = $7,100 + $30,000 (5) +4,200 + $4,200 Consulting _________ ________ __________ ________ __________ _________ New Bal . $5,700 + $9,600 + $26,000 = $7,100 + $30,000 + $ 4,200

$41,300 $41,300

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transaction 5: Provide Services for Cash FastForward plans to earn revenues by selling online ad space and consulting with clients about footwear and accessories. It earns net income only if its revenues are greater than its expenses. In its first job, FastForward pro- vides consulting services and immediately collects $4,200 cash. The accounting equation re- flects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is shown in the far right column under Revenues because the cash received is earned by providing consult- ing services.

Point: Revenue recognition prin- ciple requires that revenue is rec- ognized when work is performed.

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 to rent its facilities. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is shown in the following accounting equation as Transaction 6. FastForward also pays the biweekly $700 salary of the company’s only em- ployee. This is shown in the accounting equation as Transaction 7. Both Transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, not assets, because their benefits are used in December (they have no future benefits after December). The accounting equation shows that both transactions reduce cash and equity. The far right column shows these decreases as Expenses.

Point: Expense recognition prin- ciple requires that expenses are recognized when the revenue they help generate is recorded.

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common Stock Payable Old Bal . $1,500 + $2,500 + $26,000 = $30,000 (4) + 7,100 +$7,100 _______ _______ ________ __________ ________ New Bal . $1,500 + $9,600 + $26,000 = $ 7,100 + $30,000

$37,100 $37,100

⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common + Revenues − Expenses Payable Stock Old Bal . $5,700 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 (6) −1,000 − $1,000 Rent _________ ________ __________ _________ __________ _________ _________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 Salaries _________ ________ __________ _________ __________ _________ _________ New Bal . $4,000 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 − $ 1,700

$39,600 $39,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Increases in expenses yield decreases in equity.

Chapter 1 Accounting in Business 13

Transaction 8: Provide Services and Facilities for Credit FastForward pro- vides consulting services of $1,600 and rents its test facilities for an additional $300 to Adidas on credit. Adidas is billed for the $1,900 total. This transaction creates a new asset, called ac- counts receivable, from Adidas. Accounts receivable is increased instead of cash because the payment has not yet been received. Equity is increased from the two revenue components shown in the Revenues column of the accounting equation.

Point: Transaction 8, like 5, records revenue when work is performed, not necessarily when cash is received.

Transaction 9: Receipt of Cash from Accounts Receivable The client in Transaction 8 (Adidas) pays $1,900 to FastForward 10 days after it is billed for consulting ser- vices. This Transaction 9 does not change the total amount of assets and does not affect liabili- ties or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward performed the services in Transaction 8, not when the cash is collected.

Point: Transaction 9 involved no added client work, so no added revenue is recorded.

Point: Receipt of cash is not always a revenue.

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (Transaction 4), leaving $6,200 unpaid. This transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an ex- pense even though cash flows out of FastForward (instead the expense is recorded when FastForward uses these supplies).

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $4,000 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 − $1,700 (8) + $1,900 + 1,600 Consulting + 300 Rental ________ _________ _______ _________ _______ _________ _______ __________ New Bal . $4,000 + $ 1,900 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $4,000 + $1,900 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700 (9) +1,900 − 1,900 _________ _________ _______ _________ _______ _________ _______ ________ New Bal . $5,900 + $ 0 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $5,900 + $ 0 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700 (10) −900 −900 _______ __________ _______ _________ _______ _________ ________ ________ New Bal . $5,000 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 + $6,100 − $1,700

$40,600 $40,600

14 Chapter 1 Accounting in Business

Summary of Transactions Exhibit 1.9 shows the effects of these 11 transactions of FastForward using the accounting equa- tion. Assets equal liabilities plus equity after each transaction.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock Old Bal . $5,000 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 + $6,100 − $1,700 (11) − 200 − $200 Dividends _______ _______ _______ ________ _______ _________ ______ _______ _______ New Bal . $4,800 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 − $200 + $6,100 − $1,700

$40,400 $40,400

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Increases in dividends yield decreases in equity.

Transaction 11: Payment of Cash Dividend FastForward declares and pays a $200 cash dividend to its owner (the sole shareholder). Dividends (decreases in equity) are not reported as expenses because they do not help earn revenue. Because dividends are not expenses, they are not used in computing net income.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock (1) $30,000 = $30,000 (2) − 2,500 + $2,500 __________ ________ __________ Bal . 27,500 + 2,500 = 30,000 (3) −26,000 + $26,000 __________ ________ ____________ __________ Bal . 1,500 + 2,500 + 26,000 = 30,000 (4) + 7,100 = +$7,100 __________ ________ ____________ _________ __________ Bal . 1,500 + 9,600 + 26,000 = 7,100 + 30,000 (5) + 4,200 + $4,200 __________ ________ ____________ _________ __________ ________ Bal . 5,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 (6) − 1,000 − $1,000 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,700 (8) + $1,900 + 1,600 + 300 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 1,900 + 9,600 + 26,000 = 7,100 + 30,000 6,100 − 1,700 (9) + 1,900 − 1,900 __________ ________ ____________ _________ __________ ________ ________ Bal . 5,900 + 0 + 9,600 + 26,000 = 7,100 + 30,000 + 6,100 − 1,700 (10) − 900 − 900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,000 + 0 + 9,600 + 26,000 = 6,200 + 30,000 + 6,100 − 1,700 (11) − 200 − $200 __________ ________ ________ ____________ _________ __________ ______ ________ ________ Bal . $ 4,800 + $ 0 + $ 9,600 + $ 26,000 = $ 6,200 + $ 30,000 − $ 200 + $6,100 − $ 1,700

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

Jan. 1 Jamsetji Tata invested $4,000 cash in Tata Company in exchange for its common stock. 5 The company purchased $2,000 of equipment on credit. 14 The company provided $540 of services for a client on credit. 21 The company paid $250 cash for an employee’s salary.

Transaction Analysis

NEED-TO-KNOW 1-4

Do More: QS 1-10, QS 1-11, E 1-10, E 1-11, E 1-13

Chapter 1 Accounting in Business 15

Solution

Assets = Liabilities + Equity

Cash + Accounts + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock Jan. 1 $4,000 = $4,000 Jan. 5 + $2,000 +$2,000 Bal . 4,000 + 2,000 = 2,000 + 4,000 Jan. 14 + $540 + $540 Bal . 4,000 + 540 + 2,000 = 2,000 + 4,000 + 540 Jan. 21 −250 − $250 Bal . 3,750 + 540 + 2,000 = 2,000 + 4,000 + 540 − 250

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

$6,290 $6,290

Financial statements are prepared in the order below using the 11 transactions of FastForward. (These statements are unadjusted—we explain this in Chapters 2 and 3.) The four financial statements and their purposes follow.

COMMUNICATING WITH USERS P2 Identify and prepare basic financial statements and explain how they interrelate.

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from Trans- actions 5 and 8 and rental revenue of $300 from Transaction 8. Expenses are reported after revenues. Rent and salary expenses are from Transactions 6 and 7. Expenses are the costs to generate the revenues reported. Net income occurs when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Net income (or loss) is shown at the bottom of the state- ment and is the amount reported in December. Stockholders’ investments and dividends are not part of income.

Financial Statement Purpose

Income statement Describes a company’s revenues and expenses and computes net income or loss over a period of time.

Statement of retained earnings Explains changes in retained earnings from net income (or loss) and any dividends over a period of time.

Balance sheet Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.

Statement of cash flows Identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

Layout

Revenue – Expenses

Net income

Beg. retained earnings + Net income – Dividends

End. retained earnings

Assets = Liabilities + Equity

+/– Operating C.F. +/– Investing C.F. +/– Financing C.F.

Change in cash

Point: Net income is sometimes called earnings or profit.

Key terms are in bold and defined again in the glossary

16 Chapter 1 Accounting in Business

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . $ 4,800 Accounts payable . . . . . . . . . . . . . . . . $ 6,200 _____________ Supplies . . . . . . . . . . 9,600 Total liabilities . . . . . . . . . . . . . . . . . . 6,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . . . 4,200 _____________ Total equity . . . . . . . . . . . . . . . . . . . . . 34,200 _________ _____________ Total assets . . . . . . . . . $ 40,400 Total liabilities and equity . . . . . . . . . $ 40,400 _________ _____________ _________ _____________

Point: The income statement, the statement of retained earnings, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues

Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . . . . . . . . . $ 5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 ____________ Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 ____________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 _____________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,400 _____________ _____________

FASTFORWARD Statement of Cash Flows

For Month Ended December 31, 2019

Cash flows from operating activities

Cash received from clients ($4,200 + $1,900) . . . . . . . . . . . . . . $ 6,100 Cash paid for expenses ($2,500 + $900 + $1,000 + $700) . . . . (5,100) __________ Net cash provided by operating activities . . . . . . . . . . . . . . . . . . $ 1,000

Cash flows from investing activities

Cash paid for equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26,000) __________ Net cash used by investing activities . . . . . . . . . . . . . . . . . . . . . . (26,000)

Cash flows from financing activities

Cash investments from shareholders . . . . . . . . . . . . . . . . . . . . . . 30,000 Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . (200) __________ Net cash provided by financing activities . . . . . . . . . . . . . . . . . . 29,800 ___________ Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800

Cash balance, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . 0 ___________ Cash balance, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800 ___________ ___________

Point: A single ruled line means an addition or subtraction. Final totals are double underlined. Negative amounts may or may not be in parentheses.

EXHIBIT 1.10 Financial Statements and Their Links

Point: A statement’s heading iden- tifies the company, the statement title, and the date or time period.

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400 _____________ 4,400

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 _____________ Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . $ 4,200 _____________ _____________

Point: Arrow lines show how the statements are linked. 1 Net income is used to compute retained earnings. 2 Retained earnings is used to

prepare the balance sheet. 3 Cash from the balance sheet is

used to reconcile the statement of cash flows.

Chapter 1 Accounting in Business 17

Statement of Retained Earnings The statement of retained earnings reports how retained earnings changes over the reporting period. This statement shows beginning retained earnings, events that increase it (net income), and events that decrease it (dividends and net loss). Ending retained earnings is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of retained earnings is the second report in Exhibit 1.10. The beginning balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports a beginning balance equal to the prior period’s ending balance (such as from November 30). FastForward’s statement shows the $4,400 of net income for the period, which links the income statement to the statement of retained earnings (see line 1 ). The state- ment also reports the $200 cash dividend and FastForward’s end-of-period retained earnings balance.

Balance Sheet FastForward’s balance sheet is the third report in Exhibit 1.10. This statement shows FastForward’s financial position at the end of business day on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity balance is $34,200. Line 2 shows the link between the ending balance of the statement of retained earnings and the retained earnings balance on the balance sheet. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Both are acceptable.) As always, the accounting equation balances: Assets of $40,400 = Liabilities of $6,200 + Equity of $34,200.

Statement of Cash Flows FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the $5,100 cash paid for supplies, rent, and employee salaries. Outflows are in paren- theses to denote subtraction. Net cash provided by operating activities for December is $1,000. The second section reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include long-term borrowing and repay- ing of cash from lenders and the cash investments from, and dividends to, stockholders. FastForward reports $30,000 from the owner’s initial investment and a $200 cash dividend. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows an increased cash balance of $4,800. The ending balance is also $4,800 as it started with no cash—see line 3 .

Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

Prepare the (a) income statement, (b) statement of retained earnings, and (c) balance sheet for Apple using the following condensed data from its fiscal year ended September 30, 2017 ($ in millions).

P2 Financial Statements

NEED-TO-KNOW 1-5

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223 Investments and other assets . . . . . . . . . . . 303,373

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 Land and equipment (net) . . . . . . . . . . . . . . 33,783

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289 Selling, general, and other expenses . . . . . 39,835

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 Accounts receivable . . . . . . . . . . . . . . . . . . . 17,874

Retained earnings, Sep . 24, 2016 . . . . . . . . . . . 96,998 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169 Retained earnings, Sep . 30, 2017 . . . . . . . 98,180

APPLE

©Pavel1964/Shutterstock

18 Chapter 1 Accounting in Business

Solution ($ in millions)

APPLE Income Statement

For Fiscal Year Ended September 30, 2017

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 Expenses Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $141,048 Selling, general, and other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,835 ______________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,883 ______________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 ______________ ______________

APPLE Statement of Retained Earnings

For Fiscal Year Ended September 30, 2017

Retained earnings, Sep . 24, 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,998 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351 ______________ 145,349 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169 ______________ Retained earnings, Sep . 30, 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 98,180 ______________ ______________

APPLE Balance Sheet

September 30, 2017

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 Accounts payable . . . . . . . . . . . . . . . . . . . $ 49,049 Accounts receivable . . . . . . . . . . . . . . . . . . . . . 17,874 Other liabilities . . . . . . . . . . . . . . . . . . . . . 192,223 ___________ Land and equipment (net) . . . . . . . . . . . . . . . . 33,783 Total liabilities . . . . . . . . . . . . . . . . . . . . . . 241,272 Investments and other assets . . . . . . . . . . . . . 303,373 Equity Common stock . . . . . . . . . . . . . . . . . . . . . 35,867 Retained earnings . . . . . . . . . . . . . . . . . . 98,180 ___________ Total equity . . . . . . . . . . . . . . . . . . . . . . . . 134,047 ___________ ___________ Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 Total liabilities and equity . . . . . . . . . . . . $375,319 ___________ ___________ ___________ ___________

Do More: QS 1-12, QS 1-13, QS 1-14, E 1-15, E 1-16,

E 1-17

Return on AssetsDecision Analysis

We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we use a company’s prior-year ratios and competitor ratios to identify good, bad, or average performance. This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Return on assets (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

Decision Analysis (a section at the end of each chapter) covers ratios for decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 13

A2 Compute and interpret return on assets.

EXHIBIT 1.11 Return on Assets Return on assets =

Net income Average total assets

Net income is from the annual income statement, and average total assets is computed by adding the begin- ning and ending amounts for that same period and dividing by 2. Nike reports total net income of $4,240 million for the current year. At the beginning of the current year its total assets are $21,396 million, and at the end of the current year they total $23,259 million. Nike’s return on assets for the current year is:

Return on assets = $4,240 million

($21,396 million + $23,259 million)/2 = 19.0%

Chapter 1 Accounting in Business 19

Is a 19.0% return on assets good or bad for Nike? To help answer this question, we compare (benchmark) Nike’s return with its prior performance and the return of its competitor, Under Armour (see Exhibit 1.12). Nike shows a stable pattern of good returns that reflects effective use of assets. Nike has outperformed Under Armour in each of the last three years. Its management performed well based on Nike’s return on assets.

EXHIBIT 1.12 Nike and Under Armour Returns

Return on Assets Current Year 1 Year Ago 2 Years Ago

Nike . . . . . . . . . . . . . . . . . . . 19 .0% 17 .5% 16 .3% Under Armour . . . . . . . . . . 7 .9 9 .4 11 .4

Business Owner You own a winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 14% return on its assets. The industry return for competitors of this manufacturer is 9%. Do you purchase this manufacturer? ■ Answer: The 14% return on assets for the manufacturer exceeds the 9% industry return. This is positive for a potential purchase. Also, this purchase is an opportunity to spread your risk over two businesses. Still, you should hesitate to purchase a business whose 14% return is lower than your current 21% return. You might better direct efforts to increase investment in your resort if it can earn more than the 14% alternative.

Decision Maker

Decision Analysis ends with a role-playing scenario to show the usefulness of ratios

After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month of business.

a. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for its common stock.

b. 2 Expressions paid $600 cash for furniture for the shop. c. 3 Expressions paid $500 cash to rent space in a strip mall for August. d. 4 Purchased $1,200 of equipment on credit for the shop (recorded as accounts payable). e. 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. f. 16 Expressions provided $100 of haircutting services on credit. g. 17 Expressions received a $100 check for services previously rendered on credit. h. 18 Expressions paid $125 cash to an assistant for hours worked for the grand opening. i. 31 Cash received from services provided during the second half of August was $930. j. 31 Expressions paid $400 cash toward the accounts payable entered into on August 4. k. 31 Expressions paid a $900 cash dividend to Worthy (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table similar to the one in Exhibit 1.9: Cash; Accounts Receivable; Furniture; Store Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Show the effects of each transaction using the accounting equation.

2. Prepare an income statement for August. 3. Prepare a statement of retained earnings for August. 4. Prepare a balance sheet as of August 31. 5. Prepare a statement of cash flows for August. 6. Determine the return on assets ratio for August.

PLANNING THE SOLUTION Set up a table like Exhibit 1.9 with the appropriate columns for accounts. Analyze each transaction and show its effects as increases or decreases in the appropriate columns. Be

sure the accounting equation remains in balance after each transaction. Prepare the income statement, and identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. Use information in the Equity columns to prepare the statement of retained earnings. Use information in the last row of the transactions table to prepare the balance sheet. Prepare the statement of cash flows; include all events listed in the Cash column of the transactions

table. Classify each cash flow as operating, investing, or financing. Calculate return on assets by dividing net income by average assets.

COMPREHENSIVE

Transaction Analysis, Statement Preparation, and Return on Assets

NEED-TO-KNOW 1-6

Comprehensive Need-to-Know is a review of key chapter content; the Planning the Solution section offers strategies in solving it

20 Chapter 1 Accounting in Business

SOLUTION 1.

Assets = Liabilities + Equity

Cash + Accounts + Furniture + Store = Accounts + Common − Dividends + Revenues − Expenses Receivable Equipment Payable Stock a. $3,000 $15,000 $18,000 b. − 600 + $600 _______ ______ _________ _________ Bal . 2,400 + 600 + 15,000 = 18,000 c. − 500 − $500 _______ ______ _________ _________ ______ Bal . 1,900 + 600 + 15,000 = 18,000 − 500 d. + 1,200 +$1,200 _______ ______ _________ _________ _________ ______ Bal . 1,900 + 600 + 16,200 = 1,200 + 18,000 − 500 e. + 825 + $ 825 _______ ______ _________ _________ _________ _______ ______ Bal . 2,725 + 600 + 16,200 = 1,200 + 18,000 + 825 − 500 f. + $100 + 100 _______ ______ ______ _________ _________ _________ _______ ______ Bal . 2,725 + 100 + 600 + 16,200 = 1,200 + 18,000 + 925 − 500 g. + 100 − 100 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 2,825 + 0 + 600 + 16,200 = 1,200 + 18,000 + 925 − 500 h. − 125 − 125 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 2,700 + 0 + 600 + 16,200 = 1,200 + 18,000 + 925 − 625 i. + 930 + 930 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 3,630 + 0 + 600 + 16,200 = 1,200 + 18,000 + 1,855 − 625 j. − 400 − 400 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 3,230 + 0 + 600 + 16,200 = 800 + 18,000 + 1,855 − 625 k. − 900 − $ 900 _______ ______ ______ _________ _________ _________ ________ _______ _______ Bal . $ 2,330 + 0 + $ 600 + $ 16,200 = $ 800 + $ 18,000 − $ 900 + $1,855 − $625 _______ ______ ______ _________ _________ _________ ________ _______ _______ _______ ______ ______ _________ _________ _________ ________ _______ _______

[continued on next page]

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues

Haircutting services revenue . . . . . . . . . . . . . $ 1,855

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . $ 500

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . 625

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,230

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1* . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . 1,230 1,230

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . 900

Retained earnings, August 31 . . . . . . . . . . . . . $ 330

* If Expressions had existed before August 1, the beginning retained earnings balance would equal the prior period’s ending balance.

Chapter 1 Accounting in Business 21

6. Return on assets = Net income

Average assets =

$1,230 ($18,000* + $19,130)∕2

= $1,230 $18,565

= 6.63%

*Uses the initial $18,000 investment as the beginning balance for the start-up period only.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . $ 2,330 Accounts payable . . . . . . . . . . . . . . . . . . $ 800 Furniture . . . . . . . . . . . . . . . . . 600 Equity Store equipment . . . . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . . . . . . 18,000 Retained earnings . . . . . . . . . . . . . . . . . . 330 Total equity . . . . . . . . . . . . . . . . . . . . . . . . 18,330 Total assets . . . . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . . . . $19,130

EXPRESSIONS Statement of Cash Flows

For Month Ended August 31

Cash flows from operating activities Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,855 Cash paid for expenditures ($500 + $125 + $400) . . . . . . . . . . (1,025) Net cash provided by operating activities . . . . . . . . . . . . . . . . . . $ 830 Cash flows from investing activities Cash paid for furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600) Cash flows from financing activities Cash investments from shareholders . . . . . . . . . . . . . . . . . . . . . . 3,000 Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . (900) Net cash provided by financing activities . . . . . . . . . . . . . . . . . . 2,100 Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330 Cash balance, August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Cash balance, August 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330

APPENDIX

Return and Risk 1A This appendix covers return and risk analysis. Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest re- turn such as 2%. We also could invest in a company’s stock, or even start our own business. How do we decide among these options? The answer depends on our trade-off between return and risk. Risk is the uncertainty about the return we will earn. All business investments involve risk, but some in- vestments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts). If we buy a share of eBay or any other company, we might get a large return. However, we have no guarantee of any return; there is even the risk of loss. Exhibit 1A.1 shows recent returns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds have a low expected return, but they also have low risk because they are backed by the U.S. govern- ment. High-risk corporate bonds have a much larger potential return but have much higher risk. The trade-off between return and risk is a normal part of business. Higher risk implies higher, but riskier, expected returns. To help us make better decisions, we use accounting information to assess both return and risk.

A3 Explain the relation between return and risk.

EXHIBIT 1A.1 Average Returns for Bonds with Different Risks

Annual Return

U.S. Treasury

Low-risk corporate

Medium-risk corporate

High-risk corporate

0% 4% 8% 12%

10.9%

8.3%

5.8%

2.5%

22 Chapter 1 Accounting in Business

APPENDIX

Business Activities1B This appendix explains how the accounting equation is linked to business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning is defining an organization’s ideas, goals, and actions.

Financing Financing activities provide the resources organizations use to pay for assets such as land, buildings, and equipment. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources loaned by creditors (lenders).

Investing Investing activities are the acquiring and disposing of assets that an organization uses to buy and sell its products or services. Some organizations require land and factories to operate. Others need only an office. Invested amounts are referred to as assets. Creditor and owner financing hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This yields the accounting equation: Assets = Liabilities + Equity.

Operating Operating activities involve using resources to research, develop, purchase, produce, distribute, and market products and services. Sales and revenues are the inflow of assets from selling products and services. Costs and expenses are the outflow of assets to support operating activities. Exhibit 1B.1 summarizes business activities. Planning is part of each ac- tivity and gives them meaning and focus. Investing (assets) and financing (li- abilities and equity) are opposite each other because they always are equal. Operating activities are below to show that they are the result of investing and financing.

C5 Identify and describe the three major activities of organizations.

Point: Investing (assets) and financing (liabilities plus equity) totals are always equal.

EXHIBIT 1B.1 Activities of Organizations

Operating

Planning

la nn

in g

Planning

In vo

ic e

B ill

In vo

ic e

B ill Lones

Bes t Bu

y St ock

BANK

Investing BANKBANKBANKBANKBANK

Financing

ACCOUNTING USES External users: Do not directly run the organization and have limited access to its accounting information. Examples are lenders, shareholders, boards of directors, external auditors, nonexecutive employees, labor unions, regulators, voters, donors, suppliers, and customers. Internal users: Directly manage organization operations. Examples are the CEO and other executives, research and development managers, purchasing managers, production managers, and other managerial-level employees. Private accounting: Accounting employees working for businesses. Public accounting: Offering audit, tax, and accounting services to others.

ETHICS AND ACCOUNTING Fraud triangle: Factors that push a person to commit fraud. ∙ Opportunity: Must be able to commit fraud with a low risk of getting

caught. ∙ Pressure, or incentive: Must feel pressure or have incentive to commit

fraud. ∙ Rationalization, or attitude: Justifies fraud or does not see its criminal

nature.

Summary: Cheat Sheet

SYSTEM OF ACCOUNTS Assets: Resources a company owns or controls that are expected to yield future benefits. Liabilities: Creditors’ claims on assets. These are obligations to provide assets, products, or services to others. Equity: Shareholders’ claim on assets. It consists of:

Common stock reflects inflows of cash and other net assets from stockholders in exchange for stock.

Dividends are outflows of cash and other assets to stockholders that reduce equity.

Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consult- ing services provided, facilities rented to others, and commissions from services.

Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees.

Common Stock+ Dividends−

Revenues+

Expenses−

Common business entities: Sole Proprietorship Partnership

Number of owners 1 owner; easy to set up . 2 or more, called partners; easy to set up .

Business taxation No additional business income tax . No additional business income tax .

Owner liability Unlimited liability . Owner is personally liable for proprietorship debts .

Unlimited liability . Partners are jointly liable for partnership debts .

Legal entity Not a separate legal entity . Not a separate legal entity .

Business life Business ends with owner death or choice . Business ends with a partner death or choice .

Corporation Limited Liability Company (LLC)

Number of owners 1 or more, called stockholders; can get many investors by selling stock or shares of corporate ownership .

1 or more, called members .

Business taxation Additional corporate income tax . No additional business income tax .

Owner liability Limited liability . Owners, called stockholders (or share- holders), are not liable for corporate acts and debts .

Limited liability . Owners, called members, are not personally liable for LLC debts .

Legal entity A separate entity with the same rights and responsibili- ties as a person .

A separate entity with the same rights and responsibilities as a person .

Business life Indefinite . Indefinite .

Chapter 1 Accounting in Business 23

Accounting (3) Accounting equation (10) Assets (9) Audit (6) Auditors (6) Balance sheet (15) Bookkeeping (3) Business entity assumption (8) Common stock (8, 10) Conceptual framework (7) Contributed capital (10) Corporation (8) Cost-benefit constraint (8) Cost constraint (8) Cost principle (7) Dividends (10) Dodd-Frank Wall Street Reform and

Consumer Protection Act (6) Double taxation (9) Equity (9) Ethics (6) Events (11) Expanded accounting equation (10) Expense recognition principle (8)

Expenses (10) External transactions (11) External users (4) Financial accounting (4) Financial Accounting Standards

Board (FASB) (7) Full disclosure principle (8) Generally accepted accounting

principles (GAAP) (7) Going-concern assumption (8) Income statement (15) Internal controls (6) Internal transactions (11) Internal users (4) International Accounting Standards

Board (IASB) (7) International Financial Reporting

Standards (IFRS) (7) Liabilities (9) Limited liability company (LLC) (8) Managerial accounting (4) Matching principle (8) Measurement principle (7) Members (8)

Monetary unit assumption (8) Net income (15) Net loss (15) Owner investments (10) Partnership (8) Proprietorship (8) Recordkeeping (3) Retained earnings (10) Return (21) Return on assets (ROA) (18) Revenue recognition principle (7) Revenues (10) Risk (21) Sarbanes-Oxley Act (SOX) (6) Securities and Exchange

Commission (SEC) (7) Shareholders (8) Shares (8) Sole proprietorship (8) Statement of cash flows (15) Statement of retained earnings (15) Stock (8) Stockholders (8) Time period assumption (8)

Key Terms A list of key terms concludes each chapter (a complete glossary is also available)

Multiple Choice Quiz

1. A building is offered for sale at $500,000 but is currently as- sessed at $400,000. The purchaser of the building believes the building is worth $475,000, but ultimately purchases the building for $450,000. The purchaser records the building at:

a. $50,000. c. $450,000. e. $500,000. b. $400,000. d. $475,000.

Summary of transactions:

TRANSACTION ANALYSIS Accounting equation: Applies to all transactions and events, to all compa- nies and organizations, and to all points in time.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock (1) $30,000 = $30,000 (2) − 2,500 + $2,500 __________ ________ __________ Bal . 27,500 + 2,500 = 30,000 (3) −26,000 + $26,000 __________ ________ ____________ __________ Bal . 1,500 + 2,500 + 26,000 = 30,000 (4) + 7,100 = +$7,100 __________ ________ ____________ _________ __________ Bal . 1,500 + 9,600 + 26,000 = 7,100 + 30,000 (5) + 4,200 + $4,200 __________ ________ ____________ _________ __________ ________ Bal . 5,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 (6) − 1,000 − $1,000 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,700 (8) + $1,900 + 1,600 + 300 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 1,900 + 9,600 + 26,000 = 7,100 + 30,000 6,100 − 1,700 (9) + 1,900 − 1,900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,900 + 0 + 9,600 + 26,000 = 7,100 + 30,000 + 6,100 − 1,700 (10) − 900 − 900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,000 + 0 + 9,600 + 26,000 = 6,200 + 30,000 + 6,100 − 1,700 (11) − 200 − $200 __________ ________ ________ ____________ _________ __________ ______ ________ ________ Bal . $ 4,800 + $ 0 + $ 9,600 + $ 26,000 = $ 6,200 + $ 30,000 − $ 200 + $6,100 − $ 1,700

Transaction 1: Investment by owner Transaction 2: Purchase supplies for cash Transaction 3: Purchase equipment for cash Transaction 4: Purchase supplies on credit Transaction 5: Provide services for cash Transactions 6 and 7: Payment of expenses in cash Transaction 8: Provide services and facilities for credit Transaction 9: Receipt of cash from accounts receivable Transaction 10: Payment of accounts payable Transaction 11: Payment of cash dividends

FINANCIAL STATEMENTS Financial Statement Layout Purpose

Income statement Describes a company’s revenues and expenses and computes net income or loss over a period of time.

Statement of retained earnings

Explains changes in retained earnings from net income (or loss) and any dividends over a period of time.

Balance sheet Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.

Statement of cash flows

Identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

+/– Operating C.F. +/– Investing C.F. +/– Financing C.F.

Change in cash

Beg. retained earnings + Net income – Dividends

End. retained earnings

Assets = Liabilities + Equity

Revenue – Expenses

Net income

24 Chapter 1 Accounting in Business

2. On December 30 of the current year, KPMG signs a $150,000 contract to provide accounting services to one of its clients in the next year. KPMG has a December 31 year-end. Which accounting principle or assumption requires KPMG to record the accounting services revenue from this client in the next year and not in the current year? a. Business entity assumption b. Revenue recognition principle c. Monetary unit assumption d. Cost principle e. Going-concern assumption

3. If the assets of a company increase by $100,000 during the year and its liabilities increase by $35,000 during the same year, then the change in equity of the company during the year must have been: a. An increase of $135,000. d. An increase of $65,000. b. A decrease of $135,000. e. An increase of $100,000. c. A decrease of $65,000.

4. Brunswick borrows $50,000 cash from Third National Bank. How does this transaction affect the accounting equa- tion for Brunswick?

a. Assets increase by $50,000; liabilities increase by $50,000; no effect on equity.

b. Assets increase by $50,000; no effect on liabilities; equity increases by $50,000.

c. Assets increase by $50,000; liabilities decrease by $50,000; no effect on equity.

d. No effect on assets; liabilities increase by $50,000; eq- uity increases by $50,000.

e. No effect on assets; liabilities increase by $50,000; eq- uity decreases by $50,000.

5. Geek Squad performs services for a customer and bills the customer for $500. How would Geek Squad record this transaction? a. Accounts receivable increase by $500; revenues in-

crease by $500. b. Cash increases by $500; revenues increase by $500. c. Accounts receivable increase by $500; revenues

decrease by $500. d. Accounts receivable increase by $500; accounts payable

increase by $500. e. Accounts payable increase by $500; revenues increase

by $500. ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $450,000 is the actual cost incurred. 2. b; revenue is recorded when services are provided. 3. d;

4. a 5. a

Assets = Liabilities + Equity

+$100,000 = +$35,000 + ?

Change in equity = $100,000 − $35,000 = $65,000

A(B) Superscript letter A or B denotes assignments based on Appendix 1A or 1B.

Icon denotes assignments that involve decision making.

1. What is the purpose of accounting in society? 2. Technology is increasingly used to process accounting data.

Why then must we study and understand accounting? 3. Identify four kinds of external users and describe how

they use accounting information. 4. What are at least three questions business owners and

managers might be able to answer by looking at accounting information?

5. Identify three actual businesses that offer services and three actual businesses that offer products.

6. Describe the internal role of accounting for organizations. 7. Identify three types of services typically offered by ac-

counting professionals. 8. What type of accounting information might be useful

to the marketing managers of a business? 9. Why is accounting described as a service activity? 10. What are some accounting-related professions? 11. How do ethics rules affect auditors’ choice of clients?

12. What work do tax accounting professionals perform in ad- dition to preparing tax returns?

13. What does the concept of objectivity imply for information reported in financial statements?

14. A business reports its own office stationery on the balance sheet at its $400 cost, although it cannot be sold for more than $10 as scrap paper. Which accounting principle and/or assumption justifies this treatment?

15. Why is the revenue recognition principle needed? What does it demand?

16. Describe the four basic forms of business organization and their key attributes.

17. Define (a) assets, (b) liabilities, (c) equity, and (d) net assets.

18. What events or transactions change equity? 19. Identify the two main categories of accounting principles. 20. What do accountants mean by the term revenue? 21. Define net income and explain its computation.

Discussion Questions

Chapter 1 Accounting in Business 25

22. Identify the four basic financial statements of a business. 23. What information is reported in an income statement? 24. Give two examples of expenses a business might incur. 25. What is the purpose of the statement of retained earnings? 26. What information is reported in a balance sheet? 27. The statement of cash flows reports on what major activities? 28. Define and explain return on assets. 29.A Define return and risk. Discuss the trade-off between

them. 30.B Describe the three major business activities in organizations.

31.B Explain why investing (assets) and financing (liabilities and equity) totals are always equal.

32. Refer to Google’s financial statements in Appendix A near the end of the text. To what level of significance are dollar amounts rounded? What time period does its income statement cover?

33. Access the SEC EDGAR database (SEC.gov) and retrieve Apple’s 2017 10-K (filed November 3, 2017). Identify its auditor. What respon- sibility does its independent auditor claim regarding Apple’s financial statements?

GOOGLE

APPLE

QUICK STUDY

QS 1-1 Understanding accounting

Choose the term or phrase below that best completes each statement. a. Accounting c. Recording e. Governmental g. Language of business b. Identifying d. Communicating f. Technology h. Recordkeeping (bookkeeping) 1. reduces the time, effort, and cost of recordkeeping while improving clerical accuracy. 2. requires that we input, measure, and log transactions and events. 3. is the recording of transactions and events, either manually or electronically.

Quick Study exercises offer a brief check of key points

Connect reproduces assignments online, in static or algorithmic mode, which allows instructors to monitor, promote, and assess student learning. It can be used for practice, homework, or exams

QS 1-2 Identifying accounting users

Identify the following users as either external users (E) or internal users (I). a. Customers e. Managers i. Controllers b. Suppliers f. District attorney j. FBI and IRS c. External auditors g. Shareholders k. Consumer group d. Business press h. Lenders l. Directors

The fraud triangle asserts that the following three factors must exist for a person to commit fraud. A. Opportunity B. Pressure C. Rationalization Identify the fraud risk factor (A, B, or C) in each of the following situations.

1. The business has no cameras or security devices at its warehouse. 2. Managers are expected to grow business or be fired. 3. A worker sees other employees regularly take inventory for personal use. 4. No one matches the cash in the register to receipts when shifts end. 5. Officers are told to show rising income or risk layoffs. 6. A worker feels that fellow employees are not honest.

QS 1-3 Identifying ethical risks

This icon highlights ethics-related assignments

QS 1-4 Identifying principles, assumptions, and constraints C4

Identify each of the following terms or phrases as an accounting (a) principle, (b) assumption, or (c) constraint.

1. Full disclosure 3. Going-concern 2. Time period 4. Revenue recognition

QS 1-5 Identifying attributes of businesses

Complete the following table with either a yes or no regarding the attributes of a proprietorship, partner- ship, corporation, and limited liability company (LLC).

Attribute Present Proprietorship Partnership Corporation LLC

1 . Business taxed . . . . . . . . . . . . . . . . . .

2 . Limited liability . . . . . . . . . . . . . . . . . .

3 . Legal entity . . . . . . . . . . . . . . . . . . . . .

26 Chapter 1 Accounting in Business

QS 1-6 Identifying accounting principles and assumptions

Identify the letter for the principle or assumption from A through F in the blank space next to each num- bered situation that it best explains or justifies. A. General accounting principle B. Measurement (cost) principle C. Business entity assumption

D. Revenue recognition principle E. Expense recognition (matching) principle F. Going-concern assumption

1. In December of this year, Chavez Landscaping received a customer’s order and cash prepay- ment to install sod at a house that would not be ready for installation until March of next year. Chavez should record the revenue from the customer order in March of next year, not in December of this year.

2. If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000. 3. Mike Derr owns both Sailing Passions and Dockside Digs. In preparing financial statements

for Dockside Digs, Mike makes sure that the expense transactions of Sailing Passions are kept separate from Dockside Digs’s transactions and financial statements.

QS 1-7 Applying the accounting equation A1

a. Total assets of Charter Company equal $700,000 and its equity is $420,000. What is the amount of its liabilities?

b. Total assets of Martin Marine equal $500,000 and its liabilities and equity amounts are equal to each other. What is the amount of its liabilities? What is the amount of its equity?

This icon highlights assignments that enhance decision-making skills

QS 1-8 Applying the accounting equation

1. Use the accounting equation to compute the missing financial statement amounts (a), (b), and (c).

A B DC

Company Assets1 2 3 4

$ 75,000

85,000 (b)

$ (a)

20,000 25,000

3 2

$ 40,000

Liabilities= + Equity

A D EB F GC

1 2 3 4

1 2 $ 80,000

$ 40,000 $ 32,000 $ 16,000

$ 44,000 $ 20,000

$ 18,000 $ 8,000

(b) $ 0

$ 24,000 (a)

Company Assets ExpensesRevenuesLiabilities Common

Stock Dividends

2. Use the expanded accounting equation to compute the missing financial statement amounts (a) and (b).

QS 1-9 Identifying and computing assets, liabilities, and equity

Use Google’s December 31, 2017, financial statements, in Appendix A near the end of the text, to answer the following. a. Identify the amounts (in $ millions) of its 2017 (1) assets, (2) liabilities, and (3) equity. b. Using amounts from part a, verify that Assets = Liabilities + Equity.GOOGLE

QS 1-10 Identifying effects of transactions using accounting equation— Revenues and Expenses

Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Cash + Accounts = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation (identify each revenue and expense type, such as commissions revenue or rent expense). a. The company completed consulting work for a client and immediately collected $5,500 cash earned. b. The company completed commission work for a client and sent a bill for $4,000 to be received within

30 days. c. The company paid an assistant $1,400 cash as wages for the period. d. The company collected $1,000 cash as a partial payment for the amount owed by the client in transaction b. e. The company paid $700 cash for this period’s cleaning services.

Chapter 1 Accounting in Business 27

QS 1-11 Identifying effects of transactions using accounting equation— Assets and Liabilities

Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Cash + Supplies + Equipment + Land = Accounts + Common − Dividends + Revenues − Expenses Payable Stock

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation. a. The owner invested $15,000 cash in the company in exchange for its common stock. b. The company purchased supplies for $500 cash. c. The owner invested $10,000 of equipment in the company in exchange for more common stock. d. The company purchased $200 of additional supplies on credit. e. The company purchased land for $9,000 cash.

QS 1-12 Identifying items with financial statements

Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), or statement of cash flows (CF).

a. Assets b. Cash from operating activities c. Equipment d. Expenses

e. Liabilities f. Net decrease (or increase) in cash g. Revenues h. Total liabilities and equity

QS 1-13 Identifying income and equity accounts

Classify each of the following items as revenues (R), expenses (EX), or dividends (D). 1. Cost of sales 2. Service revenue 3. Wages expense

4. Cash dividends 5. Rent expense 6. Rental revenue

7. Insurance expense 8. Consulting revenue

QS 1-14 Identifying assets, liabilities, and equity P2

Classify each of the following items as assets (A), liabilities (L), or equity (EQ). 1. Land 2. Common stock

3. Equipment 4. Accounts payable

5. Accounts receivable 6. Supplies

QS 1-15 Preparing an income statement

On December 31, Hawkin’s records show the following accounts. Use this information to prepare a December income statement for Hawkin.

Equipment . . . . . . . . . . . $3,000 Accounts receivable . . . . . . . . . $ 600 Wages expense . . . . . . . . . . . $8,000

Cash . . . . . . . . . . . . . . . . 2,400 Services revenue . . . . . . . . . . . 16,000 Utilities expense . . . . . . . . . . 700

Rent expense . . . . . . . . . 1,500 Accounts payable . . . . . . . . . . . 6,000

QS 1-16 Computing and interpreting return on assets

In a recent year’s financial statements, Home Depot reported the following results. Compute and interpret Home Depot’s return on assets (assume competitors average an 11.0% return on assets).

Sales . . . . . . . . . . . . . $95 billion Net income . . . . . . . . . . . . $8 billion Average total assets . . . . . . . $42 billion

QS 1-17 Identifying and computing assets, liabilities, and equity

Use Samsung’s December 31, 2017, financial statements in Appendix A near the end of the text to an- swer the following. a. Identify the amounts (in millions of Korean won) of Samsung’s 2017 (1) assets, (2) liabilities, and

(3) equity. b. Using amounts from part a, verify that Assets = Liabilities + Equity.

Samsung

28 Chapter 1 Accounting in Business

EXERCISES

Exercise 1-1 Classifying activities reflected in the accounting system C1

Classify the following activities as part of the identifying (I), recording (R), or communicating (C) aspects of accounting.

1. Analyzing and interpreting reports. 2. Presenting financial information. 3. Keeping a log of service costs. 4. Measuring the costs of a product.

5. Preparing financial statements. 6. Acquiring knowledge of revenue transactions. 7. Observing transactions and events. 8. Registering cash sales of products sold.

Exercise 1-3 Describing accounting responsibilities

Many accounting professionals work in one of the following three areas. A. Financial accounting B. Managerial accounting C. Tax accounting Identify the area of accounting that is most involved in each of the following responsibilities.

1. Internal auditing 2. External auditing 3. Cost accounting 4. Budgeting

5. Enforcing tax laws 6. Planning transactions to minimize taxes 7. Preparing external financial statements 8. Analyzing external financial reports

Exercise 1-4 Learning the language of business

C1 C2 C3

Match each of the numbered descriptions 1 through 5 with the term or phrase it best reflects. Indicate your answer by writing the letter A through H for the term or phrase in the blank provided. A. Audit B. GAAP

C. Ethics D. FASB

1. An assessment of whether financial statements follow GAAP. 2. Amount a business earns in excess of all expenses and costs associated with its sales and

revenues. 3. A group that sets accounting principles in the United States. 4. Accounting professionals who provide services to many clients. 5. Principles that determine whether an action is right or wrong.

G. Net income H. IASB

E. SEC F. Public accountants

Part A. Identify the following questions as most likely to be asked by an internal (I) or an external (E) user of accounting information.

1. Which inventory items are out of stock? 2. Should we make a five-year loan to that business? 3. What are the costs of our product’s ingredients? 4. Should we buy, hold, or sell a company’s stock? 5. Should we spend additional money for redesign of our product? 6. Which firm reports the highest sales and income? 7. What are the costs of our service to customers?

Part B. Identify the following users as either an internal (I) or an external (E) user. 1. Research and development executive 2. Human resources executive 3. Politician 4. Shareholder

5. Distribution manager 6. Creditor 7. Production supervisor 8. Purchasing manager

Exercise 1-2 Identifying accounting users and uses

Match each of the numbered descriptions 1 through 7 with the term or phrase it best reflects. Indicate your answer by writing the letter A through G for the term or phrase in the blank provided. A. Ethics B. Fraud triangle C. Prevention

D. Internal controls E. Sarbanes-Oxley Act

1. Requires the SEC to pay whistleblowers. 2. Examines whether financial statements are prepared using GAAP; it does not ensure absolute

accuracy of the statements.

F. Audit G. Dodd-Frank Act

Exercise 1-5 Identifying ethical terminology

Most Exercises and Quick Study assignments are supported with Guided Examples (“Hints”) in Connect using different numbers; an instructor can choose whether to make them available to students

Chapter 1 Accounting in Business 29

3. Requires documentation and verification of internal controls and increases emphasis on inter- nal control effectiveness.

4. Procedures set up to protect company property and equipment, ensure reliable accounting, promote efficiency, and encourage adherence to policies.

5. A less expensive and more effective means to stop fraud. 6. Three factors push a person to commit fraud: opportunity, pressure, and rationalization. 7. Beliefs that distinguish right from wrong.

Exercise 1-6 Distinguishing business organizations

The following describe several different business organizations. Determine whether each description best refers to a sole proprietorship (SP), partnership (P), corporation (C), or limited liability company (LLC).

a. Micah and Nancy own Financial Services, which pays a business income tax. Micah and Nancy do not have personal responsibility for the debts of Financial Services.

b. Riley and Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the business.

c. IBC Services does not have separate legal existence apart from the one person who owns it. d. Trent Company is owned by Trent Malone, who is personally liable for the company’s debts. e. Ownership of Zander Company is divided into 1,000 shares of stock. The company pays a

business income tax. f. Physio Products does not pay income taxes and has one owner. The owner has unlimited lia-

bility for business debt. g. AJ Company pays a business income tax and has two owners. h. Jeffy Auto is a separate legal entity from its owner, but it does not pay a business income tax.

Exercise 1-7 Identifying accounting principles and assumptions

Enter the letter A through H for the principle or assumption in the blank space next to each numbered description that it best reflects. A. General accounting principle B. Measurement (cost) principle C. Business entity assumption D. Revenue recognition principle

E. Specific accounting principle F. Expense recognition (matching) principle G. Going-concern assumption H. Full disclosure principle

1. A company reports details behind financial statements that would impact users’ decisions. 2. Financial statements reflect the assumption that the business continues operating. 3. A company records the expenses incurred to generate the revenues reported. 4. Concepts, assumptions, and guidelines for preparing financial statements. 5. Each business is accounted for separately from its owner or owners. 6. Revenue is recorded when products and services are delivered. 7. Detailed rules used in reporting events and transactions. 8. Information is based on actual costs incurred in transactions.

Exercise 1-8 Using the accounting equation

Determine the missing amount from each of the separate situations a, b, and c below.

A B C Assets1

2 3 4

(a)$

154,000 100,000

(c)

$ 20,000 34,000 (b)

$ 45,000

40,000

Liabilities= + Equity

Exercise 1-9 Using the accounting equation

Answer the following questions. Hint: Use the accounting equation. a. At the beginning of the year, Addison Company’s assets are $300,000 and its equity is $100,000. During

the year, assets increase $80,000 and liabilities increase $50,000. What is the equity at year-end? b. Office Store Co. has assets equal to $123,000 and liabilities equal to $47,000 at year-end. What is the

equity for Office Store Co. at year-end? c. At the beginning of the year, Quaker Company’s liabilities equal $70,000. During the year, assets in-

crease by $60,000, and at year-end assets equal $190,000. Liabilities decrease $5,000 during the year. What are the beginning and ending amounts of equity?

Check (c) Beg. equity, $60,000

30 Chapter 1 Accounting in Business

Zen began a new consulting firm on January 5. Following is a financial summary, including balances, for each of the company’s first five transactions (using the accounting equation form).

Assets = Liabilities + Equity

Transaction Cash + Accounts + Office + Office = Accounts + Common + Revenues Receivable Supplies Furniture Payable Stock

1. $40,000 + $ 0 + $ 0 + $ 0 = $ 0 + $40,000 + $ 0 2. 38,000 + 0 + 3,000 + 0 = 1,000 + 40,000 + 0 3. 30,000 + 0 + 3,000 + 8,000 = 1,000 + 40,000 + 0 4. 30,000 + 6,000 + 3,000 + 8,000 = 1,000 + 40,000 + 6,000 5. 31,000 + 6,000 + 3,000 + 8,000 = 1,000 + 40,000 + 7,000

Identify the explanation from a through j below that best describes each transaction 1 through 5 above and enter it in the blank space in front of each numbered transaction. a. The company purchased office furniture for $8,000 cash. b. The company received $40,000 cash from a bank loan. c. The owner invested $1,000 cash in the business in exchange for its common stock. d. The owner invested $40,000 cash in the business in exchange for its common stock. e. The company purchased office supplies for $3,000 by paying $2,000 cash and putting $1,000 on credit. f. The company billed a customer $6,000 for services provided. g. The company purchased office furniture worth $8,000 on credit. h. The company provided services for $1,000 cash. i. The company sold office supplies for $3,000 and received $2,000 cash and $1,000 on credit. j. The company provided services for $6,000 cash.

Identify the explanation from a through j below that best describes each transaction 1 through 5 and enter it in the blank space in front of each numbered transaction. a. The company purchased $1,000 of office supplies on credit. b. The company collected $1,900 cash from an account receivable. c. The company sold land for $4,000 cash. d. The company paid $1,000 cash in dividends to shareholders. e. The company purchased office supplies for $1,000 cash. f. The company purchased land for $4,000 cash. g. The company billed a client $1,900 for services provided. h. The company paid $1,000 cash toward an account payable. i. The owner invested $1,900 cash in the business in exchange for its common stock. j. The company sold office supplies for $1,900 on credit.

The following table shows the effects of transactions 1 through 5 on the assets, liabilities, and equity of Mulan’s Boutique.

Assets = Liabilities + Equity

Cash + Accounts + Office + Land = Accounts + Common + Revenues Receivable Supplies Payable Stock $ 21,000 + $ 0 + $3,000 + $19,000 = $ 0 + $43,000 + $ 0

1. − 4,000 + 4,000 2. + 1,000 +1,000 3. + 1,900 + 1,900 4. − 1,000 − 1,000 5. + 1,900 − 1,900

$ 17,900 + $ 0 + $4,000 + $23,000 = $ 0 + $43,000 + $1,900

Exercise 1-10 Analysis using the accounting equation

Exercise 1-11 Identifying effects of transactions on the accounting equation

Chapter 1 Accounting in Business 31

For each transaction a through f, identify its impact on the accounting equation (select from 1 through 5 below). a. The company pays cash toward an account payable. b. The company purchases equipment on credit. c. The owner invests cash in the business in exchange for its common stock. d. The company pays cash dividends to shareholders. e. The company purchases supplies for cash. f. The company provides services for cash.

1. Decreases an asset and decreases equity. 2. Increases an asset and increases a liability. 3. Decreases an asset and decreases a liability.

4. Increases an asset and decreases an asset. 5. Increases an asset and increases equity.

On October 1, Ebony Ernst organized Ernst Consulting; on October 3, the owner contributed $84,000 in assets in exchange for its common stock to launch the business. On October 31, the company’s records show the fol- lowing items and amounts. Use this information to prepare an October income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . $11,360 Cash dividends . . . . . . . . . . . . . . . . . . . . . . . $ 2,000

Accounts receivable . . . . . . . . . . . . 14,000 Consulting revenue . . . . . . . . . . . . . . . . . . . . 14,000

Office supplies . . . . . . . . . . . . . . . . 3,250 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . 3,550

Land . . . . . . . . . . . . . . . . . . . . . . . . . 46,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . 7,000

Office equipment . . . . . . . . . . . . . . 18,000 Telephone expense . . . . . . . . . . . . . . . . . . . . 760

Accounts payable . . . . . . . . . . . . . . 8,500 Miscellaneous expenses . . . . . . . . . . . . . . . . 580

Common stock . . . . . . . . . . . . . . . . 84,000

Exercise 1-15 Preparing an income statement

Check Net income, $2,110

Exercise 1-12 Identifying effects of transactions on the accounting equation

Swiss Group reports net income of $40,000 for 2019. At the beginning of 2019, Swiss Group had $200,000 in assets. By the end of 2019, assets had grown to $300,000. What is Swiss Group’s 2019 return on assets? How would you assess its performance if competitors average an 11% return on assets?

Exercise 1-14 Analyzing return on assets

Ming Chen began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Ming Chen (the owner) completed these transactions. a. Owner invested $60,000 cash in the company along with equipment that had a $15,000 market value

in exchange for its common stock. b. The company paid $1,500 cash for rent of office space for the month. c. The company purchased $10,000 of additional equipment on credit (payment due within 30 days). d. The company completed work for a client and immediately collected the $2,500 cash earned. e. The company completed work for a client and sent a bill for $8,000 to be received within 30 days. f. The company purchased additional equipment for $6,000 cash. g. The company paid an assistant $3,000 cash as wages for the month. h. The company collected $5,000 cash as a partial payment for the amount owed by the client in transaction e. i. The company paid $10,000 cash to settle the liability created in transaction c. j. The company paid $1,000 cash in dividends to the owner (sole shareholder).

Required

Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of the transactions on individual items of the accounting equation. Show new balances after each transaction.

Check Ending balances: Cash, $46,000; Expenses, $4,500

Exercise 1-13 Identifying effects of transactions using the accounting equation

Assets = Liabilities + Equity

Cash + Accounts + Equipment = Accounts + Common – Dividends + Revenues – Expenses Receivable Payable Stock

Use the information in Exercise 1-15 to prepare an October statement of retained earnings for Ernst Consulting.

Exercise 1-16 Preparing a statement of retained earnings P2

32 Chapter 1 Accounting in Business

Use the information in Exercise 1-15 to prepare an October 31 balance sheet for Ernst Consulting. Hint: The solution to Exercise 1-16 can help.

Exercise 1-17 Preparing a balance sheet P2

Indicate the section (O, I, or F) where transactions 1 through 8 would appear on the statement of cash flows. O. Cash flows from operating activity F. Cash flows from financing activity I. Cash flows from investing activity

1. Cash purchase of equipment 2. Cash paid for dividends 3. Cash paid for advertising 4. Cash paid for wages

5. Cash paid on account payable to supplier 6. Cash received from clients 7. Cash paid for rent 8. Cash investment from shareholders

Exercise 1-19 Identifying sections of the statement of cash flows

Selling and administrative costs . . . . . . . . . . . . . $ 12,196

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,584

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,800

Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,413

Ford Motor Company, one of the world’s largest automakers, reports the following income statement accounts for the year ended December 31 ($ in millions). Use this information to prepare Ford’s income statement for the year ended December 31.

Exercise 1-20 Preparing an income statement for a company

Match each transaction a through e to one of the following activities of an organization: financing activity (F), investing activity (I), or operating activity (O).

a. An owner contributes cash to the business in exchange for its common stock. b. An organization borrows money from a bank. c. An organization advertises a new product. d. An organization sells some of its land. e. An organization purchases equipment.

Exercise 1-21B Identifying business activities

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . €75,350

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,946

Selling and administrative costs . . . . . . . . . . . . . €6,139

Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 4,988

BMW Group, one of Europe’s largest manufacturers, reports the following income statement accounts for the year ended December 31 (euros in millions). Use this information to prepare BMW’s income state- ment for the year ended December 31.

Exercise 1-22 Preparing an income statement for a company

Use the information in Exercise 1-15 to prepare an October 31 statement of cash flows for Ernst Consulting. Assume the following additional information. a. The owner’s initial investment consists of $38,000 cash and $46,000 in land in exchange for its common

stock. b. The company’s $18,000 equipment purchase is paid in cash. c. The accounts payable balance of $8,500 consists of the $3,250 office supplies purchase and $5,250 in

employee salaries yet to be paid. d. The company’s rent, telephone, and miscellaneous expenses are paid in cash. e. No cash has been collected on the $14,000 consulting fees earned.

Exercise 1-18 Preparing a statement of cash flows

Check Net increase in cash, $11,360

Answer the following questions. Hint: Use the accounting equation. a. On January 1, Lumia Company’s liabilities are $60,000 and its equity is $40,000. On January 3, Lumia

purchases and installs solar panel assets costing $10,000. For the panels, Lumia pays $4,000 cash and promises to pay the remaining $6,000 in six months. What is the total of Lumia’s assets after the solar panel purchase?

b. On March 1, ABX Company’s assets are $100,000 and its liabilities are $30,000. On March 5, ABX is fined $15,000 for failing emission standards. ABX immediately pays the fine in cash. After the fine is paid, what is the amount of equity for ABX?

c. On August 1, Lola Company’s assets are $30,000 and its liabilities are $10,000. On August 4, Lola issues a sustainability report following SASB guidelines. Investors react positively to this report. On August 5, a new investor contributes $3,000 cash and $7,000 in equipment in exchange for ownership in Lola. After the investment, what is the amount of equity for Lola?

Exercise 1-23 Using the accounting equation

This icon highlights sustainability-related assignments

Chapter 1 Accounting in Business 33

Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with dollar amounts. The first transaction is completed as an example.

Required

a. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total eq- uity. For the income statement, identify how each transaction affects net income.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating ac- tivities, cash flows from investing activities, and cash flows from financing activities.

Problem Set B, located at the end of Problem Set A, is provided for each problem to reinforce the learning process

PROBLEM SET A

Problem 1-1A Identifying effects of transactions on financial statements

A1 P1

a. b.

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Investing Financing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests $900 cash in business in exchange for stock +900 +900 +900

2 Receives $700 cash for services provided

3 Pays $500 cash for employee wages

4 Buys $100 of equipment on credit

5 Purchases $200 of supplies on credit

6 Buys equipment for $300 cash

7 Pays $200 on accounts payable

8 Provides $400 services on credit

9 Pays $50 cash in dividends

10 Collects $400 cash on accounts receivable

[continued on next page]

The following financial statement information is from five separate companies. Problem 1-2A Computing missing information using accounting knowledge

A1 P1

Company Company Company Company Company A B C D E

December 31, 2018

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $55,000 $34,000 $24,000 $60,000 $119,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 24,500 21,500 9,000 40,000 ? December 31, 2019

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 40,000 ? 85,000 113,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . ? 26,500 29,000 24,000 70,000 During year 2019

Stock issuances . . . . . . . . . . . . . . . . . . . . 6,000 1,400 9,750 ? 6,500 Net income (loss) . . . . . . . . . . . . . . . . . . . 8,500 ? 8,000 14,000 20,000 Cash dividends . . . . . . . . . . . . . . . . . . . . . 3,500 2,000 5,875 0 11,000

Required

1. Answer the following questions about Company A. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019? 2. Answer the following questions about Company B. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is net income for year 2019?

Check (1b) $41,500

(2c) $1,600

34 Chapter 1 Accounting in Business

3. Compute the amount of assets for Company C on December 31, 2019. 4. Compute the amount of stock issuances for Company D during year 2019. 5. Compute the amount of liabilities for Company E on December 31, 2018.

(3) $55,875

Problem 1-4A Preparing a statement of retained earnings P2

Use the information in Problem 1-3A to prepare a year-end statement of retained earnings for Armani Company.

Problem 1-5A Preparing a balance sheet

Use the information in Problem 1-3A to prepare a year-end balance sheet for Armani Company.

Problem 1-7A Analyzing transactions and preparing financial statements

P1 P2

Gabi Gram started The Gram Co., a new business that began operations on May 1. The Gram Co. com- pleted the following transactions during its first month of operations.

May 1 G. Gram invested $40,000 cash in the company in exchange for its common stock. 1 The company rented a furnished office and paid $2,200 cash for May’s rent. 3 The company purchased $1,890 of office equipment on credit. 5 The company paid $750 cash for this month’s cleaning services. 8 The company provided consulting services for a client and immediately collected $5,400

cash. 12 The company provided $2,500 of consulting services for a client on credit. 15 The company paid $750 cash for an assistant’s salary for the first half of this month. 20 The company received $2,500 cash payment for the services provided on May 12. 22 The company provided $3,200 of consulting services on credit. 25 The company received $3,200 cash payment for the services provided on May 22. 26 The company paid $1,890 cash for the office equipment purchased on May 3. 27 The company purchased $80 of office equipment on credit. 28 The company paid $750 cash for an assistant’s salary for the second half of this month. 30 The company paid $300 cash for this month’s telephone bill. 30 The company paid $280 cash for this month’s utilities. 31 The company paid $1,400 cash in dividends to the owner (sole shareholder).

Problem 1-6A Preparing a statement of cash flows

Following is selected financial information of Kia Company for the year ended December 31, 2019.

Cash used by investing activities . . . . . . . . . . $(2,000)

Net increase in cash . . . . . . . . . . . . . . . . . . . . 1,200

Cash used by financing activities . . . . . . . . . . (2,800)

Cash from operating activities . . . . . . . . . . $6,000

Cash, December 31, 2018 . . . . . . . . . . . . . 2,300

Required

Prepare the 2019 year-end statement of cash flows for Kia Company. Check Cash balance, Dec. 31, 2019, $3,500

Problem 1-3A Preparing an income statement

As of December 31, 2019, Armani Company’s financial records show the following items and amounts.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . 9,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . 11,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Retained earnings, Dec . 31, 2018 . . . . . . . . . . 3,000

Retained earnings, Dec . 31, 2019 . . . . . . . . . . . . $ 5,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Consulting revenue . . . . . . . . . . . . . . . . . . . . . . . 33,000

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Selling and administrative expenses . . . . . . . . . . 8,000

Required

Prepare the 2019 year-end income statement for Armani Company.Check Net income, $15,000

Chapter 1 Accounting in Business 35

Required

1. Create the following table similar to the one in Exhibit 1.9.

Check (1) Ending balances: Cash, $42,780; Expenses, $5,030

Assets = Liabilities + Equity

Date Cash + Accounts + Office = Accounts + Common – Dividends + Revenues – Expenses Receivable Equipment Payable Stock

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

2. Prepare the income statement and the statement of retained earnings for the month of May, and the balance sheet as of May 31.

3. Prepare the statement of cash flows for the month of May.

(2) Net income, $6,070; Total assets, $44,750

Assets = Liabilities + Equity

Cash + Accounts + Office + Office + Office = Accounts + Common – Dividends + Revenues – Expenses Receivable Supplies Equipment Suite Payable Stock

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Determine the company’s net income. (2) Net income, $4,500

Problem 1-8A Analyzing effects of transactions

A1 P1

Lita Lopez started Biz Consulting, a new business, and completed the following transactions during its first year of operations. a. Lita Lopez invested $70,000 cash and office equipment valued at $10,000 in the company in exchange

for its common stock. b. The company purchased an office suite for $40,000 cash. c. The company purchased office equipment for $15,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $500 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,800 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash fee. h. The company paid $3,275 cash in dividends to the owner (sole shareholder). i. The company received $1,800 cash as partial payment from the client described in transaction f. j. The company made a partial payment of $700 cash on the equipment purchased in transaction d. k. The company paid $1,800 cash for the office secretary’s wages for this period.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Check (1) Ending balances: Cash, $14,525; Expenses, $2,300; Accounts Payable, $2,200

Sanyu Sony started a new business and completed these transactions during December.

Dec. 1 Sanyu Sony transferred $65,000 cash from a personal savings account to a checking account in the name of Sony Electric in exchange for its common stock.

2 The company rented office space and paid $1,000 cash for the December rent. 3 The company purchased $13,000 of electrical equipment by paying $4,800 cash and agreeing to

pay the $8,200 balance in 30 days. 5 The company purchased office supplies by paying $800 cash. 6 The company completed electrical work and immediately collected $1,200 cash for these services. 8 The company purchased $2,530 of office equipment on credit. 15 The company completed electrical work on credit in the amount of $5,000. 18 The company purchased $350 of office supplies on credit. 20 The company paid $2,530 cash for the office equipment purchased on December 8. 24 The company billed a client $900 for electrical work completed; the balance is due in 30 days. 28 The company received $5,000 cash for the work completed on December 15. 29 The company paid the assistant’s salary of $1,400 cash for this month. 30 The company paid $540 cash for this month’s utility bill. 31 The company paid $950 cash in dividends to the owner (sole shareholder).

Problem 1-9A Analyzing transactions and preparing financial statements

C4 P1 P2

36 Chapter 1 Accounting in Business

Required

1. Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Date Cash + Accounts + Office + Office + Electrical = Accounts + Common − Dividends + Revenues − Expenses Receivable Supplies Equipment Equipment Payable Stock

Check (1) Ending balances: Cash, $59,180; Accounts Payable, $8,550

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Prepare the income statement and the statement of retained earnings for the current month, and the balance sheet as of the end of the month.

3. Prepare the statement of cash flows for the current month.

Analysis Component

4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $65,000 and that Sony Electric obtained another $16,000 in cash by borrowing it from a bank. Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

(2) Net income, $4,160; Total assets, $76,760

Kyzera manufactures, markets, and sells cellular telephones. The average total assets for Kyzera is $250,000. In its most recent year, Kyzera reported net income of $65,000 on revenues of $475,000.

Required

1. What is Kyzera’s return on assets? 2. Does return on assets seem satisfactory for Kyzera given that its competitors average a 12% return on

assets? 3. What are total expenses for Kyzera in its most recent year? 4. What is the average total amount of liabilities plus equity for Kyzera?

Problem 1-10A Determining expenses, liabilities, equity, and return on assets

A1 A2

Check (3) $410,000

(4) $250,000

Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures for these businesses for a recent year follow.

Key Figures ($ millions) Coca-Cola PepsiCo

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $46,542 $66,504

Net income . . . . . . . . . . . . . . . . . . . . . . . 8,634 6,462

Average assets . . . . . . . . . . . . . . . . . . . . 76,448 70,518

Required

1. Compute return on assets for (a) Coca-Cola and (b) PepsiCo. 2. Which company is more successful in its total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-11A Computing and interpreting return on assets

Check (1a) 11.3%; (1b) 9.2%

All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” is most risky and “4” is least risky.

a. Lowest-risk corporate bond c. Company stock in a start-up b. Medium-risk corporate bond d. U.S. government Treasury bond

Problem 1-12AA Identifying risk and return

A start-up company often engages in the following transactions during its first year of operations. Classify those transactions in one of the three major categories of an organization’s business activities. F. Financing I. Investing O. Operating

1. Shareholders investing in business 2. Purchasing a building 3. Purchasing land 4. Borrowing cash from a bank

Problem 1-13AB Describing business activities

C5 5. Purchasing equipment 6. Selling and distributing products 7. Paying for advertising 8. Paying employee wages

Chapter 1 Accounting in Business 37

An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity.

Problem 1-14AB Describing business activities C5

PROBLEM SET B

Problem 1-1B Identifying effects of transactions on financial statements

A1 P1

Required

a. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total eq- uity. For the income statement, identify how each transaction affects net income.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating ac- tivities, cash flows from investing activities, and cash flows from financing activities.

a. b.

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Investing Financing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests $800 cash in business in exchange for stock +800 +800 +800

2 Purchases $100 of supplies on credit

3 Buys equipment for $400 cash

4 Provides services for $900 cash

5 Pays $400 cash for rent incurred

6 Buys $200 of equipment on credit

7 Pays $300 cash for wages incurred

8 Pays $50 cash in dividends

9 Provides $600 services on credit

10 Collects $600 cash on accounts receivable

The following financial statement information is from five separate companies. Problem 1-2B Computing missing information using accounting knowledge

A1 P1

Company Company Company Company Company V W X Y Z

December 31, 2018

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,000 $ 80,000 $141,500 $92,500 $144,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 60,000 68,500 51,500 ? December 31, 2019

Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000 100,000 186,500 ? 170,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 ? 65,800 42,000 42,000 During year 2019

Stock issuances . . . . . . . . . . . . . . . . . . . 5,000 20,000 ? 48,100 60,000 Net income (or loss) . . . . . . . . . . . . . . . ? 40,000 18,500 24,000 32,000 Cash dividends . . . . . . . . . . . . . . . . . . . 5,500 2,000 0 20,000 8,000

Required

1. Answer the following questions about Company V. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the net income or loss for the year 2019? [continued on next page]

Check (1b) $23,000

38 Chapter 1 Accounting in Business

2. Answer the following questions about Company W. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019? 3. Compute the amount of stock issuances for Company X during 2019. 4. Compute the amount of assets for Company Y on December 31, 2019. 5. Compute the amount of liabilities for Company Z on December 31, 2018.

(2c) $22,000

(4) $135,100

As of December 31, 2019, Audi Company’s financial records show the following items and amounts.Problem 1-3B Preparing an income statement

P2 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100

Retained earnings, Dec . 31, 2018 . . . . . . . . . . . . . 900

Retained earnings, Dec . 31, 2019 . . . . . . . . . . . . . . . $1,300

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600

Consulting revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 6,600

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Selling and administrative expenses . . . . . . . . . . . . . 1,600

Required

Prepare the 2019 year-end income statement for Audi Company.Check Net income, $3,000

Use the information in Problem 1-3B to prepare a year-end statement of retained earnings for Audi Company.

Problem 1-4B Preparing a statement of retained earnings P2

Use the information in Problem 1-3B to prepare a year-end balance sheet for Audi Company.Problem 1-5B Preparing a balance sheet P2

Nina Niko launched a new business, Niko’s Maintenance Co., that began operations on June 1. The fol- lowing transactions were completed by the company during that first month.

June 1 Nina Niko invested $130,000 cash in the company in exchange for its common stock. 2 The company rented a furnished office and paid $6,000 cash for June’s rent. 4 The company purchased $2,400 of equipment on credit. 6 The company paid $1,150 cash for this month’s advertising of the opening of the business. 8 The company completed maintenance services for a customer and immediately collected $850 cash. 14 The company completed $7,500 of maintenance services for City Center on credit. 16 The company paid $800 cash for an assistant’s salary for the first half of the month. 20 The company received $7,500 cash payment for services completed for City Center on June 14. 21 The company completed $7,900 of maintenance services for Paula’s Beauty Shop on credit. 24 The company completed $675 of maintenance services for Build-It Coop on credit. 25 The company received $7,900 cash payment from Paula’s Beauty Shop for the work completed

on June 21. 26 The company made payment of $2,400 cash for equipment purchased on June 4. 28 The company paid $800 cash for an assistant’s salary for the second half of this month. 29 The company paid $4,000 cash in dividends to the owner (sole shareholder). 30 The company paid $150 cash for this month’s telephone bill. 30 The company paid $890 cash for this month’s utilities.

Problem 1-7B Analyzing transactions and preparing financial statements

P1 P2

Problem 1-6B Preparing a statement of cash flows

Selected financial information of Banji Company for the year ended December 31, 2019, follows.

Cash from investing activities . . . . . . . . . . . . . . . $1,600

Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . 400

Cash from financing activities . . . . . . . . . . . . . . . 1,800

Cash used by operating activities . . . . . . . . . . $(3,000)

Cash, December 31, 2018 . . . . . . . . . . . . . . . . 1,300

Required

Prepare the 2019 year-end statement of cash flows for Banji Company.

Chapter 1 Accounting in Business 39

Required

1. Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Date Cash + Accounts + Equipment = Accounts + Common – Dividends + Revenues – Expenses Receivable Payable Stock

2. Prepare the income statement and the statement of retained earnings for the month of June, and the balance sheet as of June 30.

3. Prepare the statement of cash flows for the month of June.

(2) Net income, $7,135; Total assets, $133,135

Check (1) Ending balances: Cash, $130,060; Expenses, $9,790

Problem 1-9B Analyzing transactions and preparing financial statements

C4 P1 P2

Rivera Roofing Company, owned by Reyna Rivera, began operations in July and completed these transac- tions during that first month of operations. July 1 Reyna Rivera invested $80,000 cash in the company in exchange for its common stock. 2 The company rented office space and paid $700 cash for the July rent. 3 The company purchased roofing equipment for $5,000 by paying $1,000 cash and agreeing to

pay the $4,000 balance in 30 days. 6 The company purchased office supplies for $600 cash. 8 The company completed work for a customer and immediately collected $7,600 cash for the work. 10 The company purchased $2,300 of office equipment on credit. 15 The company completed work for a customer on credit in the amount of $8,200. 17 The company purchased $3,100 of office supplies on credit. 23 The company paid $2,300 cash for the office equipment purchased on July 10. 25 The company billed a customer $5,000 for work completed; the balance is due in 30 days. 28 The company received $8,200 cash for the work completed on July 15. 30 The company paid an assistant’s salary of $1,560 cash for this month. 31 The company paid $295 cash for this month’s utility bill. 31 The company paid $1,800 cash in dividends to the owner (sole shareholder).

Problem 1-8B Analyzing effects of transactions

A1 P1

Neva Nadal started a new business, Nadal Computing, and completed the following transactions during its first year of operations. a. Neva Nadal invested $90,000 cash and office equipment valued at $10,000 in the company in

exchange for its common stock. b. The company purchased an office suite for $50,000 cash. c. The company purchased office equipment for $25,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office equipment on credit. e. The company paid a local newspaper $750 cash for printing an announcement of the office’s opening. f. The company completed a financial plan for a client and billed that client $2,800 for the service. g. The company designed a financial plan for another client and immediately collected a $4,000 cash fee. h. The company paid $11,500 cash in dividends to the owner (sole shareholder). i. The company received $1,800 cash from the client described in transaction f. j. The company made a payment of $700 cash on the equipment purchased in transaction d. k. The company paid $2,500 cash for the office secretary’s wages.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Check (1) Ending balances: Cash, $5,350; Expenses, $3,250; Accounts Payable, $2,200

Assets = Liabilities + Equity

Cash + Accounts + Office + Office + Office = Accounts + Common – Dividends + Revenues – Expenses Receivable Supplies Equipment Suite Payable Stock

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Determine the company’s net income. (2) Net income, $3,550

40 Chapter 1 Accounting in Business

Required

1. Create the following table similar to the one in Exhibit 1.9.

Assets = Liabilities + Equity

Date Cash + Accounts + Office + Office + Roofing = Accounts + Common − Dividends + Revenues − Expenses Receivable Supplies Equipment Equipment Payable Stock

Use additions and subtractions within the table to show the dollar effects of each transaction on indi- vidual items of the accounting equation. Show new balances after each transaction.

2. Prepare the income statement and the statement of retained earnings for the month of July, and the balance sheet as of July 31.

3. Prepare the statement of cash flows for the month of July.

Analysis Component

4. Assume that the $5,000 purchase of roofing equipment on July 3 was financed from an owner investment of another $5,000 cash in the business in exchange for more common stock (instead of the purchase conditions described in the transaction above). Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

Check (1) Ending balances: Cash, $87,545; Accounts Payable, $7,100

(2) Net income, $18,245; Total assets, $103,545

Ski-Doo Company manufactures, markets, and sells snowmobiles and snowmobile equipment and acces- sories. The average total assets for Ski-Doo is $3,000,000. In its most recent year, Ski-Doo reported net income of $201,000 on revenues of $1,400,000.

Required

1. What is Ski-Doo Company’s return on assets? 2. Does return on assets seem satisfactory for Ski-Doo given that its competitors average a 9.5% return

on assets? 3. What are the total expenses for Ski-Doo Company in its most recent year? 4. What is the average total amount of liabilities plus equity for Ski-Doo Company?

Problem 1-10B Determining expenses, liabilities, equity, and return on assets

A1 A2

Check (3) $1,199,000

(4) $3,000,000

Problem 1-11B Computing and interpreting return on assets

Check (1a) 1.6%; (1b) 4.5%

AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures for these businesses for a recent year follow.

Key Figures ($ millions) AT&T Verizon

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,723 $110,875

Net income . . . . . . . . . . . . . . . . . . . . . . . 4,184 10,198

Average assets . . . . . . . . . . . . . . . . . . . . 269,868 225,233

Required

1. Compute return on assets for (a) AT&T and (b) Verizon. 2. Which company is more successful in the total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-12BA Identifying risk and return

All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” reflects the highest expected return and “4” the lowest expected return.

a. Low-risk corporate bond c. Money stored in a fireproof vault b. Stock of a successful company d. U.S. Treasury bond

Problem 1-13BB Describing business activities

A start-up company often engages in the following activities during its first year of operations. Classify each of the following activities into one of the three major activities of an organization. F. Financing I. Investing O. Operating

1. Providing client services 2. Obtaining a bank loan 3. Purchasing machinery 4. Research for its products

5. Supervising workers 6. Shareholders investing in business 7. Renting office space 8. Paying utilities expenses

Chapter 1 Accounting in Business 41

Problem 1-14BB Describing business activities C5

Identify in outline format the three major business activities of an organization. For each of these activi- ties, identify at least two specific transactions or events normally undertaken by the business’s owners or its managers.

SERIAL PROBLEM Business Solutions

C4 P1

SP 1 On October 1, 2019, Santana Rey launched a computer services company, Business Solutions, that is organized as a corporation and provides consulting services, computer system installations, and custom program development.

Required

Create a table like the one in Exhibit 1.9 using the following headings for columns: Cash; Accounts Receivable; Computer Supplies; Computer System; Office Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Then use additions and subtractions within the table to show the dollar effects for each of the following October transactions for Business Solutions on the individual items of the accounting equation. Show new balances after each transaction.

Oct. 1 S. Rey invested $45,000 cash, a $20,000 computer system, and $8,000 of office equipment in the company in exchange for its common stock.

3 The company purchased $1,420 of computer supplies on credit from Harris Office Products. 6 The company billed Easy Leasing $4,800 for services performed in installing a new web server. 8 The company paid $1,420 cash for the computer supplies purchased from Harris Office Prod-

ucts on October 3. 10 The company hired Lyn Addie as a part-time assistant for $125 per day, as needed. 12 The company billed Easy Leasing another $1,400 for services performed. 15 The company received $4,800 cash from Easy Leasing as partial payment toward its account. 17 The company paid $805 cash to repair computer equipment damaged when moving it. 20 The company paid $1,728 cash for advertisements published in the local newspaper. 22 The company received $1,400 cash from Easy Leasing toward its account. 28 The company billed IFM Company $5,208 for services performed. 31 The company paid $875 cash for Lyn Addie’s wages for seven days of work this month. 31 The company paid $3,600 cash in dividends to the owner (sole shareholder).

Serial Problem starts here and continues throughout the text

©Alexander Image/Shutterstock

Check Ending balances: Cash, $42,772; Revenues, $11,408; Expenses, $3,408

GENERAL LEDGER PROBLEM

Accounting professionals apply many technology tools to aid them in their everyday tasks and decision making. The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so the accounting professional can focus on the impacts of each transaction on the full set of finan- cial statements. Chapter 2 is the first chapter to use this tool in helping students see the advantages of technology and, in particular, the power of the General Ledger tool in accounting practice, including financial analysis and “what-if” scenarios.

COMPANY ANALYSIS A1 A2

Accounting Analysis

AA 1-1 Key financial figures for Apple’s two most recent fiscal years follow.

Accounting Analysis (AA) is a section aimed to refine company analysis, comparative analysis, and global analysis skills; Accounting Analysis assignments are available in Connect.

$ millions Current Year Prior Year

Liabilities + Equity . . . . . . . . . . . . . . . . . $375,319 $321,686 Net income . . . . . . . . . . . . . . . . . . . . . . . 48,351 45,687

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . 229,234 215,639

Required

1. What is the total amount of assets invested in Apple in the current year? 2. What is Apple’s return on assets for the current year? 3. How much are total expenses for Apple for the current year? 4. Is Apple’s current-year return on assets better or worse than competitors’ average of 10% return?

APPLE

42 Chapter 1 Accounting in Business

ETHICS CHALLENGE C3 C4

BTN 1-1 Tana Thorne works in a public accounting firm and hopes to eventually be a partner. The man- agement of Allnet Company invites Thorne to prepare a bid to audit Allnet’s financial statements. In dis- cussing the audit fee, Allnet’s management suggests a fee range in which the amount depends on the reported profit of Allnet. The higher its profit, the higher will be the audit fee paid to Thorne’s firm.

Required

1. Identify the parties potentially affected by this audit and the fee plan proposed. 2. What are the ethical factors in this situation? Explain. 3. Would you recommend that Thorne accept this audit fee arrangement? Why or why not? 4. Describe some ethical considerations guiding your recommendation.

Beyond the Numbers

Beyond the Numbers (BTN) is a special problem section aimed to refine communication, conceptual, analysis, and research skills. It includes many activities helpful in developing an active learning environment.

AA 1-2 Key comparative figures ($ millions) for both Apple and Google follow.COMPARATIVE ANALYSIS A1 A2

APPLE GOOGLE

Apple Google

Key Figures Current Year Prior Year Current Year Prior Year

Liabilities + Equity . . . . . . . . . . $375,319 $321,686 $197,295 $167,497 Net income . . . . . . . . . . . . . . . . 48,351 45,687 12,662 19,478

Revenues . . . . . . . . . . . . . . . . . . 229,234 215,639 110,855 90,272

Required

1. What is the total amount of assets invested for the current year in (a) Apple and (b) Google? 2. What is the current-year return on assets for (a) Apple and (b) Google? 3. How much are current-year expenses for (a) Apple and (b) Google? 4. Is the current-year return on assets better than the 10% return of competitors for (a) Apple and

(b) Google? 5. Relying only on return on assets, would we invest in Google or Apple?

Note: Reference to Google throughout the text refers to Alphabet Inc., as Google is a wholly owned subsidiary of Alphabet.

AA 1-3 Samsung is a leading global manufacturer that competes with Apple and Google. Key financial figures for Samsung follow.

Required

1. What is the return on assets for Samsung in the (a) current year and (b) prior year? 2. Does Samsung’s return on assets exhibit a favorable or unfavorable change? 3. Is Samsung’s current-year return on assets better or worse than that for (a) Apple and (b) Google?

GLOBAL ANALYSIS A1 A2

APPLE GOOGLE

Samsung Korean Won & USD Samsung* Apple Google in millions Current Year Prior Year Current Year Current Year

Average assets . . . . . . . . . . ₩281,963,207 ₩252,176,923 $348,503 $182,396

Net income . . . . . . . . . . . . . 42,186,747 22,726,092 48,351 12,662

Revenues . . . . . . . . . . . . . . . 239,575,376 201,866,745 229,234 110,855

*Figures prepared in accordance with International Financial Reporting Standards as adopted by the Republic of Korea.

BTN 1-2 Refer to this chapter’s opening feature about Apple. Assume that the owners, sometime during their first five years of business, desire to expand their computer product services to meet business demand regarding computing services. They eventually decide to meet with their banker to discuss a loan to allow Apple to expand and offer computing services.

COMMUNICATING IN PRACTICE C2 C4

APPLE

Chapter 1 Accounting in Business 43

Required

1. Prepare a half-page report outlining the information you would request from the owners if you were the loan officer.

2. Indicate whether the information you request and your loan decision are affected by the form of busi- ness organization for Apple.

BTN 1-3 Visit the EDGAR database at SEC.gov. Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker: RMCF) filed on May 23, 2017, covering its 2017 fiscal year.

Required

1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2013–2017. Describe the revenue trend for RMCF over this five-year period.

2. Has RMCF been profitable (see net income) over this five-year period? Support your answer.

TAKING IT TO THE NET A2

BTN 1-4 Teamwork is important in today’s business world. Successful teams schedule convenient meet- ings, maintain regular communications, and cooperate with and support their members. This assignment aims to establish support/learning teams, initiate discussions, and set meeting times.

Required

1. Form teams and open a team discussion to determine a regular time and place for your team to meet between each scheduled class meeting. Notify your instructor via a memorandum or e-mail message as to when and where your team will hold regularly scheduled meetings.

2. Develop a list of telephone numbers, LinkedIn pages, and/or e-mail addresses of your teammates.

TEAMWORK IN ACTION C1

BTN 1-5 Refer to this chapter’s opening feature about Apple. Assume that the owners decide to open a new company with an innovative mobile app devoted to microblogging for accountants and those learning accounting. This new company will be called AccountApp.

Required

1. AccountApp obtains a $500,000 loan and the two owners contribute $250,000 in total from their own savings in exchange for ownership of the new company.

a. What is the new company’s total amount of liabilities plus equity? b. What is the new company’s total amount of assets? 2. If the new company earns $80,250 in net income in the first year of operation, compute its return on

assets (assume average assets equal $750,000). Assess its performance if competitors average a 10% return.

ENTREPRENEURIAL DECISION A1 A2

APPLE

Check (2) 10.7%

BTN 1-6 You are to interview a local business owner. (This can be a friend or relative.) Opening lines of communication with members of the business community can provide personal benefits of business net- working. If you do not know the owner, you should call ahead to introduce yourself and explain your position as a student and your assignment requirements. You should request a 30-minute appointment for a face-to-face or phone interview to discuss the form of organization and operations of the business. Be prepared to make a good impression.

Required

1. Identify and describe the main operating activities and the form of organization for this business. 2. Determine and explain why the owner(s) chose this particular form of organization. 3. Identify any special advantages and/or disadvantages the owner(s) experiences in operating with this

form of business organization.

HITTING THE ROAD C4

Learning Objectives

CONCEPTUAL C1 Explain the steps in processing

transactions and the role of source documents.

C2 Describe an account and its use in recording transactions.

C3 Describe a ledger and a chart of accounts.

PROCEDURAL P1 Record transactions in a journal and post

entries to a ledger.

P2 Prepare and explain the use of a trial balance.

P3 Prepare financial statements from business transactions.

C4 Define debits and credits and explain double-entry accounting.

ANALYTICAL A1 Analyze the impact of transactions on

accounts and financial statements.

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Chapter Preview

2 Accounting for Business Transactions

NTK 2-4

TRIAL BALANCE

P2 Trial balance preparation and use

Error identification

NTK 2-5

FINANCIAL STATEMENTS

P3 Financial statement preparation

A2 Debt ratio

NTK 2-3

RECORDING TRANSACTIONS

P1 Journalizing and posting

A1 Processing transactions— Examples

NTK 2-1

SYSTEM OF ACCOUNTS

Using financial statements

C1 Source documents

C2 Types of accounts C3 General ledger

NTK 2-2

DEBITS AND CREDITS

T-account

C4 Debits and credits

Normal balance

“I’m always confident”—James Park

Have a Fit

SAN FRANCISCO—James Park and Eric Friedman created a wooden box with a circuit board inside. James recalls that to fix an antenna, he “literally took a piece of foam and put it on the circuit board.” Their device could be used to track fitness activ- ity, such as steps taken. The device James and Eric built would later be known as a Fitbit (Fitbit.com).

As Fitbit grew, the co-founders struggled to track sales and expenses. “It was pretty challenging,” recalls James. “I would just try to use the weekend to see if I could catch up.” James and Eric knew that having reliable accounting data would help “manage the ups and downs of running a company.”

To address this concern, the co-founders took action. They set up recordkeeping processes, transaction analysis, control procedures, and financial statement reporting. “You need to see the data,” insists James.

With accounting data, James says he “can uncover insights that weren’t possible or very practical before . . . and enable the discovery of new insights and trends.”

Eric offers the following advice to aspiring entrepreneurs unsure of how to unlock the potential of accounting data: “Get your hands dirty and do it yourself. You learn more that way.”

Sources: Fitbit website, January 2019; Wareable.com, September 2016; Business Wire, November 2015; Fortune, July 2015; Marketing Land, March 2015; Fast Company, March 2014

©Daniel Boczarski/Stringer/Fitbit/Getty Images

Business transactions and events are the starting points of financial statements. The process to go from transactions and events to financial statements includes the following. Identify each transaction and event from source documents. Analyze each transaction and event using the accounting equation. Record relevant transactions and events in a journal. Post journal information to ledger accounts. Prepare and analyze the trial balance and financial

statements.

Source Documents Source documents identify and describe transactions and events entering the accounting sys- tem. They can be in hard copy or electronic form. Examples are sales receipts, checks, purchase orders, bills from suppliers, payroll records, and bank statements. For example, cash registers record each sale on a tape or electronic file. This record is a source document for recording sales in the accounting system. Source documents are objective and reliable evidence about transac- tions and events and their amounts.

The “Account” Underlying Financial Statements An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense. The general ledger, or simply ledger, is a record of all accounts used by a company. The ledger is often in electronic form. While most companies’ ledgers have similar accounts, a company often uses one or more unique accounts to match its type of operations. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. Exhibit 2.1 shows common asset, liability, and equity accounts.

Asset Accounts Assets are resources owned or controlled by a company. Resources have expected future benefits. Most accounting systems include (at a minimum) separate accounts for the assets described here. Cash A Cash account shows a company’s cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any funds that a bank accepts for de- posit (coins, checks, money orders, and checking account balances).

C2 Describe an account and its use in recording transactions.

BASIS OF FINANCIAL STATEMENTS C1 Explain the steps in process- ing transactions and the role of source documents.

Transactions analyzed with accounting equation

Transaction occurs with source documents

Z-Mart Stores

Transactions recorded and posted

Transactions reported in financial statements

Dec. 1 Cash C. Taylor, Capital

Receive investment by owner.

Account Titles and Explanation PRDate

30,000

Debit

30,000

Credit

307 101

General Journal

General Ledger

Dec. 1 G1 30,000 30,000

Date PR

Cash

Debit Credit Account no. 101

BalanceExplanation

Dec. 1 G1 30,000 30,000

Date PR

C. Taylor, Capital

Debit Credit Account no. 307

BalanceExplanation

Assets

Cash

Accoun ts paya

ble

Supplie s

Unearn ed con

sult. re venue

Prepai d insur

ance

Total li abilitie

Equipm ent

Liabilit ies

Equity

C. Tayl or, Cap

ital

Total a ssets

Total li abilitie

s and e quity

FASTF ORWA

Income Statem

ent

For Mo nth En

ded De cembe

r 31,

Revenu es

Rental revenu

Total re venues

Expens es

Salarie s expe

nse

Rent ex pense

Utilitie s expe

nse

Total e xpense

Net inc ome

Plus: Investm

ents by owner

Net inc ome

Less: Withdr

awals b y owne

$FAST FORWA

Statem ent of

Owner ’s Equi

For Mo nth En

ded De cembe

r 31,

FASTF ORWA

Balanc e Shee

Decem ber 31,

Point: Accounting records also are called accounting books or the books.

46 Chapter 2 Accounting for Business Transactions

Accounts Receivable Accounts receivable are held by a seller and are promises of payment from customers to sellers. Accounts receivable are increased by credit sales or sales on account (or on credit). They are decreased by customer payments. We record all increases and decreases in receivables in the Accounts Receivable account. When there are multiple customers, separate records are kept for each, titled Accounts Receivable—‘Customer Name’.

Note Receivable A note receivable, or promissory note, is a written promise of another en- tity to pay a specific sum of money on a specified future date to the holder of the note; the holder has an asset recorded in a Note (or Notes) Receivable account.

Prepaid Accounts Prepaid accounts (or prepaid expenses) are assets from prepayments of future expenses (expenses expected to be incurred in future accounting periods). When the ex- penses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts are prepaid insurance, prepaid rent, and prepaid ser- vices. Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal plans). When financial statements are prepared, (1) all expired and used prepaid accounts are recorded as expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future benefits). Chapter 3 covers prepaid accounts in detail.

Supplies Accounts Supplies are assets until they are used. When they are used up, their costs are reported as expenses. Unused supplies are recorded in a Supplies asset account. Supplies often are grouped by purpose—for example, office supplies and store supplies. Office supplies include paper and pens. Store supplies include packaging and cleaning materials.

Equipment Accounts Equipment is an asset. When equipment is used and wears down, its cost is gradually reported as an expense (called depreciation). Equipment often is grouped by its purpose—for example, office equipment and store equipment. Office equipment includes com- puters and desks. The Store Equipment account includes counters and cash registers.

Buildings Accounts Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits. When a building is used and wears down, its cost is reported as an expense (called depreciation). When several buildings are owned, separate ac- counts are sometimes kept for each of them.

Land The cost of land is recorded in a Land account. The cost of buildings located on the land is separately recorded in building accounts.

Point: Customers and others who owe a company are debtors.

Point: A note receivable is differ- ent than an account receivable because it comes from a formal contract called a promissory note. A note receivable usually requires interest, whereas an account receivable does not.

Point: At the beginning of the term, a prepaid college parking pass is an asset that allows a stu- dent to park on campus. Benefits of the parking pass expire as the term progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.

Point: Some assets are called intangible because they do not have physical existence. Coca-Cola reports billions in intangible assets.

Patents Land

Long-Term Notes Payable

= + Equity AccountsLiability Accounts

Accrued Liabilities

Unearned Revenue Short-Term Notes Payable

Accounts Payable

Dividends

Revenues Expenses

Common Stock

Buildings Equipment

Investment in Land Supplies

Prepaid Accounts Inventory

Notes Receivable Accounts Receivable

Cash

Asset Accounts

EXHIBIT 2.1 Accounts Organized by the Accounting Equation

Women Entrepreneurs Sara Blakely (in photo), the billionaire entrepreneur/owner of SPANX, has promised to do- nate half of her wealth to charity. The Center for Women’s Business Research reports the following for women-owned businesses.

• They total more than 11 million and employ nearly 20 million workers.

• They generate $2.5 trillion in annual sales and tend to embrace technology.

• They are philanthropic—70% of owners volunteer at least once per month. ■

Decision Insight

©Rob Kim/Getty Images

Chapter 2 Accounting for Business Transactions 47

Liability Accounts Liabilities are obligations to transfer assets or provide products or services to others. They are claims (by creditors) against assets. Creditors are individuals and organizations that have rights to receive payments from a company. Common liability accounts are described here.

Accounts Payable Accounts payable are promises to pay later. Payables can come from purchases of merchandise-for-resale, supplies, equipment, and services. We record all increases and decreases in payables in the Accounts Payable account. When there are multiple suppliers, separate records are kept for each, titled Accounts Payable—‘Supplier Name’.

Note Payable A note payable is a written promissory note to pay a future amount. It is re- corded as either a short-term note payable or a long-term note payable, depending on when it must be repaid. We explain short- and long-term classification in the next two chapters.

Unearned Revenue Accounts Unearned revenue is a liability that is settled in the future when a company delivers its products or services. When customers pay in advance for products or services (before revenue is earned), the seller records this receipt as unearned revenue. Examples of unearned revenue include magazine subscriptions collected in advance by a pub- lisher, rent collected in advance by a landlord, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions and Unearned Rent. When products and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees Revenue and Rent Revenue.1

Accrued Liabilities Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These often are recorded in separate liability accounts by the same title. If they are not a large amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial statements often report totals of several ledger accounts.)

Point: Accounts payable also are called trade payables.

Point: Two words that almost always identify liability accounts: “payable,” meaning liabilities that must be paid, and “unearned,” meaning liabilities that must be fulfilled.

1In practice, account titles vary. Subscription Fees Revenue is sometimes called Subscription Fees, Subscription Fees Earned, or Earned Subscription Fees. Rent Revenue is sometimes called Rent Earned, Rental Revenue, or Earned Rent Revenue. Titles can differ even within the same industry. Product sales are called net sales at Apple, revenues at Google, and revenue at Samsung. Revenues or fees is commonly used with service businesses, and net sales or sales is used with product businesses.

Unearned Revenue The Dallas Cowboys, Atlanta Falcons, New England Patriots, and most NFL teams have over $100 million in advance ticket sales in Unearned Revenue. When a team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenue. Teams in other major sports such as the National Women’s Soccer League and the Women’s National Basketball Association also have unearned revenue. ■

Decision Insight

©Mike Zarrilli/Getty Images

Equity Accounts The owner’s claim on a company’s assets is called equity, stockholders’ equity, or shareholders’ equity. Equity is the owner’s residual interest in the assets of a business after subtracting liabilities. Equity is impacted by four types of accounts.

= – + –Equity Dividends Revenues ExpensesCommon stock

We show this in Exhibit 2.2 by expanding the accounting equation. We also organize assets and liabilities into subgroups that have similar attributes. An important subgroup for both assets and liabilities is the current items. Current items are expected to be either collected or owed within the next year. The next chapter explains this. At this point, know that a classified balance sheet groups accounts into classifications (such as land and buildings into Plant Assets) and it reports current assets before noncurrent assets and current liabilities before noncurrent liabilities.

Point: A note payable is different than an account payable because it comes from a formal contract called a promissory note and requires interest.

48 Chapter 2 Accounting for Business Transactions

Owner Investments When an owner invests in a company, it increases both assets and equity. The increase to equity is recorded in the account titled Common Stock. Owner invest- ments are not revenues of the business.

Owner Distributions When a corporation distributes assets to its owners, it decreases both company assets and total equity. The decrease to equity is recorded in an account titled Dividends. Dividends are not expenses of the business; they are simply the opposite of owner investments.

Revenue Accounts Amounts received from sales of products and services to customers are recorded in revenue accounts, which increase equity. Examples of revenue accounts are Sales, Commissions Earned, Professional Fees Earned, Rent Revenue, and Interest Revenue. Revenues always increase equity.

Expense Accounts Amounts used for costs of providing products and services are recorded in expense accounts, which decrease equity. Examples of expense accounts are Advertising Expense, Salaries Expense, Rent Expense, Utilities Expense, and Insurance Expense. Expenses always decrease equity. A variety of revenues and expenses are in the chart of accounts at the end of this book. (Different companies use different account titles to describe the same thing. For example, some use Interest Revenue instead of Interest Earned.)

Point: Dividends account can be viewed as a contra equity account because it reduces the normal balance of equity.

Revenues ExpensesDividends

Dividends Revenues Expenses

Common Stock

Patents

Land

Long-Term Notes Payable

= + Equity AccountsLiability Accounts

Accrued Liabilities

Unearned Revenue Short-Term Notes Payable

Accounts Payable

Dividends

Common Stock

Buildings Equipment

Investment in Land

Supplies Prepaid Accounts

Inventory Notes Receivable

Accounts Receivable Cash

Asset Accounts

Long-Term Investments

Plant Assets

Current Assets Current Liabilities

Long-Term Liabilities

Intangible Assets

Revenues Expenses

EXHIBIT 2.2 Accounts Classified by the Expanded Accounting Equation

Sporting Accounts The Cleveland Cavaliers, Boston Celtics, Golden State Warriors, and other NBA teams have revenue accounts that include Ticket Sales, Broadcast Fees, and Advertising Revenues. Expense accounts include Player Salaries, NBA Franchise Costs, and Promotional Costs. ■

Decision Insight

C3 Describe a ledger and a chart of accounts.

Ledger and Chart of Accounts The collection of all accounts and their balances is called a ledger (or general ledger). A com- pany’s size and diversity of operations affect the number of accounts needed. A small company

can have as few as 20 accounts; a large company can require thousands. The chart of accounts is a list of all ledger accounts and has an identification number assigned to each account. Exhibit 2.3 shows a common numbering system of accounts for a smaller business.

These account numbers have a three-digit code that is useful in record- keeping. In this example, the first digit of asset accounts is a 1, the first digit of liability accounts is a 2, and so on. The second and third digits relate to the accounts’ subcategories. Exhibit 2.4 shows a partial chart of accounts for FastForward.

Asset accounts Liability accounts Equity accounts Revenue accounts Expense accounts

Chart of Accounts

101–199 201–299 301–399 401–499 501–699

EXHIBIT 2.3 Typical Chart of Accounts for a Smaller Business

Chapter 2 Accounting for Business Transactions 49

EXHIBIT 2.4 Partial Chart of Accounts for FastForward

Chart of Accounts

Assets

101 Cash 106 Accounts receivable 126 Supplies 128 Prepaid insurance 167 Equipment

Liabilities

201 Accounts payable

236 Unearned consulting revenue

Revenues Expenses 403 Consulting revenue 622 Salaries expense

406 Rental revenue 637 Insurance expense

640 Rent expense

652 Supplies expense

690 Utilities expense

307 Common stock

318 Retained earnings

319 Dividends

Equity

Classify each of the following accounts as either an asset (A), liability (L), or equity (EQ) account.

Classifying Accounts

NEED-TO-KNOW 2-1

C1 C2 C3

1. Prepaid Rent 2. Common Stock 3. Note Receivable 4. Accounts Payable

5. Accounts Receivable 6. Equipment 7. Interest Payable 8. Unearned Revenue

9. Land 10. Prepaid Insurance 11. Wages Payable 12. Rent Payable

Solution

1. A 2. EQ 3. A 4. L 5. A 6. A 7. L 8. L 9. A 10. A 11. L 12. L Do More: QS 2-2, QS 2-3

Debits and Credits A T-account represents a ledger account and is used to show the effects of transactions. Its name comes from its shape like the letter T. The layout of a T-account is shown in Exhibit 2.5.

The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. To enter amounts on the left side of an account is to debit the account. To enter amounts on the right side is to credit the account. The term debit or credit, by itself, does not mean increase or decrease. Whether a debit or a credit is an increase or decrease depends on the account.

The difference between total debits and total credits for an account, including any beginning balance, is the account balance. When total debits exceed total credits, the account has a debit balance. It has a credit balance when total credits exceed total debits. When total debits equal total credits, the account has a zero balance.

Double-Entry System Double-entry accounting demands the accounting equation remain in balance, which means that for each transaction: At least two accounts are involved, with at least one debit and one credit. Total amount debited must equal total amount credited.

This means total debits must equal total credits for all entries, and total debit account balances in the ledger must equal total credit account balances. The system for recording debits and credits follows the accounting equation—see Exhibit 2.6.

DOUBLE-ENTRY ACCOUNTING

C4 Define debits and credits and explain double-entry accounting.

EXHIBIT 2.5 The T-Account (Left side) (Right side)

Debit Credit

Account Title

Point: Dr. and Cr. come from 18th-century English where terms debitor and creditor were used instead of debit and credit. Dr. and Cr. use the first and last let- ters of these terms, just as we still do for Saint (St.) and Doctor (Dr.).

“Total debits equal total credits for

each entry.”

50 Chapter 2 Accounting for Business Transactions

Net increases or decreases on one side have equal net effects on the other side. For exam- ple, a net increase in assets must include an equal net increase on the liabilities and equity side. Some transactions affect only one side of the equation, such as acquiring a land asset by giving up a cash asset, but their net effect on this one side is zero.

The left side is the normal balance side for assets; the right side is the normal balance side for liabilities and equity. This matches their layout in the accounting equation, where assets are on the left side and liabilities and equity are on the right.

Equity increases from revenues and owner investments (stock issuances), and it decreases from expenses and dividends. We see this by expanding the accounting equation to include debits and credits in double-entry form, as shown in Exhibit 2.7.

Point: Assets are on the left-hand side of the equation and thus in- crease on the left. Liabilities and equity are on the right-hand side of the equation and thus increase on the right.

Debit for increases

Credit for decreases

–

= +

– +

Debit for decreases

Credit for increases

– +

Debit for decreases

Credit for increases

Assets Liabilities Equity

Normal Normal Normal

EXHIBIT 2.6 Debits and Credits in the Accounting Equation

–

= + – + – Dr. for

increases Cr. for

decreases

Assets Liabilities Dividends Revenues ExpensesCommon Stock

+ +– +– – +– –+ Dr. for

decreases Cr. for

increases

+ Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases

Equity

Normal Normal Normal Normal Normal Normal

EXHIBIT 2.7 Debit and Credit Effects for Component Accounts

Increases (credits) to common stock and revenues increase equity; increases (debits) to dividends and expenses decrease equity. The normal balance of each account is the side where increases are recorded.

The T-account for FastForward’s Cash account, reflecting its first 11 transactions (from Exhibit 1.9), is shown in Exhibit 2.8. The total increases (debits) in its Cash account are $36,100, and the total decreases (credits) are $31,300. Total debits exceed total credits by $4,800, result- ing in its ending debit balance of $4,800.

Point: DrEAD means debit (Dr) is the normal balance side for Expense, Asset, and Dividend accounts; credit the others.

Point: The ending balance is on the side with the larger dollar amount. Also, a plus (+) and minus (−) are not used in a T-account.

EXHIBIT 2.8 Computing the Balance for a T-Account

Cash

Receive investment by owner for stock 30,000 Purchase of supplies 2,500

Consulting services revenue earned 4,200 Purchase of equipment 26,000

Collection of account receivable 1,900 Payment of rent 1,000

Payment of salary 700

Payment of account payable 900

Payment of cash dividend 200

Balance 4,800

⎧ ⎨ ⎩

⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

36,100

36,100 − 31,300

31,300

Identify the normal balance (debit [Dr] or credit [Cr]) for each of the following accounts.

Normal Account Balance

NEED-TO-KNOW 2-2 1. Prepaid Rent 2. Common Stock 3. Note Receivable 4. Accounts Payable

5. Accounts Receivable 6. Equipment 7. Interest Payable 8. Unearned Revenue

9. Land 10. Prepaid Insurance 11. Dividends 12. Utilities Expense

Solution

1. Dr. 2. Cr. 3. Dr. 4. Cr. 5. Dr. 6. Dr. 7. Cr. 8. Cr. 9. Dr. 10. Dr. 11. Dr. 12. Dr. Do More: QS 2-4, QS 2-5,

QS 2-7, E 2-4

Point: Debit and credit are accounting directions for left and right.

Chapter 2 Accounting for Business Transactions 51

This section explains the analyzing, recording, and posting of transactions.

Journalizing and Posting Transactions The four steps of processing transactions are shown in Exhibit 2.9. Steps 1 and 2—transaction analysis and the accounting equation—already were covered. This section focuses on steps 3 and 4. Step 3 is to record each transaction chronologically in a journal. A journal is a complete record of each transaction in one place. It also shows debits and credits for each transaction. Recording transactions in a journal is called journalizing. Step 4 is to transfer (or post) entries from the journal to the ledger. Transferring journal entry information to the ledger is called posting.

ANALYZING AND PROCESSING TRANSACTIONS

P1 Record transactions in a journal and post entries to a ledger.

Services Contract

Deposit

TOTAL

1 30,000 Bank Statement

Client Billing Sales Receipt

Purchase Order Dec. 1 Cash Common Stock

30,000

2,500

30,000

2,500 SuppliesDec. 2 Cash

General Journal Debit for

increases

Credit for

decreases

–

= +

– 1 Debit for

decreases

Credit for

increases – + Debit for

decreases

Credit for

increasesAssets Liabilities

Equity

Assets = Liabilities + Equity

Step 1: Identify transactions and source documents.

Step 2: Analyze transactions using the accounting equation.

Step 3: Record journal entry.

General Journal

Ledger

Step 4: Post entry to ledger.

EXHIBIT 2.9 Steps in Processing Transactions

Journalizing Transactions Journalizing transactions requires an understanding of a journal. While companies can use various journals, every company uses a general journal. It can be used to record any transaction. Exhibit 2.10 shows how the first two transactions of FastForward are recorded in a general journal.

To record entries in a general journal, apply these steps; refer to Exhibit 2.10.

a Date the transaction: Enter the year at the top of the first column and the month and day on the first line of each journal entry.

b Enter titles of accounts debited and then enter amounts in the Debit column on the same line. Account titles are taken from the chart of accounts and are aligned with the left margin of the Account Titles and Explanation column.

c Enter titles of accounts credited and then enter amounts in the Credit column on the same line. Account titles are from the chart of accounts and are indented from the left margin of the Account Titles and Explanation column to separate them from debited accounts.

d Enter a brief explanation of the transaction on the line below the entry (it often references a source document). This explanation is indented about half as far as the credited account titles to avoid confusing it with accounts, and it is italicized.

A blank line is left between each journal entry for clarity. When a transaction is first recorded, the posting reference (PR) column is left blank (in a manual system). Later, when posting entries to the ledger, the identification numbers of the individual ledger accounts are entered in the PR column.

Balance Column Account T-accounts are simple and show how the accounting pro- cess works. However, actual accounting systems need more structure and therefore use a differ- ent formatting of T-accounts, called balance column accounts, shown in Exhibit 2.11.

Point: There are no exact rules for a journal entry explanation—it should be short yet describe why an entry is made.

Dec. 1

Dec. 2

Cash

Common Stock Receive investment by owner.

Purchase supplies for cash.

Supplies

Account Titles and Explanation PRDate

30,000

2,500

Debit

30,000

2,500

Credit 2019 a

General Journal

b c

EXHIBIT 2.10 Partial General Journal for FastForward

52 Chapter 2 Accounting for Business Transactions

Processing Transactions—An Example We use FastForward to show how double-entry accounting is used in analyzing and processing transactions. Analysis of each transaction follows the four steps of Exhibit 2.9.

Step 1 Identify the transaction and any source documents. Step 2 Analyze the transaction using the accounting equation. Step 3 Record the transaction in journal entry form applying double-entry accounting. Step 4 Post the entry (for simplicity, we use T-accounts to represent ledger accounts).

A1 Analyze the impact of transactions on accounts and financial statements.

Key:

Enter the debit account number from the ledger in the PR column of the journal (blue line).

Identify credit account in ledger: enter date, journal page, amount, and balance (gold line).

Enter the credit account number from the ledger in the PR column of the journal (green line).

Identify debit account in ledger: enter date, journal page, amount, and balance (red line).

Dec. 1 2019

Cash Common Stock

Receive investment by owner.

Account Titles and Explanation PRDate

30,000

Debit

30,000

Credit

307 101

General Journal

General Ledger

Dec. 1 G1 30,000 30,000

Date PR

Cash

Debit Credit Account No. 101

BalanceExplanation

Dec. 1 G1 30,000 30,000

Date PR

Common Stock

Debit Credit Account No. 307

BalanceExplanation

2019

EXHIBIT 2.12 Posting an Entry to the Ledger

Dec. 2 Dec. 3 Dec. 10

Dec. 1 2019

G1 G1 G1 G1

30,000

4,200

2,500 26,000

30,000 27,500

1,500 5,700

Date PR Cash

General Ledger

Debit Credit Account No. 101

BalanceExplanation

EXHIBIT 2.11 Cash Account in Balance Column Format

Point: Posting is automatic with accounting software.

Point: The fundamental concepts of a manual system are identical to those of a computerized information system.

The balance column account format is similar to a T-account in having columns for debits and credits. It is different in including transaction date and explanation col- umns. It also has a column with the balance of the account after each entry is recorded. FastForward’s Cash account in Exhibit 2.11 is debited on December 1 for the $30,000 owner investment, yielding a $30,000 debit balance. The

account is credited on December 2 for $2,500, yielding a $27,500 debit balance. On December 3, it is credited for $26,000, and its debit balance is reduced to $1,500. The Cash account is debited for $4,200 on December 10, and its debit balance increases to $5,700; and so on.

The heading of the Balance column does not show whether it is a debit or credit balance. Instead, an account is assumed to have a normal balance. Unusual events can sometimes temporarily create an abnormal balance. An abnormal balance is a balance on the side where decreases are recorded. For example, a customer might mistakenly overpay a bill. This gives that customer’s account receiv- able an abnormal (credit) balance. An abnormal balance often is identified by setting it in brackets or entering it in red. A zero balance is shown by writing zero or a dash in the Balance column.

Posting Journal Entries Step 4 of processing transactions is to post journal entries to ledger accounts. All entries are posted to the ledger before financial statements are prepared so that account balances are up-to-date. When entries are posted to the ledger, the debits in journal entries are transferred into ledger accounts as debits, and credits are transferred into ledger ac- counts as credits. Exhibit 2.12 shows four parts to posting a journal entry. A Identify the led- ger account(s) that is debited in the entry. In the ledger, enter the entry date, the journal and page in its PR column, the debit amount, and the new balance of the ledger account. (G shows it came from the general journal.) B Enter the ledger account number in the PR col- umn of the journal. Parts C and D repeat the first two steps for credit entries and amounts. The posting process creates a link between the ledger and the journal entry. This link is a useful cross-reference for tracing an amount from one record to another.

Point: Explanations are included in ledger accounts only for unusual transactions or events.

Chapter 2 Accounting for Business Transactions 53

1. Receive Investment by Owner

2 Analyze Assets = Liabilities + Equity Common Cash Stock +30,000 = 0 +30,000

1 Identify FastForward receives $30,000 cash from Chas Taylor in exchange for common stock.

3 RecoRd (1) Cash 101 30,000 Common Stock 307 30,000

4 Post

(1) 30,000

Cash 101

(1) 30,000

Common Stock 307

Date Account Titles and Explanation PR Debit Credit

(2) 2,500

Supplies 126

(1) 30,000 (2) 2,500

Cash 101

4 Post

2. Purchase Supplies for Cash

1 Identify FastForward pays $2,500 cash for supplies. 2 analyze Assets = Liabilities + Equity

Cash Supplies −2,500 +2,500 = 0 + 0

Changes the composition of assets but not the total.

3 RecoRd (2) Supplies 126 2,500 Cash 101 2,500

Date Account Titles and Explanation PR Debit Credit

3. Purchase Equipment for Cash

1 Identify FastForward pays $26,000 cash for equipment.

Changes the composition of assets but not the total.

3 RecoRd (3) Equipment 167 26,000 Cash 101 26,000

(3) 26,000

Equipment 167 4 Post

(1) 30,000 (2) 2,500

(3) 26,000

Cash 101

2 analyze Assets = Liabilities + Equity Cash Equipment

−26,000 +26,000 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

FASTForward

4. Purchase Supplies on Credit

1 Identify FastForward purchases $7,100 of supplies on credit from a supplier.

3 RecoRd (4) Supplies 126 7,100 Accounts Payable 201 7,100

(4) 7,100

Accounts Payable 201

4 Post

(2) 2,500

(4) 7,100

Supplies 126

2 analyze Assets = Liabilities + Equity Accounts Supplies Payable

+7,100 = +7,100 + 0

Date Account Titles and Explanation PR Debit Credit

Study each transaction before moving to the next. The first 11 transactions are from Chapter 1, and we analyze five additional December transactions of FastForward (numbered 12 through 16).

Point: In Need-to-Know 2-5, we show how to use balance column accounts for the ledger.

5. Provide Services for Cash

1 Identify FastForward provides consulting services and immediately collects $4,200 cash.

2 analyze Assets = Liabilities + Equity Consulting Cash Revenue +4,200 = 0 +4,200

3 RecoRd (5) Cash 101 4,200 Consulting Revenue 403 4,200

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

Cash 101

(5) 4,200

Consulting Revenue 403

4 Post

Date Account Titles and Explanation PR Debit Credit ©Adie Bush/Getty Images

54 Chapter 2 Accounting for Business Transactions

9. Receipt of Cash on Account

1 Identify FastForward receives $1,900 cash from the customer billed in Transaction 8.

2 analyze

3 RecoRd (9) Cash 101 1,900 Accounts Receivable 106 1,900

4 Post

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000 (7) 700

Cash 101

(8) 1,900 (9) 1,900

Accounts Receivable 106

Assets = Liabilities + Equity Accounts

Cash Receivable +1,900 −1,900 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

8. Provide Consulting and Rental Services on Credit

1 Identify FastForward provides consulting services of $1,600 and rents its test facilities for $300. The customer is billed $1,900 for these services.

2 analyze

3 RecoRd (8) Accounts Receivable 106 1,900 Consulting Revenue 403 1,600

Rental Revenue 406 300

4 Post

(8) 1,900

Accounts Receivable 106

(5) 4,200

(8) 1,600

Consulting Revenue 403

(8) 300

Rental Revenue 406

Assets = Liabilities + Equity Accounts Consulting Rental

Receivable Revenue Revenue +1,900 = 0 +1,600 +300

Date Account Titles and Explanation PR Debit Credit

Point: The revenue recognition principle requires revenue to be recognized when the company provides products and services to a customer. This is not necessarily the same time that the customer pays.

Point: Transaction 8 is a compound journal entry, which is an entry that affects three or more accounts. The rule that total debits equal total credits continues.

6. Payment of Expense in Cash

1 Identify FastForward pays $1,000 cash for December rent. 2 analyze Assets = Liabilities + Equity

Rent Cash Expense −1,000 = 0 −1,000

3 RecoRd (6) Rent Expense 640 1,000 Cash 101 1,000

4 Post

(6) 1,000

Rent Expense 640

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(6) 1,000

Cash 101

Date Account Titles and Explanation PR Debit Credit

7. Payment of Expense in Cash

1 Identify FastForward pays $700 cash for employee salary. 2 analyze Assets = Liabilities + Equity

Salaries Cash Expense −700 = 0 −700

3 RecoRd (7) Salaries Expense 622 700 Cash 101 700

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(6) 1,000

(7) 700

Cash 101

(7) 700

Salaries Expense 622 4 Post

Date Account Titles and Explanation PR Debit Credit

Point: Salary usually refers to compensation of a fixed amount for a given time period. Wages is compensation based on time worked.

Chapter 2 Accounting for Business Transactions 55

10. Partial Payment of Accounts Payable

1 Identify FastForward pays CalTech Supply $900 cash toward the payable of Transaction 4.

2 analyze

3 RecoRd (10) Accounts Payable 201 900 Cash 101 900

4 Post

(10) 900 (4) 7,100

Accounts Payable 201

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

(10) 900

Cash 101

Assets = Liabilities + Equity Cash Accounts Payable −900 = −900 + 0

Date Account Titles and Explanation PR Debit Credit

11. Payment of Cash Dividend

1 Identify FastForward pays a $200 cash dividend.

2 analyze

3 RecoRd (11) Dividends 319 200 Cash 101 200

4 Post

(11) 200

Dividends 319

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(7) 700

(10) 900

(11) 200

Cash 101

Assets = Liabilities + Equity Cash Dividends −200 = 0 −200

Date Account Titles and Explanation PR Debit Credit

Point: Dividends always decrease equity.

12. Receipt of Cash for Future Services

1 Identify FastForward receives $3,000 cash in advance of providing consulting services to a customer.

2 analyze

Accepting $3,000 cash requires FastForward to perform future services and is a liability. No revenue is recorded until services are provided.

3 RecoRd (12) Cash 101 3,000 Unearned Consulting

Revenue 236 3,000 (12) 3,000

Unearned Consulting Revenue 236

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700 (10) 900

(11) 200

Cash 101 4 Post

Assets = Liabilities + Equity Unearned

Cash Consulting Revenue +3,000 = +3,000 + 0

Date Account Titles and Explanation PR Debit Credit

Point: “Unearned” accounts are liabilities that must be fulfilled.

13. Pay Cash for Future Insurance Coverage

1 Identify FastForward pays $2,400 cash (insurance premium) for a 24-month insurance policy. Coverage begins on December 1.

2 Analyze

Changes the composition of assets from cash to prepaid insurance. Expense is recorded as insur- ance coverage expires.

3 RecoRd (13) Prepaid Insurance 128 2,400 Cash 101 2,400

(13) 2,400

Prepaid Insurance 128

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

Cash 101

4 Post

Assets = Liabilities + Equity Prepaid

Cash Insurance −2,400 +2,400 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

56 Chapter 2 Accounting for Business Transactions

14. Purchase Supplies for Cash

1 Identify FastForward pays $120 cash for supplies.

2 analyze

3 RecoRd (14) Supplies 126 120 Cash 101 120

(2) 2,500

(4) 7,100

(14) 120

Supplies 126

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

Cash 101

4 Post

Assets = Liabilities + Equity Cash Supplies

−120 +120 = 0 + 0

Date Account Titles and Explanation PR Debit Credit

Point: Luca Pacioli, a 15th-century monk and famous mathematician, was the first to devise double- entry accounting.

15. Payment of Expense in Cash

1 Identify FastForward pays $305 cash for December utilities expense.

3 RecoRd (15) Utilities Expense 690 305 Cash 101 305

(15) 305

Utilities Expense 690

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 305

Cash 101

4 Post

2 Analyze Assets = Liabilities + Equity Utilities Cash Expense −305 = 0 −305

Date Account Titles and Explanation PR Debit Credit

16. Payment of Expense in Cash

2 Analyze Assets = Liabilities + Equity Salaries Cash Expense −700 = 0 −700

1 Identify FastForward pays $700 cash in employee salary for work performed in the latter part of December.

3 RecoRd (16) Salaries Expense 622 700 Cash 101 700

(7) 700

(16) 700

Salaries Expense 622

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 305

(16) 700

Cash 101

4 Post

Date Account Titles and Explanation PR Debit Credit

Chapter 2 Accounting for Business Transactions 57

Summarizing Transactions in a Ledger Exhibit 2.13 shows the ledger accounts (in T-account form) of FastForward after all 16 transac- tions are recorded and posted and the balances computed. The accounts are grouped into three columns following the accounting equation: assets, liabilities, and equity. Totals for the three columns obey the accounting equation:

Assets equal $42,395 ($4,275 + $0 + $9,720 + $2,400 + $26,000). Liabilities equal $9,200 ($6,200 + $3,000). Equity equals $33,195 ($30,000 − $200 + $5,800 + $300 − $1,400 − $1,000 − $305).

The accounting equation: $42,395 = $9,200 + $33,195. Common stock, dividends, revenue, and expense accounts reflect transactions that

change equity. Revenue and expense account balances are reported in the income statement.

Debit and Credit Rules Increase Accounts (normal bal.) Decrease

Asset . . . . . . . . . . . . Debit Credit Liability . . . . . . . . . . . Credit Debit Common Stock . . . . Credit Debit Dividends . . . . . . . . . Debit Credit Revenue . . . . . . . . . Credit Debit Expense . . . . . . . . . Debit Credit

EXHIBIT 2.13 Ledger for FastForward (in T-Account Form)

$42,395 = $9,200 + $33,195

Cash 101

(1) 30,000 (2) 2,500

(5) 4,200 (3) 26,000

(9) 1,900 (6) 1,000

(12) 3,000 (7) 700

(10) 900

(11) 200

(13) 2,400

(14) 120

(15) 305

(16) 700

Balance 4,275

Accounts Receivable 106

(8) 1,900 (9) 1,900

Balance 0

Supplies 126

(2) 2,500

(4) 7,100

(14) 120

Balance 9,720

Prepaid Insurance 128

(13) 2,400

Equipment 167

(3) 26,000

Accounts Payable 201

(10) 900 (4) 7,100

Balance 6,200

Unearned Consulting Revenue 236

(12) 3,000

Common Stock 307

(1) 30,000

Dividends 319

(11) 200

Consulting Revenue 403

(5) 4,200

(8) 1,600

Balance 5,800

Rental Revenue 406

(8) 300

Rent Expense 640

(6) 1,000

Utilities Expense 690

(15) 305

Accounts in this white area are on the income statement .

Salaries Expense 622

(7) 700

(16) 700

Balance 1,400

FASTForward

Assets = Liabilities + Equity General Ledger

58 Chapter 2 Accounting for Business Transactions

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. For each transaction, (a) analyze the transaction using the accounting equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Tata Company has the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Equipment (167); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Wages Expense (601).

Jan. 1 Jamsetji Tata invested $4,000 cash in the Tata Company in exchange for common stock. 5 Tata Company purchased $2,000 of equipment on credit. 14 Tata Company provided $540 of services for a client on credit.

Solution

Recording Transactions

NEED-TO-KNOW 2-3

P1 A1

Jan. 1 Receive Investment by Owner

a analyze Assets = Liabilities + Equity Common Cash Stock +4,000 = 0 +4,000

b RecoRd Jan . 1 Cash 101 4,000 Common Stock 307 4,000

c Post

Jan . 1 4,000

Cash 101

Jan . 1 4,000

Common Stock 307Date Account Titles and Explanation PR Debit Credit

Jan. 5 Purchase Equipment on Credit

b RecoRd Jan . 5 Equipment 167 2,000 Accounts Payable 201 2,000

Jan . 5 2,000

Accounts Payable 201

c Post

Jan . 5 2,000

Equipment 167 a analyze Assets = Liabilities + Equity

Accounts Equipment Payable

+2,000 = +2,000 + 0

Date Account Titles and Explanation PR Debit Credit

Do More: QS 2-6, E 2-7, E 2-9, E 2-11, E 2-12

Jan. 14 Provide Services on Credit

a analyze Assets = Liabilities + Equity Accounts Services Receivable Revenue +540 = 0 +540

b RecoRd Jan . 14 Accounts Receivable 106 540 Services Revenue 403 540

Jan . 14 540

Accounts Receivable 106

Jan . 14 540

Services Revenue 403

c Post

Date Account Titles and Explanation PR Debit Credit

A trial balance is a list of all ledger accounts and their balances at a point in time. Exhibit 2.14 shows the trial balance for FastForward after its 16 entries are posted to the ledger. (This is an unadjusted trial balance. Chapter 3 explains adjustments.)

Preparing a Trial Balance Preparing a trial balance has three steps.

1. List each account title and its amount (from the ledger) in the trial balance. If an account has a zero balance, list it with a zero in its normal balance column (or omit it).

2. Compute the total of debit balances and the total of credit balances. 3. Verify (prove) total debit balances equal total credit balances.

TRIAL BALANCE P2 Prepare and explain the use of a trial balance.

Chapter 2 Accounting for Business Transactions 59

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275

Accounts receivable . . . . . . . . . . . 0

Supplies . . . . . . . . . . . . . . . . . . . . . 9,720

Prepaid insurance . . . . . . . . . . . . . 2,400

Equipment . . . . . . . . . . . . . . . . . . . 26,000

Accounts payable . . . . . . . . . . . . . $ 6,200

Unearned consulting revenue . . . 3,000

Common stock . . . . . . . . . . . . . . . 30,000

Dividends . . . . . . . . . . . . . . . . . . . 200

Consulting revenue . . . . . . . . . . . 5,800

Rental revenue . . . . . . . . . . . . . . . 300

Salaries expense . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . 305

Totals . . . . . . . . . . . . . . . . . . . . . . . $45,300 $45,300

The total of debit balances equals the total of credit balances for the trial bal- ance in Exhibit 2.14. Equality of these two totals does not guarantee that no errors were made. For example, the column totals will be equal when a debit or credit of a correct amount is made to a wrong account. Another error not identified with a trial balance is when equal debits and credits of an incor- rect amount are entered.

Searching for Errors If the trial balance does not balance (when its columns are not equal), the error(s) must be found and corrected. An efficient way to search for an error is to check the journalizing, post- ing, and trial balance preparation in reverse order. Step 1 is to verify that the trial bal- ance columns are correctly added. If step 1 does not find the error, step 2 is to verify that account balances are accurately entered from the ledger. Step 3 is to see whether a debit (or credit) balance is mistakenly listed in the trial balance as a credit (or debit). A clue to this error is when the difference between total debits and total credits equals twice the amount of the incorrect account balance. Step 4 is to recompute each account balance in the ledger. Step 5 is to verify that each journal entry is properly posted. Step 6 is to verify that the original journal entry has equal debits and credits. At this point, the errors should be uncovered.

Point: A trial balance is not a financial statement but a tool for checking equality of debits and credits in the ledger.

EXHIBIT 2.14 Trial Balance (Unadjusted)

Example: If a credit to Unearned Revenue was incorrectly posted to the Revenue ledger account, would the ledger still balance? Answer: The ledger would bal- ance, but liabilities would be understated, equity would be overstated, and income would be overstated.

Accounting Quality Recording valid and accurate transactions enhances the quality of financial statements. Roughly 30% of employees in IT report observing misconduct such as falsifying accounting data. They also report increased incidences of such misconduct in recent years. Source: KPMG. ■

Ethical Risk

Financial Statements Prepared from Trial Balance Financial Statements across Time How financial statements are linked in time is shown in Exhibit 2.15. A balance sheet reports an organization’s financial position at a point in time. The income statement, statement of retained earnings, and statement of cash flows report financial performance over a period of time. The three statements in the middle column of Exhibit 2.15 explain how financial position changes from the beginning to the end of a reporting period.

A one-year (annual) reporting period is common, as are semiannual, quarterly, and monthly periods. The one-year reporting period is called the accounting, or fiscal, year. Businesses whose accounting year begins on January 1 and ends on December 31 are called calendar-year companies.

Financial Statement Preparation This section shows how to prepare financial statements from the trial balance. (These are unadjusted statements. Chapter 3 explains adjust- ments.) We prepare these statements in the following order.

Beginning Balance Sheet Ending Balance SheetIncome Statement

Statement of Cash Flows Statement of Retained Earnings

Cash $30,000 Liabilities $ 0 Other assets 0 Equity 30,000 Total assets $30,000 Total $30,000

Cash $ 4,275 Liabilities $ 9,200 Other assets 38,120 Equity 33,195 Total assets $42,395 Total $42,395

Expenses Net income

2,705 $3,395

Revenues $6,100

Point in time Point in timePeriod of time

EXHIBIT 2.15 Links between Financial Statements across Time

P3 Prepare financial statements from business transactions.

FASTForward

60 Chapter 2 Accounting for Business Transactions

1 Income Statement An income statement reports revenues earned minus expenses incurred over a period of time. FastForward’s income statement for December is shown at the top right side of Exhibit 2.16. Information about revenues and expenses is taken from the trial balance on the left side. Net income of $3,395 is the bottom line for the income statement. Owner investments and dividends are not part of income.

2 Statement of Retained Earnings The statement of retained earnings reports how retained earnings changes over the reporting period. FastForward’s statement of retained earnings is the second report in Exhibit 2.16. It shows the $3,395 of net income, the $200 divi- dend, and the $3,195 end-of-period balance. (The beginning balance in the statement of retained earnings is rarely zero, except in the first period of operations. The beginning balance in January 2020 is $3,195, which is December 2019’s ending balance.)

3 Balance Sheet The balance sheet reports the financial position of a company at a point in time. FastForward’s balance sheet is the third report in Exhibit 2.16. This statement shows financial condition at the close of business on December 31. The left side of the balance

Point: An income statement also is called an earnings statement, a statement of operations, or a P&L (profit and loss) statement. A balance sheet also is called a statement of financial position.

Point: Revenues and expenses are not reported in detail in the statement of retained earnings. Instead, their effects are reflected through net income.

EXHIBIT 2.16 Financial Statements Prepared from Trial Balance

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . $5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,705

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,395

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,395 3,395

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,195

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . . $ 4,275 Accounts payable . . . . . . . . . . . . $ 6,200

Supplies . . . . . . . . . . . 9,720 Unearned consulting revenue . . . 3,000

Prepaid insurance . . . 2,400 Total liabilities . . . . . . . . . . . . . . . 9,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . 3,195 Total equity . . . . . . . . . . . . . . . . . . 33,195

Total assets $42,395 Total liabilities and equity . . . . . . . $42,395

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275

Accounts receivable . . . . . . . . . . . 0

Supplies . . . . . . . . . . . . . . . . . . . . . 9,720

Prepaid insurance . . . . . . . . . . . . . 2,400

Equipment . . . . . . . . . . . . . . . . . . . 26,000

Accounts payable . . . . . . . . . . . . . $ 6,200

Unearned consulting revenue . . . 3,000

Common stock . . . . . . . . . . . . . . . 30,000

Dividends . . . . . . . . . . . . . . . . . . . 200

Consulting revenue . . . . . . . . . . . 5,800

Rental revenue . . . . . . . . . . . . . . . 300

Salaries expense . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . 305

Totals . . . . . . . . . . . . . . . . . . . . . . . $45,300 $45,300

Each account on the trial balance is either an asset (to balance sheet), liability (to balance sheet), or equity (to income statement or to statement of retained earnings) .

Point: A statement’s heading lists the 3 W’s: Who—name of organization, What—name of statement, When—point in time or period of time.

Point: Arrow lines show how the statements are linked.

Point: To foot a column of numbers is to add them.

Chapter 2 Accounting for Business Transactions 61

sheet lists its assets: cash, supplies, prepaid insurance, and equipment. The liabilities section of the balance sheet shows that it owes $6,200 to creditors and $3,000 in services to customers who paid in advance. The equity section shows an ending balance of $33,195. Note the link between the ending balance of the statement of retained earnings and the retained earnings bal- ance. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, fol- lowed by liabilities and then equity. Either presentation is acceptable.)

Decision Maker

©REDPIXEL.PL/Shutterstock

Prepare a trial balance for Apple using the following condensed data from its recent fiscal year ended September 30 ($ in millions).

Preparing Trial Balance

NEED-TO-KNOW 2-4

P2Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,867 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Cost of sales (and other expenses) . . . . . . . . . . 141,048

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 47,169

Investments and other assets . . . . . . . . . . . . . . . . . . 303,373

Land and equipment . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Selling and other expense . . . . . . . . . . . . . . . . . . . . 39,835

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Retained earnings, beginning fiscal year . . . . . . . . . 96,998

Solution ($ in millions)

APPLE

APPLE Trial Balance

September 30

Do More: E 2-8, E 2-10

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874

Land and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,783

Investments and other assets . . . . . . . . . . . . . . . . . . . . . . 303,373

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867

Retained earnings, beginning fiscal year . . . . . . . . . . . . . . 96,998

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229,234

Cost of sales (and other expenses) . . . . . . . . . . . . . . . . . . 141,048

Selling and other expense . . . . . . . . . . . . . . . . . . . . . . . . . 39,835

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $603,371 $603,371

This problem extends Need-to-Know 1-6 from Chapter 1: Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for com-

mon stock. 2 Expressions paid $600 cash for furniture for the shop. 3 Expressions paid $500 cash to rent space in a strip mall for August. 4 Expressions purchased $1,200 of equipment on credit for the shop (recorded as accounts pay-

able). 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. 16 Expressions provided $100 of haircutting services on account. 17 Expressions received a $100 check for services previously rendered on account. 18 Expressions paid $125 to an assistant for hours worked for the grand opening. 31 Cash received from services provided during the second half of August was $930. 31 Expressions paid $400 cash toward the account payable entered into on August 4. 31 Expressions paid a $900 cash dividend to Worthy (sole shareholder).

Required

1. Open the following ledger accounts in balance column format (account numbers are in parentheses): Cash (101); Accounts Receivable (102); Furniture (161); Store Equipment (165); Accounts Payable (201); Common Stock (307); Dividends (319); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

COMPREHENSIVE

Journalizing and Posting Transactions, Statement Preparation, and Debt Ratio

NEED-TO-KNOW 2-5

EXHIBIT 2.17 Debt Ratio Debt ratio =

Total liabilities Total assets

62 Chapter 2 Accounting for Business Transactions

A2 Compute the debt ratio and describe its use in analyzing financial condition.

Debt RatioDecision Analysis

Decision Maker

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

Company ($ millions) Current Year 1 Year Ago 2 Years Ago

Costco Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $25,268 $20,831 $22,174

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,347 $33,163 $33,017

Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.70 0.63 0.67

Walmart Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 .59 0 .58 0 .58

Chapter 2 Accounting for Business Transactions 63

2. Post the journal entries from part 1 to the ledger accounts. 3. Prepare a trial balance as of August 31. 4. Prepare an income statement for August. 5. Prepare a statement of retained earnings for August. 6. Prepare a balance sheet as of August 31. 7. Determine the debt ratio as of August 31.

Extended Analysis

8. In the coming months, Expressions will have a greater variety of business transactions. Identify which accounts are debited and which are credited for the following transactions. Hint: We must use some accounts not opened in part 1.

a. Purchase supplies with cash. b. Pay cash for future insurance coverage. c. Receive cash for services to be provided in the future. d. Purchase supplies on account.

PLANNING THE SOLUTION Analyze each transaction and use the debit and credit rules to prepare a journal entry for each. Post each debit and each credit from journal entries to their ledger accounts and cross-reference each

amount in the posting reference (PR) columns of the journal and ledger. Calculate each account balance and list the accounts with their balances on a trial balance. Verify that total debits in the trial balance equal total credits. To prepare the income statement, identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. Use information in the ledger to prepare the statement of retained earnings. Use information in the ledger to prepare the balance sheet. Calculate the debt ratio by dividing total liabilities by total assets. Analyze the future transactions to identify the accounts affected and apply debit and credit rules.

SOLUTION 1. General journal entries.

[continued on next page]

General Journal Date Account Titles and Explanation PR Debit Credit

Aug . 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 3,000

Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 15,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 18,000

Owner’s investment in exchange for stock.

2 Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 600

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 600

Purchased furniture for cash.

3 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 500

Paid rent for August.

4 Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 1,200

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 1,200

Purchased additional equipment on credit.

15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 825

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 825

Cash receipts from first half of August.

64 Chapter 2 Accounting for Business Transactions

16 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 100

Record revenue for services provided on account.

17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

Record cash received as payment on account.

18 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 125

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 125

Paid wages to assistant.

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 930

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 930

Cash receipts from second half of August.

31 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 400

Paid cash toward accounts payable.

31 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 900

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 900

Paid a cash dividend.

[continued from previous page]

2. Post journal entries from part 1 to the ledger accounts (in balance column format).

Cash Account No. 101

Date PR Debit Credit Balance

Aug . 1 G1 3,000 3,000

2 G1 600 2,400

3 G1 500 1,900

15 G1 825 2,725

17 G1 100 2,825

18 G1 125 2,700

31 G1 930 3,630

31 G1 400 3,230

31 G1 900 2,330

Accounts Receivable Account No. 102

Date PR Debit Credit Balance

Aug . 16 G1 100 100

17 G1 100 0

Furniture Account No. 161

Date PR Debit Credit Balance

Aug . 2 G1 600 600

Store Equipment Account No. 165

Date PR Debit Credit Balance

Aug . 1 G1 15,000 15,000

4 G1 1,200 16,200

Accounts Payable Account No. 201

Date PR Debit Credit Balance

Aug . 4 G1 1,200 1,200 31 G1 400 800

Common Stock Account No. 307

Date PR Debit Credit Balance

Aug . 1 G1 18,000 18,000

Dividends Account No. 319

Date PR Debit Credit Balance

Aug . 31 G1 900 900

Haircutting Services Revenue Account No. 403

Date PR Debit Credit Balance

Aug . 15 G1 825 825 16 G1 100 925 31 G1 930 1,855

Wages Expense Account No. 623

Date PR Debit Credit Balance

Aug . 18 G1 125 125

Rent Expense Account No. 640

Date PR Debit Credit Balance

Aug . 3 G1 500 500

General Ledger

Chapter 2 Accounting for Business Transactions 65

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . $ 2,330 Accounts payable . . . . . . . . . . . . . . . . . . $ 800

Furniture . . . . . . . . . . . . . . . . . 600 Equity Store equipment . . . . . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . . . . . . 18,000

Retained earnings . . . . . . . . . . . . . . . . . . 330

Total equity . . . . . . . . . . . . . . . . . . . . . . . . 18,330

Total assets . . . . . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . . . . $19,130

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues

Haircutting services revenue . . . . . . . . . . . . $1,855

Operating expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . $500

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Total operating expenses . . . . . . . . . . . . . . . 625

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,230

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1 . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,230

1,230

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . 900

Retained earnings, August 31 . . . . . . . . . . . . . . . . . . $ 330

3. Prepare a trial balance from the ledger—see how it feeds the financial statements.

EXPRESSIONS Trial Balance

August 31

Debit Credit Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,330

Accounts receivable . . . . . . . . . . . . . . . . . . . 0

Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Store equipment . . . . . . . . . . . . . . . . . . . . . . 16,200

Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 800

Common stock . . . . . . . . . . . . . . . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Haircutting services revenue . . . . . . . . . . . . 1,855

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . 500

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,655 $20,655

7. Debt ratio = Total liabilities

Total assets =

$800 $19,130

= 4.18%

8a. Supplies debited 8c. Cash debited Cash credited Unearned Services Revenue credited 8b. Prepaid Insurance debited 8d. Supplies debited Cash credited Accounts Payable credited

Account (45) Account balance (49) Balance column account (51) Chart of accounts (48) Compound journal entry (54) Credit (49) Creditors (47) Debit (49)

Debt ratio (62) Debtors (46) Dividends (48) Double-entry accounting (49) General journal (51) General ledger (45) Journal (51) Journalizing (51)

Ledger (45) Posting (51) Posting reference (PR) column (51) Source documents (45) T-account (49) Trial balance (58) Unearned revenue (47)

Key Terms

66 Chapter 2 Accounting for Business Transactions

SYSTEM OF ACCOUNTS Asset Accounts Cash: A company’s cash balance. Accounts receivable: Held by a seller; promises of payment from custom- ers to sellers. Accounts receivable are increased by credit sales; often phrased as sales on account or on credit. Note receivable: Held by a lender; a borrower’s written promise to pay the lender a specific sum of money on a specified future date. Prepaid accounts (or expenses): Assets that arise from prepayment of future expenses. Examples are prepaid insurance and prepaid rent. More assets: Supplies, equipment, buildings, and land. Liability Accounts Accounts payable: Held by a buyer; a buyer’s promise to pay a seller later for goods or services received. More generally, payables arise from pur- chases of merchandise for resale, supplies, services, and other items. Note payable: Held by a borrower; a written promissory note to pay a future amount at a future date. Unearned revenue: A liability to be settled in the future when a company delivers its products or services. When a customer pays in advance for products or services (before revenue is earned), the seller records this receipt as unearned revenue. Accrued liabilities: Amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. Equity Accounts Common stock: When an owner invests in a company in exchange for stock, the company increases both assets and equity. Dividends: When a company pays dividends, it decreases both company assets and total equity. Revenue: Amounts received from sales of products and services to cus- tomers. Revenue increases equity. Expenses: Costs of providing products and services. Expenses decrease equity.

DEBITS AND CREDITS The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. Double-entry accounting transaction rules: ∙ At least two accounts are involved, with at least one debit and one credit. ∙ Total amount debited must equal total amount credited. Debits and credits in accounting equation:

–

= + – + – Dr. for

increases Cr. for

decreases

Assets Liabilities Dividends Revenues ExpensesCommon Stock

+ +– +– – +– –+ Dr. for

decreases Cr. for

increases

+ Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases Dr. for

increases Cr. for

decreases Dr. for

decreases Cr. for

increases

Equity

Normal Normal Normal Normal Normal Normal

Net increases or decreases on one side have equal net effects on the other side. Left side is the normal balance side for assets. Right side is the normal balance side for liabilities and equity.

Summary: Cheat Sheet

RECORDING TRANSACTIONS Receive owner investment for stock: (1) Cash 101 30,000 Common Stock 307 30,000

Date Account Titles and Explanation PR Debit Credit

(2) Supplies 126 2,500 Cash 101 2,500

Date Account Titles and Explanation PR Debit Credit

Purchase supplies for cash:

(3) Equipment 167 26,000 Cash 101 26,000

Date Account Titles and Explanation PR Debit Credit

Purchase equipment for cash:

(4) Supplies 126 7,100 Accounts Payable 201 7,100

Date Account Titles and Explanation PR Debit Credit

Purchase supplies on credit:

Provide services for cash:

(5) Cash 101 4,200 Consulting Revenue 403 4,200

Date Account Titles and Explanation PR Debit Credit

FINANCIAL STATEMENTS

(6) Rent Expense 640 1,000 Cash 101 1,000

Date Account Titles and Explanation PR Debit Credit

(7) Salaries Expense 622 700 Cash 101 700

Date Account Titles and Explanation PR Debit Credit

(15) Utilities Expense 690 305 Cash 101 305

Date Account Titles and Explanation PR Debit Credit

Payment of expenses in cash:

(8) Accounts Receivable 106 1,900 Consulting Revenue 403 1,600 Rental Revenue 406 300

Date Account Titles and Explanation PR Debit Credit

Provide consulting and rental services on credit:

(9) Cash 101 1,900 Accounts Receivable 106 1,900

Date Account Titles and Explanation PR Debit Credit

Receipt of cash on account:

(10) Accounts Payable 201 900 Cash 101 900

Date Account Titles and Explanation PR Debit Credit

Partial payment of accounts payable:

(11) Dividends 319 200 Cash 101 200

Date Account Titles and Explanation PR Debit Credit

Payment of cash dividend:

(12) Cash 101 3,000 Unearned Consulting Revenue 236 3,000

Date Account Titles and Explanation PR Debit Credit

Receipt of cash for future services:

(13) Prepaid Insurance 128 2,400 Cash 101 2,400

Date Account Titles and Explanation PR Debit Credit

Pay cash for future insurance coverage:

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . $5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,705

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,395

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,395 3,395

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,195

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . . $ 4,275 Accounts payable . . . . . . . . . . . . $ 6,200

Supplies . . . . . . . . . . . 9,720 Unearned consulting revenue . . . 3,000

Prepaid insurance . . . 2,400 Total liabilities . . . . . . . . . . . . . . . 9,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . 3,195 Total equity . . . . . . . . . . . . . . . . . . 33,195

Total assets $42,395 Total liabilities and equity . . . . . . . $42,395

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275

Accounts receivable . . . . . . . . . . . 0

Supplies . . . . . . . . . . . . . . . . . . . . . 9,720

Prepaid insurance . . . . . . . . . . . . . 2,400

Equipment . . . . . . . . . . . . . . . . . . . 26,000

Accounts payable . . . . . . . . . . . . . $ 6,200

Unearned consulting revenue . . . 3,000

Common stock . . . . . . . . . . . . . . . 30,000

Dividends . . . . . . . . . . . . . . . . . . . 200

Consulting revenue . . . . . . . . . . . . 5,800

Rental revenue . . . . . . . . . . . . . . . 300

Salaries expense . . . . . . . . . . . . . . 1,400

Rent expense . . . . . . . . . . . . . . . . 1,000

Utilities expense . . . . . . . . . . . . . . 305

Totals . . . . . . . . . . . . . . . . . . . . . . . $45,300 $45,300

Each account on the trial balance is either an asset (to balance sheet), liability (to balance sheet), or equity (to income statement or to statement of retained earnings) .

Chapter 2 Accounting for Business Transactions 67

Multiple Choice Quiz

1. Amalia Company received its utility bill for the current pe- riod of $700 and immediately paid it. Its journal entry to record this transaction includes a a. Credit to Utility Expense for $700. b. Debit to Utility Expense for $700. c. Debit to Accounts Payable for $700. d. Debit to Cash for $700. e. Credit to Accounts Receivable for $700.

2. On May 1, Mattingly Lawn Service collected $2,500 cash from a customer in advance of five months of lawn ser- vice. Mattingly’s journal entry to record this transaction includes a a. Credit to Unearned Lawn Service Fees for $2,500. b. Debit to Lawn Service Fees Earned for $2,500. c. Credit to Cash for $2,500. d. Debit to Unearned Lawn Service Fees for $2,500. e. Credit to Accounts Payable for $2,500.

3. Liang Shue contributed $250,000 cash and land worth $500,000 to open his new business, Shue Consulting. Which of the following journal entries does Shue Consulting make to record this transaction? a. Cash Assets . . . . . . . . . . . . . 750,000 Common Stock . . . . . . . . 750,000 b. Common Stock . . . . . . . . . . 750,000 Assets. . . . . . . . . . . . . . . . 750,000

c. Cash . . . . . . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . . . . . . 500,000 Common Stock . . . . . . . . 750,000 d. Common Stock . . . . . . . . . . 750,000 Cash . . . . . . . . . . . . . . . . . 250,000 Land . . . . . . . . . . . . . . . . . 500,000

4. A trial balance prepared at year-end shows total credits ex- ceed total debits by $765. This discrepancy could have been caused by a. An error in the general journal where a $765 increase in

Accounts Payable was recorded as a $765 decrease in Accounts Payable.

b. The ledger balance for Accounts Payable of $7,650 be- ing entered in the trial balance as $765.

c. A general journal error where a $765 increase in Accounts Receivable was recorded as a $765 increase in Cash.

d. The ledger balance of $850 in Accounts Receivable was entered in the trial balance as $85.

e. An error in recording a $765 increase in Cash as a credit.

5. Bonaventure Company has total assets of $1,000,000, lia- bilities of $400,000, and equity of $600,000. What is its debt ratio (rounded to a whole percent)? a. 250% c. 67% e. 40% b. 167% d. 150%

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; debit Utility Expense for $700, and credit Cash for $700. 2. a; debit Cash for $2,500 and credit Unearned Lawn Service Fees

for $2,500. 3. c; debit Cash for $250,000, debit Land for $500,000, and credit

Common Stock for $750,000.

4. d 5. e; Debt ratio = $400,000/$1,000,000 = 40%

Icon denotes assignments that involve decision making.

1. Provide the names of two (a) asset accounts, (b) liability accounts, and (c) equity accounts.

2. What is the difference between a note payable and an ac- count payable?

3. Discuss the steps in processing business transactions. 4. What kinds of transactions can be recorded in a general

journal? 5. Are debits or credits typically listed first in general journal

entries? Are the debits or the credits indented? 6. Should a transaction be recorded first in a journal or the

ledger? Why? 7. If assets are valuable resources and asset accounts have debit

balances, why do expense accounts also have debit balances? 8. Why does the recordkeeper prepare a trial balance?

9. If an incorrect amount is journalized and posted to the ac- counts, how should the error be corrected?

10. Identify the four financial statements of a business. 11. What information is reported in a balance sheet? 12. What information is reported in an income statement? 13. Why does the user of an income statement need to

know the time period that it covers? 14. Define (a) assets, (b) liabilities, and (c) equity. 15. Which financial statement is sometimes called the state-

ment of financial position?

16. Review the Apple balance sheet in Appendix A. Identify three accounts on its bal- ance sheet that carry debit balances and three accounts on its balance sheet that carry credit balances.

Discussion Questions

APPLE

68 Chapter 2 Accounting for Business Transactions

17. Review the Google balance sheet in Appendix A. Identify an asset with the word receivable in its account title and a liability with the word payable in its account title.

18. Review the Samsung balance sheet in Appendix A. Identify three current liabili- ties and three noncurrent liabilities in its balance sheet.

SamsungGOOGLE

QUICK STUDY

QS 2-1 Identifying source documents C1

Identify the items from the following list that are likely to serve as source documents. a. Sales receipt d. Prepaid insurance account g. Income statement b. Trial balance e. Invoice from supplier h. Bank statement c. Balance sheet f. Company revenue account i. Telephone bill

QS 2-2 Identifying financial statement accounts

Classify each of the following accounts as an asset (A), liability (L), or equity (EQ) account. a. Cash d. Prepaid Insurance g. Accounts Payable b. Prepaid Rent e. Office Equipment h. Unearned Rent Revenue c. Office Supplies f. Common Stock i. Dividends

QS 2-3 Reading a chart of accounts

A chart of accounts is a list of all ledger accounts and an identification number for each. One example of a chart of accounts is near the end of the book on pages CA and CA-1. Using that chart, identify the fol- lowing accounts as either an asset (A), liability (L), equity (EQ), revenue (R), or expense (E) account, along with its identification number. a. Advertising Expense d. Machinery g. Notes Payable b. Rent Revenue e. Accounts Payable h. Common Stock c. Rent Receivable f. Furniture i. Utilities Expense

QS 2-4 Identifying normal balance

Identify the normal balance (debit or credit) for each of the following accounts. a. Fees Earned (Revenues) d. Wages Expense g. Wages Payable b. Office Supplies e. Accounts Receivable h. Building c. Dividends f. Prepaid Rent i. Common Stock

QS 2-5 Linking debit or credit with normal balance

Indicate whether a debit or credit decreases the normal balance of each of the following accounts. a. Interest Payable e. Common Stock i. Dividends b. Service Revenue f. Prepaid Insurance j. Unearned Revenue c. Salaries Expense g. Buildings k. Accounts Payable d. Accounts Receivable h. Interest Revenue l. Land

QS 2-6 Analyzing transactions and preparing journal entries

For each transaction, (1) analyze the transaction using the accounting equation, (2) record the transaction in journal entry form, and (3) post the entry using T-accounts to represent ledger accounts. Use the follow- ing (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Office Supplies (124); Trucks (153); Equipment (167); Accounts Payable (201); Unearned Landscaping Revenue (236); Common Stock (307); Dividends (319); Landscaping Revenue (403); Wages Expense (601), and Landscaping Expense (696). a. On May 15, DeShawn Tyler opens a landscaping company called Elegant Lawns by investing $7,000

in cash along with equipment having a $3,000 value in exchange for common stock. b. On May 21, Elegant Lawns purchases office supplies on credit for $500. c. On May 25, Elegant Lawns receives $4,000 cash for performing landscaping services. d. On May 30, Elegant Lawns receives $1,000 cash in advance of providing landscaping services to

a customer.

Identify whether a debit or credit results in the indicated change for each of the following accounts. a. To increase Land f. To decrease Prepaid Rent b. To decrease Cash g. To increase Notes Payable c. To increase Fees Earned (Revenues) h. To decrease Accounts Receivable d. To increase Salaries Expense i. To increase Common Stock e. To decrease Unearned Revenue j. To increase Store Equipment

QS 2-7 Analyzing debit or credit by account

Chapter 2 Accounting for Business Transactions 69

Indicate the financial statement on which each of the following items appears. Use I for income statement, E for statement of retained earnings, and B for balance sheet. a. Services Revenue e. Equipment i. Dividends b. Interest Payable f. Prepaid Insurance j. Office Supplies c. Accounts Receivable g. Buildings k. Interest Expense d. Salaries Expense h. Rental Revenue l. Insurance Expense

QS 2-9 Classifying accounts in financial statements

Prepare general journal entries for the following transactions of Green Energy Company. Use the follow- ing (partial) chart of accounts: Cash; Accounts Receivable; Supplies; Accounts Payable; Consulting Revenue; and Utilities Expense.

May 1 The company billed a customer $2,000 in consulting revenue for sustainable proposals. 3 The company purchased $300 of energy-efficient supplies on credit. 9 The company collected $500 cash as partial payment of the May 1 consulting revenue. 20 The company paid $300 cash toward the payable for energy-efficient supplies. 31 The company paid $100 cash for May’s renewable energy utilities.

QS 2-11 Preparing journal entries

Determine the ending balance of each of the following T-accounts. QS 2-10 Computing T-account balance

C4 Cash

100 50 300 60 20

Accounts Payable

2,000 8,000 2,700

Supplies

10,000 3,800 1,100

a. b. c.

Accounts Receivable

600 150 150 150 100

Wages Payable

700 700

Cash

11,000 4,500 800 6,000 100 1,300

d. e. f.

A trial balance has total debits of $20,000 and total credits of $24,500. Which one of the following errors would create this imbalance? Explain. a. A $2,250 debit to Utilities Expense in a journal entry was incorrectly posted to the ledger as a $2,250

credit, leaving the Utilities Expense account with a $3,000 debit balance. b. A $4,500 debit to Salaries Expense in a journal entry was incorrectly posted to the ledger as a $4,500

credit, leaving the Salaries Expense account with a $750 debit balance. c. A $2,250 credit to Consulting Fees Earned (Revenues) in a journal entry was incorrectly posted to the

ledger as a $2,250 debit, leaving the Consulting Fees Earned account with a $6,300 credit balance. d. A $2,250 debit posting to Accounts Receivable was posted mistakenly to Land. e. A $4,500 debit posting to Equipment was posted mistakenly to Cash. f. An entry debiting Cash and crediting Accounts Payable for $4,500 was mistakenly not posted.

QS 2-8 Identifying a posting error

QS 2-12 Preparing an income statement

Liu Zhang operates Lawson Consulting, which began operations on June 1. On June 30, the company’s records show the following selected accounts and amounts for the month of June. Prepare a June income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . $5,000

Accounts receivable . . . . . . . 4,500

Equipment . . . . . . . . . . . . . . . . 6,500

Accounts payable . . . . . . . . . . $ 3,000

Common stock . . . . . . . . . . . . 10,500

Dividends . . . . . . . . . . . . . . . . 1,500

Service revenue . . . . . . . . . $12,000

Rent expense . . . . . . . . . . . 2,000

Wages expense . . . . . . . . . 6,000

QS 2-13 Preparing a statement of retained earnings P3

Use the information in QS 2-12 to prepare a June statement of retained earnings for Lawson Consulting. The Retained Earnings account balance at June 1 was $0. Hint: Net income for June is $4,000.

70 Chapter 2 Accounting for Business Transactions

QS 2-14 Preparing a balance sheet P3

Use the information in QS 2-12 and QS 2-13 to prepare a June 30 balance sheet for Lawson Consulting. Hint: The ending Retained Earnings account balance as of June 30 is $2,500.

Exercise 2-2 Identifying and classifying accounts

Enter the number for the item that best completes each of the descriptions below. 1. Asset 2. Equity 3. Account 4. Liability 5. Three a. Balance sheet accounts are arranged into general categories. b. Common Stock and Dividends are examples of accounts. c. Accounts Payable and Note Payable are examples of accounts. d. Accounts Receivable, Prepaid Accounts, Supplies, and Land are examples of accounts. e. A(n) is a record of increases and decreases in a specific asset, liability, equity, revenue, or

expense item.

Exercise 2-3 Identifying a ledger and chart of accounts

Enter the number for the item that best completes each of the descriptions below. 1. Chart 2. General ledger 3. Journal 4. Account 5. Source document a. A(n) of accounts is a list of all accounts a company uses, not including account balances. b. The is a record containing all accounts used by a company, including account balances. c. A(n) describes transactions entering an accounting system, such as a purchase order. d. Increases and decreases in a specific asset, liability, equity, revenue, or expense are recorded in

a(n) . e. A(n) has a complete record of every transaction recorded.

Exercise 2-4 Identifying type and normal balances of accounts

For each of the following, (1) identify the type of account as an asset, liability, equity, revenue, or expense; (2) identify the normal balance of the account; and (3) enter debit (Dr.) or credit (Cr.) to identify the kind of entry that would increase the account balance. a. Land e. Accounts Receivable i. Fees Earned b. Cash f. Dividends j. Equipment c. Legal Expense g. License Fee Revenue k. Notes Payable d. Prepaid Insurance h. Unearned Revenue l. Common Stock

QS 2-15 Computing and using the debt ratio A2

In a recent year’s financial statements, Home Depot reported the following: Total liabilities = $38,633 million and Total assets = $42,966 million. Compute and interpret Home Depot’s debt ratio (assume com- petitors average a 60.0% debt ratio).

EXERCISES

Exercise 2-1 Steps in analyzing and recording transactions C1

Order the following steps in the accounting process that focus on analyzing and recording transactions. a. Prepare and analyze the trial balance. b. Analyze each transaction from source documents. c. Record relevant transactions in a journal. d. Post journal information to ledger accounts.

Groro Co. bills a client $62,000 for services provided and agrees to accept the following three items in full payment: (1) $10,000 cash, (2) equipment worth $80,000, and (3) to assume responsibility for a $28,000 note payable related to the equipment. For this transaction, (a) analyze the transaction using the account- ing equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Use the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Supplies (124); Equipment (167); Accounts Payable (201); Note Payable (245); Common Stock (307); and Revenue (404).

Exercise 2-5 Analyzing effects of a compound entry

Use the information in each of the following separate cases to calculate the unknown amount. a. Corentine Co. had $152,000 of accounts payable on September 30 and $132,500 on October 31. Total

purchases on account during October were $281,000. Determine how much cash was paid on accounts payable during October.

b. On September 30, Valerian Co. had a $102,500 balance in Accounts Receivable. During October, the company collected $102,890 from its credit customers. The October 31 balance in Accounts Receivable was $89,000. Determine the amount of sales on account that occurred in October.

Exercise 2-6 Analyzing account entries and balances

[continued on next page]

Chapter 2 Accounting for Business Transactions 71

Prepare general journal entries for the following transactions of a new company called Pose-for-Pics. Use the following (partial) chart of accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; Common Stock; Photography Fees Earned; and Utilities Expense.

Aug. 1 Madison Harris, the owner, invested $6,500 cash and $33,500 of photography equipment in the company in exchange for common stock.

2 The company paid $2,100 cash for an insurance policy covering the next 24 months. 5 The company purchased office supplies for $880 cash. 20 The company received $3,331 cash in photography fees earned. 31 The company paid $675 cash for August utilities.

Exercise 2-7 Preparing general journal entries

Use the information in Exercise 2-7 to prepare a trial balance for Pose-for-Pics. Begin by opening these T-accounts: Cash; Office Supplies; Prepaid Insurance; Photography Equipment; Common Stock; Photography Fees Earned; and Utilities Expense. Then, (1) post the general journal entries to these T-accounts (which will serve as the ledger) and (2) prepare the August 31 trial balance.

Exercise 2-8 Preparing T-accounts (ledger) and a trial balance P2

Prepare general journal entries to record the transactions below for Spade Company by using the follow- ing accounts: Cash; Accounts Receivable; Office Supplies; Office Equipment; Accounts Payable; Common Stock; Dividends; Fees Earned; and Rent Expense. Use the letters beside each transaction to identify entries. After recording the transactions, post them to T-accounts, which serve as the general ledger for this assignment. Determine the ending balance of each T-account. a. Kacy Spade, owner, invested $100,750 cash in the company in exchange for common stock. b. The company purchased office supplies for $1,250 cash. c. The company purchased $10,050 of office equipment on credit. d. The company received $15,500 cash as fees for services provided to a customer. e. The company paid $10,050 cash to settle the payable for the office equipment purchased in

transaction c. f. The company billed a customer $2,700 as fees for services provided. g. The company paid $1,225 cash for the monthly rent. h. The company collected $1,125 cash as partial payment for the account receivable created in

transaction f. i. The company paid a $10,000 cash dividend to the owner (sole shareholder).

Exercise 2-9 Recording effects of transactions in T-accounts

Check Cash ending balance, $94,850

After recording the transactions of Exercise 2-9 in T-accounts and calculating the balance of each account, prepare a trial balance. Use May 31 as its report date.

Exercise 2-10 Preparing a trial balance P2

c. During October, Alameda Company had $102,500 of cash receipts and $103,150 of cash disburse- ments. The October 31 Cash balance was $18,600. Determine how much cash the company had at the close of business on September 30.

1. Prepare general journal entries for the following transactions of Valdez Services. a. The company paid $2,000 cash for payment on a 6-month-old account payable for office supplies. b. The company paid $1,200 cash for the just completed two-week salary of the receptionist. c. The company paid $39,000 cash for equipment purchased. d. The company paid $800 cash for this month’s utilities. e. The company paid a $4,500 cash dividend to the owner (sole shareholder).

2. Transactions a, c, and e did not result in an expense. Match each transaction (a, c, and e) with one of the following reasons for not recording an expense.

This transaction is a distribution of cash to the owner. Even though equity decreased, that decrease did not occur in the process of providing goods or services to customers. This transaction decreased cash in settlement of a previously existing liability (equity did not change). Supplies expense is recorded when assets are used, not necessarily when cash is paid. This transaction involves the purchase of an asset. The form of the company’s assets changed, but total assets did not (and neither did equity).

Exercise 2-11 Analyzing and journalizing transactions involving cash payments

72 Chapter 2 Accounting for Business Transactions

1. Prepare general journal entries for the following transactions of Valdez Services. a. Brina Valdez invested $20,000 cash in the company in exchange for common stock. b. The company provided services to a client and immediately received $900 cash. c. The company received $10,000 cash from a client in payment for services to be provided next year. d. The company received $3,500 cash from a client in partial payment of accounts receivable. e. The company borrowed $5,000 cash from the bank by signing a note payable.

2. Transactions a, c, d, and e did not yield revenue. Match each transaction (a, c, d, and e) with one of the following reasons for not recording revenue.

This transaction changed the form of an asset from a receivable to cash. Total assets were not increased (revenue was recognized when the services were originally provided). This transaction brought in cash (increased assets), and it also increased a liability by the same amount (represented by the signing of a note to repay the amount). This transaction brought in cash, but this is an owner investment. This transaction brought in cash, but it created a liability to provide services to the client in the next year.

Exercise 2-12 Analyzing and journalizing transactions involving receipt of cash

Fill in each of the following T-accounts for Belle Co.’s seven transactions listed here. The T-accounts repre- sent Belle Co.’s general ledger. Code each entry with transaction number 1 through 7 (in order) for reference. 1. D. Belle created a new business and invested $6,000 cash, $7,600 of equipment, and $12,000 in web servers

in exchange for common stock. 2. The company paid $4,800 cash in advance for prepaid insurance coverage. 3. The company purchased $900 of supplies on account. 4. The company paid $800 cash for selling expenses. 5. The company received $4,500 cash for services provided. 6. The company paid $900 cash toward accounts payable. 7. The company paid $3,400 cash for equipment.

Exercise 2-13 Entering transactions into T-accounts

Cash

Equipment

Common Stock

Supplies

Web Servers

Services Revenue

Prepaid Insurance

Accounts Payable

Selling Expenses

Exercise 2-14 Preparing general journal entries P1

Use information from Exercise 2-13 to prepare the general journal entries for Belle Co.’s first seven transactions.

Determine net income or net loss for the business during the year for each of the following separate cases. a. Owner made no investments in the business, and no dividends were paid during the year. b. Owner made no investments in the business, but dividends were $1,250 cash per month. c. No dividends were paid during the year, but the owner did invest an additional $55,000 cash in

exchange for common stock. d. Dividends were $1,250 cash per month, and the owner invested an additional $35,000 cash in exchange

for common stock.

A corporation had the following assets and liabilities at the beginning and end of this year.

Assets Liabilities

Beginning of the year . . . . . . . . . . . . $ 60,000 $20,000

End of the year . . . . . . . . . . . . . . . . . 105,000 36,000

Exercise 2-15 Computing net income

Carmen Camry operates a consulting firm called Help Today, which began operations on August 1. On August 31, the company’s records show the following selected accounts and amounts for the month of August. Use this information to prepare an August income statement for the business.

Exercise 2-16 Preparing an income statement C3 P3

Chapter 2 Accounting for Business Transactions 73

Use the information in Exercise 2-16 to prepare an August statement of retained earnings for Help Today. The Retained Earnings account balance at August 1 was $0. Hint: Net income for August is $10,470.

Exercise 2-17 Preparing a statement of retained earnings P3

Use the information in Exercise 2-16 to prepare an August 31 balance sheet for Help Today. Hint: The ending Retained Earnings account balance as of August 31 is $4,470.

Exercise 2-18 Preparing a balance sheet P3

Compute the missing amount for each of the following separate companies in columns B through E. Exercise 2-19 Analyzing changes in a company’s equity

110,000 $ 0

? 22,000

104,000

? $ 0

(47,000) 90,000 85,000

87,000 $ 0

(10,000) (4,000)

210,000 $ 0

(55,000) ?

110,000

2 1

3 4 5 6

A B C D E

CBS ABC CNN NBC

Equity, beginning of year

Equity, end of year

Owner investments during the year Dividends during the year Net income (loss) for the year

Check Net income, $10,470

Cash . . . . . . . . . . . . . . . . . . $25,360 Accounts receivable . . . . . . 22,360 Office supplies . . . . . . . . . . 5,250 Land . . . . . . . . . . . . . . . . . . 44,000 Office equipment . . . . . . . . 20,000

Accounts payable . . . . . . . . . . . $ 10,500 Common stock . . . . . . . . . . . . . 102,000 Dividends . . . . . . . . . . . . . . . . . 6,000 Consulting fees earned . . . . . . 27,000 Rent expense . . . . . . . . . . . . . . 9,550

Salaries expense . . . . . . . . . . $5,600 Telephone expense . . . . . . . . 860 Miscellaneous expenses . . . . 520

Posting errors are identified in the following table. In column (1), enter the amount of the difference be- tween the two trial balance columns (debit and credit) due to the error. In column (2), identify the trial balance column (debit or credit) with the larger amount if they are not equal. In column (3), identify the account(s) affected by the error. In column (4), indicate the amount by which the account(s) in column (3) is under- or overstated. Item (a) is completed as an example.

Exercise 2-20 Identifying effects of posting errors on the trial balance A1 P2

Exercise 2-21 Analyzing a trial balance error

P1 P2

You are told the column totals in a trial balance are not equal. After careful analysis, you discover only one error. Specifically, a correctly journalized credit purchase of an automobile for $18,950 is posted from the journal to the ledger with an $18,950 debit to Automobiles and another $18,950 debit to Accounts Payable. The Automobiles account has a debit balance of $37,100 on the trial balance. (1) Answer each of the following questions and (2) compute the dollar amount of any misstatement for parts a through d. a. Is the Debit column total of the trial balance overstated, understated, or correctly stated? b. Is the Credit column total of the trial balance overstated, understated, or correctly stated? c. Is the Automobiles account balance overstated, understated, or correctly stated in the trial balance? d. Is the Accounts Payable account balance overstated, understated, or correctly stated in the trial balance? e. If the Debit column total of the trial balance is $200,000 before correcting the error, what is the total

of the Credit column before correction?

(1) (2) (3) (4) Difference between Column with Identify Amount That Debit and Credit the Larger Account(s) Account(s) Is Over- or Description of Posting Error Columns Total Incorrectly Stated Understated

a . $3,600 debit to Rent Expense is $2,260 Credit Rent Expense Rent Expense posted as a $1,340 debit . understated $2,260

b . $6,500 credit to Cash is posted twice as two credits to Cash .

c . $10,900 debit to the Dividends account is debited to Common Stock .

d . $2,050 debit to Prepaid Insurance is posted as a debit to Insurance Expense .

e . $38,000 debit to Machinery is posted as a debit to Accounts Payable .

f . $5,850 credit to Services Revenue is posted as a $585 credit .

g . $1,390 debit to Store Supplies is not posted .

74 Chapter 2 Accounting for Business Transactions

Exercise 2-23 Preparing journal entries

Prepare general journal entries for the following transactions of Sustain Company. Use the following (par- tial) chart of accounts: Cash; Prepaid Insurance; Accounts Receivable; Furniture; Accounts Payable; Unearned Revenue; Fees Earned; and Common Stock.

June 1 T. James, owner, invested $11,000 cash in Sustain Company in exchange for common stock. 2 The company purchased $4,000 of furniture made from reclaimed wood on credit. 3 The company paid $600 cash for a 12-month insurance policy on the reclaimed furniture. 4 The company billed a customer $3,000 in fees earned from preparing a sustainability report. 12 The company paid $4,000 cash toward the payable from the June 2 furniture purchase. 20 The company collected $3,000 cash for fees billed on June 4. 21 T. James invested an additional $10,000 cash in Sustain Company in exchange for common stock. 30 The company received $5,000 cash in advance of providing sustainability services to a customer.

Exercise 2-22 Calculating and interpreting the debt ratio

a. Compute the debt ratio for each of the three companies. b. Which company has the most financial leverage?

67,000 $22,000

12,000 150,000

$ 40,000

68,000 27,000

$19,000

5,000 147,000

$ 30,000

17,000

ExpensesCompany Total Assets Net Income Total Liabilities

DreamWorks Pixar Universal

Aracel Engineering completed the following transactions in the month of June. a. Jenna Aracel, the owner, invested $100,000 cash, office equipment with a value of $5,000, and

$60,000 of drafting equipment to launch the company in exchange for common stock. b. The company purchased land worth $49,000 for an office by paying $6,300 cash and signing a long-

term note payable for $42,700. c. The company purchased a portable building with $55,000 cash and moved it onto the land acquired in b. d. The company paid $3,000 cash for the premium on an 18-month insurance policy. e. The company completed and delivered a set of plans for a client and collected $6,200 cash. f. The company purchased $20,000 of additional drafting equipment by paying $9,500 cash and signing

a long-term note payable for $10,500.

Problem 2-2A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

PROBLEM SET A

Problem 2-1A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Karla Tanner opened a web consulting business called Linkworks and completed the following transac- tions in its first month of operations.

Apr. 1 Tanner invested $80,000 cash along with office equipment valued at $26,000 in the company in exchange for common stock.

2 The company prepaid $9,000 cash for 12 months’ rent for office space. Hint: Debit Prepaid Rent for $9,000.

3 The company made credit purchases for $8,000 in office equipment and $3,600 in office sup- plies. Payment is due within 10 days.

6 The company completed services for a client and immediately received $4,000 cash. 9 The company completed a $6,000 project for a client, who must pay within 30 days. 13 The company paid $11,600 cash to settle the account payable created on April 3. 19 The company paid $2,400 cash for the premium on a 12-month insurance policy. Hint: Debit

Prepaid Insurance for $2,400. 22 The company received $4,400 cash as partial payment for the work completed on April 9. 25 The company completed work for another client for $2,890 on credit. 28 The company paid a $5,500 cash dividend. 29 The company purchased $600 of additional office supplies on credit. 30 The company paid $435 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of April 30.

Check (2) Ending balances: Cash, $59,465; Accounts Receivable, $4,490; Accounts Payable, $600

(3) Total debits, $119,490

Chapter 2 Accounting for Business Transactions 75

Denzel Brooks opened a web consulting business called Venture Consultants and completed the following transactions in March.

Mar. 1 Brooks invested $150,000 cash along with $22,000 in office equipment in the company in exchange for common stock.

2 The company prepaid $6,000 cash for six months’ rent for an office. Hint: Debit Prepaid Rent for $6,000.

3 The company made credit purchases of office equipment for $3,000 and office supplies for $1,200. Payment is due within 10 days.

6 The company completed services for a client and immediately received $4,000 cash. 9 The company completed a $7,500 project for a client, who must pay within 30 days. 12 The company paid $4,200 cash to settle the account payable created on March 3. 19 The company paid $5,000 cash for the premium on a 12-month insurance policy. Hint: Debit

Prepaid Insurance for $5,000. 22 The company received $3,500 cash as partial payment for the work completed on March 9. 25 The company completed work for another client for $3,820 on credit. 29 The company paid a $5,100 cash dividend. 30 The company purchased $600 of additional office supplies on credit. 31 The company paid $500 cash for this month’s utility bill.

Required

1. Prepare general journal entries to record these transactions (use the account titles listed in part 2). 2. Open the following ledger accounts—their account numbers are in parentheses (use the balance col-

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of March.

Check (2) Ending balances: Cash, $136,700; Accounts Receivable, $7,820; Accounts Payable, $600

(3) Total debits, $187,920

Problem 2-3A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

g. The company completed $14,000 of engineering services for a client. This amount is to be received in 30 days.

h. The company purchased $1,150 of additional office equipment on credit. i. The company completed engineering services for $22,000 on credit. j. The company received a bill for rent of equipment that was used on a recently completed job. The

$1,333 rent cost must be paid within 30 days. k. The company collected $7,000 cash in partial payment from the client described in transaction g. l. The company paid $1,200 cash for wages to a drafting assistant. m. The company paid $1,150 cash to settle the account payable created in transaction h. n. The company paid $925 cash for minor maintenance of its drafting equipment. o. The company paid a $9,480 cash dividend. p. The company paid $1,200 cash for wages to a drafting assistant. q. The company paid $2,500 cash for advertisements on the web during June.

Required

umn format): Cash (101); Accounts Receivable (106); Prepaid Insurance (108); Office Equipment (163); Drafting Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Engineering Fees Earned (402); Wages Expense (601); Equipment Rental Expense (602); Advertising Expense (603); and Repairs Expense (604). Post the journal entries from part 1 to the accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of June.

Check (2) Ending balances: Cash, $22,945; Accounts Receivable, $29,000; Accounts Payable, $1,333

(3) Trial balance totals, $261,733

Problem 2-4A Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Business transactions completed by Hannah Venedict during the month of September are as follows. a. Venedict invested $60,000 cash along with office equipment valued at $25,000 in a new business

named HV Consulting in exchange for common stock. b. The company purchased land valued at $40,000 and a building valued at $160,000. The purchase is

paid with $30,000 cash and a long-term note payable for $170,000. c. The company purchased $2,000 of office supplies on credit. [continued on next page]

76 Chapter 2 Accounting for Business Transactions

Problem 2-5A Computing net income from equity analysis, preparing a balance sheet, and computing the debt ratio

C2 A1 A2 P3

The accounting records of Nettle Distribution show the following assets and liabilities as of December 31, 2018 and 2019.

December 31 2018 2019

Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 64,300 $ 15,640

Accounts receivable . . . . . . . . . . . . 26,240 19,100

Office supplies . . . . . . . . . . . . . . . . 3,160 1,960

Office equipment . . . . . . . . . . . . . . 44,000 44,000

Trucks . . . . . . . . . . . . . . . . . . . . . . . 148,000 157,000

December 31 2018 2019

Building . . . . . . . . . . . . . . . . . . . . . . $ 0 $80,000

Land . . . . . . . . . . . . . . . . . . . . . . . . 0 60,000

Accounts payable . . . . . . . . . . . . . . 3,500 33,500

Note payable . . . . . . . . . . . . . . . . . 0 40,000

Required

1. Prepare balance sheets for the business as of December 31, 2018 and 2019. Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.

2. Compute net income for 2019 by comparing total equity amounts for these two years and using the following information: During 2019, the owner invested $35,000 additional cash in the business (in exchange for common stock) and the company paid a $19,000 cash dividend.

3. Compute the 2019 year-end debt ratio (in percent and rounded to one decimal).

Check (2) Net income, $6,000

(3) Debt ratio, 19.5%

Yi Min started an engineering firm called Min Engineering. He began operations and completed seven transactions in May, which included his initial investment of $18,000 cash. After those seven transactions, the ledger included the following accounts with normal balances.

Problem 2-6A Analyzing account balances and reconstructing transactions

C1 C3 A1 P2 Cash . . . . . . . . . . . . . . . . . $37,600 Office supplies . . . . . . . . . 890

Prepaid insurance . . . . . . . 4,600

Office equipment . . . . . . . $12,900

Accounts payable . . . . . . . 12,900

Common stock . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . $ 3,370

Engineering fees earned . . . . . . . 36,000

Rent expense . . . . . . . . . . . . . . . . 7,540

Required

1. Prepare a trial balance for this business as of the end of May. 2. The following seven transactions produced the account balances shown above. a. Y. Min invested $18,000 cash in the business in exchange for common stock. b. Paid $7,540 cash for monthly rent expense for May. c. Paid $4,600 cash in advance for the annual insurance premium beginning the next period.

Check (1) Trial balance totals, $66,900 (2) Ending Cash balance, $37,600

Check (2) Ending balances: Cash, $12,665; Office Equipment, $50,900

(3) Trial balance totals, $291,350

d. Venedict invested her personal automobile in the company in exchange for more common stock. The automobile has a value of $16,500 and is to be used exclusively in the business.

e. The company purchased $5,600 of additional office equipment on credit. f. The company paid $1,800 cash salary to an assistant. g. The company provided services to a client and collected $8,000 cash. h. The company paid $635 cash for this month’s utilities. i. The company paid $2,000 cash to settle the account payable created in transaction c. j. The company purchased $20,300 of new office equipment by paying $20,300 cash. k. The company completed $6,250 of services for a client, who must pay within 30 days. l. The company paid $1,800 cash salary to an assistant. m. The company received $4,000 cash in partial payment on the receivable created in transaction k. n. The company paid a $2,800 cash dividend.

Required

umn format): Cash (101); Accounts Receivable (106); Office Supplies (108); Office Equipment (163); Automobiles (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Salaries Expense (601); and Utilities Expense (602). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of September.

[continued from previous page]

Chapter 2 Accounting for Business Transactions 77

Angela Lopez owns and manages a consulting firm called Metrix, which began operations on March 1. On March 31, Metrix shows the following selected accounts and amounts for the month of March.

Problem 2-7A Preparing an income statement, statement of retained earnings, and balance sheet

Equipment . . . . . . . . . . . . . . $ 4,000

Salaries expense . . . . . . . . 3,000

Consulting revenue . . . . . . 12,000

Cash . . . . . . . . . . . . . . . . . . 8,000

Utilities expense . . . . . . . . . 200

Note payable . . . . . . . . . . . 2,400

Accounts receivable . . . . . . . . $ 3,500

Common stock . . . . . . . . . . . . 11,600

Dividends . . . . . . . . . . . . . . . . 2,000

Office supplies . . . . . . . . . . . . 1,500

Rental revenue . . . . . . . . . . . . 500

Advertising expense . . . . . . . . 400

Prepaid insurance . . . . . . . $1,000

Accounts payable . . . . . . . 1,300

Note receivable . . . . . . . . 2,500

Rent expense . . . . . . . . . . 2,000

Unearned revenue . . . . . . 300

Required

1. Prepare a March income statement for the business. 2. Prepare a March statement of retained earnings. The Retained Earnings account balance at March 1 was

$0, and the owner invested $11,600 cash in the company on March 2 in exchange for common stock. 3. Prepare a March 31 balance sheet. Hint: Use the Retained Earnings account balance calculated in part 2.

PROBLEM SET B

Problem 2-1B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Humble Management Services opened for business and completed these transactions in September.

Sep. 1 Henry Humble, the owner, invested $38,000 cash along with office equipment valued at $15,000 in the company in exchange for common stock.

2 The company prepaid $9,000 cash for 12 months’ rent for office space. Hint: Debit Prepaid Rent for $9,000.

4 The company made credit purchases for $8,000 in office equipment and $2,400 in office sup- plies. Payment is due within 10 days.

8 The company completed work for a client and immediately received $3,280 cash. 12 The company completed a $15,400 project for a client, who must pay within 30 days. 13 The company paid $10,400 cash to settle the payable created on September 4. 19 The company paid $1,900 cash for the premium on an 18-month insurance policy. Hint: Debit

Prepaid Insurance for $1,900. 22 The company received $7,700 cash as partial payment for the work completed on September 12. 24 The company completed work for another client for $2,100 on credit. 28 The company paid a $5,300 cash dividend. 29 The company purchased $550 of additional office supplies on credit. 30 The company paid $860 cash for this month’s utility bill.

Required

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (401); and Utilities Expense (690). Post journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of September.

Check (2) Ending balances: Cash, $21,520; Accounts Receivable, $9,800; Accounts Payable, $550

(3) Total debits, $74,330

d. Purchased office supplies for $890 cash. e. Purchased $12,900 of office equipment on credit (with accounts payable). f. Received $36,000 cash for engineering services provided in May. g. The company paid a $3,370 cash dividend. Prepare a Cash T-account, enter the cash effects (if any) of each transaction, and compute the ending

Cash balance. Code each entry in the T-account with one of the transaction codes a through g.

At the beginning of April, Bernadette Grechus launched a custom computer solutions company called Softworks. The company had the following transactions during April. a. Bernadette Grechus invested $65,000 cash, office equipment with a value of $5,750, and $30,000 of

computer equipment in the company in exchange for common stock. b. The company purchased land worth $22,000 for an office by paying $5,000 cash and signing a long-

term note payable for $17,000.

Problem 2-2B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

[continued on next page]

78 Chapter 2 Accounting for Business Transactions

Zucker Management Services opened for business and completed these transactions in November.

Nov. 1 Matt Zucker, the owner, invested $30,000 cash along with $15,000 of office equipment in the company in exchange for common stock.

2 The company prepaid $4,500 cash for six months’ rent for an office. Hint: Debit Prepaid Rent for $4,500.

4 The company made credit purchases of office equipment for $2,500 and of office supplies for $600. Payment is due within 10 days.

8 The company completed work for a client and immediately received $3,400 cash. 12 The company completed a $10,200 project for a client, who must pay within 30 days. 13 The company paid $3,100 cash to settle the payable created on November 4. 19 The company paid $1,800 cash for the premium on a 24-month insurance policy. 22 The company received $5,200 cash as partial payment for the work completed on November 12. 24 The company completed work for another client for $1,750 on credit. 28 The company paid a $5,300 cash dividend. 29 The company purchased $249 of additional office supplies on credit. 30 The company paid $831 cash for this month’s utility bill.

Required

umn format): Cash (101); Accounts Receivable (106); Office Supplies (124); Prepaid Insurance (128); Prepaid Rent (131); Office Equipment (163); Accounts Payable (201); Common Stock (307); Dividends (319); Services Revenue (403); and Utilities Expense (690). Post the journal entries from part 1 to the ledger accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of November.

Check (2) Ending balances: Cash, $23,069; Accounts Receivable, $6,750; Accounts Payable, $249

(3) Total debits, $60,599

Problem 2-3B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

c. The company purchased a portable building with $34,500 cash and moved it onto the land acquired in b.

d. The company paid $5,000 cash for the premium on a two-year insurance policy. e. The company provided services to a client and immediately collected $4,600 cash. f. The company purchased $4,500 of additional computer equipment by paying $800 cash and signing a

long-term note payable for $3,700. g. The company completed $4,250 of services for a client. This amount is to be received within

30 days. h. The company purchased $950 of additional office equipment on credit. i. The company completed client services for $10,200 on credit. j. The company received a bill for rent of a computer testing device that was used on a recently com-

pleted job. The $580 rent cost must be paid within 30 days. k. The company collected $5,100 cash in partial payment from the client described in transaction i. l. The company paid $1,800 cash for wages to an assistant. m. The company paid $950 cash to settle the payable created in transaction h. n. The company paid $608 cash for minor maintenance of the company’s computer equipment. o. The company paid a $6,230 cash dividend. p. The company paid $1,800 cash for wages to an assistant. q. The company paid $750 cash for advertisements on the web during April.

Required

umn format): Cash (101); Accounts Receivable (106); Prepaid Insurance (108); Office Equipment (163); Computer Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Payable (250); Common Stock (307); Dividends (319); Fees Earned (402); Wages Expense (601); Computer Rental Expense (602); Advertising Expense (603); and Repairs Expense (604). Post the journal entries from part 1 to the accounts and enter the balance after each posting.

3. Prepare a trial balance as of the end of April.

Check (2) Ending balances: Cash, $17,262; Accounts Receivable, $9,350; Accounts Payable, $580

(3) Trial balance totals, $141,080

[continued from previous page]

Chapter 2 Accounting for Business Transactions 79

Problem 2-4B Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Nuncio Consulting completed the following transactions during June. a. Armand Nuncio, the owner, invested $35,000 cash along with office equipment valued at $11,000 in

the new company in exchange for common stock. b. The company purchased land valued at $7,500 and a building valued at $40,000. The purchase is paid

with $15,000 cash and a long-term note payable for $32,500. c. The company purchased $500 of office supplies on credit. d. A. Nuncio invested his personal automobile in the company in exchange for more common stock. The

automobile has a value of $8,000 and is to be used exclusively in the business. e. The company purchased $1,200 of additional office equipment on credit. f. The company paid $1,000 cash salary to an assistant. g. The company provided services to a client and collected $3,200 cash. h. The company paid $540 cash for this month’s utilities. i. The company paid $500 cash to settle the payable created in transaction c. j. The company purchased $3,400 of new office equipment by paying $3,400 cash. k. The company completed $4,200 of services for a client, who must pay within 30 days. l. The company paid $1,000 cash salary to an assistant. m. The company received $2,200 cash in partial payment on the receivable created in transaction k. n. The company paid a $1,100 cash dividend.

Required

3. Prepare a trial balance as of the end of June.

Check (2) Ending balances: Cash, $17,860; Office Equipment, $15,600

(3) Trial balance totals, $95,100

Problem 2-5B Computing net income from equity analysis, preparing a balance sheet, and computing the debt ratio

C2 A1 A2 P3

The accounting records of Tama Co. show the following assets and liabilities as of December 31, 2018 and 2019.

December 31 2018 2019

Cash . . . . . . . . . . . . . . . . . . . . . . . . $30,000 $ 5,000

Accounts receivable . . . . . . . . . . . . 35,000 25,000

Office supplies . . . . . . . . . . . . . . . . 8,000 13,500

Office equipment . . . . . . . . . . . . . . 40,000 40,000

Machinery . . . . . . . . . . . . . . . . . . . . 28,000 28,500

December 31 2018 2019

Building . . . . . . . . . . . . . . . . . . $ 0 $250,000

Land . . . . . . . . . . . . . . . . . . . . 0 50,000

Accounts payable . . . . . . . . . . 4,000 12,000

Note payable . . . . . . . . . . . . . 0 250,000

Required

2. Compute net income for 2019 by comparing total equity amounts for these two years and using the following information: During 2019, the owner invested $5,000 additional cash in the business (in exchange for common stock) and the company paid a $3,000 cash dividend.

3. Compute the December 31, 2019, debt ratio (in percent and rounded to one decimal).

Check (2) Net income, $11,000

(3) Debt ratio, 63.6%

Roshaun Gould started a web consulting firm called Gould Solutions. He began operations and completed seven transactions in April that resulted in the following accounts, which all have normal balances.

Problem 2-6B Analyzing account balances and reconstructing transactions

C1 C3 A1 P2 Cash . . . . . . . . . . . . . . . . . $20,000

Office supplies . . . . . . . . . 750

Prepaid rent . . . . . . . . . . . 1,800

Office equipment . . . . . . . $12,250

Accounts payable . . . . . . . 12,250

Common stock . . . . . . . . . 15,000

Dividends . . . . . . . . . . . . . . . . . . . $ 5,200

Consulting fees earned . . . . . . . . 20,400

Miscellaneous expenses . . . . . . . 7,650

80 Chapter 2 Accounting for Business Transactions

Required

1. Prepare a trial balance for this business as of the end of April. 2. The following seven transactions produced the account balances shown above. a. Gould invested $15,000 cash in the business in exchange for common stock. b. Paid $1,800 cash in advance for next month’s rent expense. c. Paid $7,650 cash for miscellaneous expenses. d. Purchased office supplies for $750 cash. e. Purchased $12,250 of office equipment on credit (with accounts payable). f. Received $20,400 cash for consulting services provided in April. g. The company paid a $5,200 cash dividend. Prepare a Cash T-account, enter the cash effects (if any) of each transaction, and compute the ending

Cash balance. Code each entry in the T-account with one of the transaction codes a through g.

Check (1) Trial balance totals, $47,650 (2) Ending Cash balance, $20,000

Victoria Rivera owns and manages a consulting firm called Prisek, which began operations on July 1. On July 31, the company’s records show the following selected accounts and amounts for the month of July.

Problem 2-7B Preparing an income statement, statement of retained earnings, and balance sheet

Equipment . . . . . . . . . . . . . $12,000 Salaries expense . . . . . . . 9,000 Consulting revenue . . . . . 36,000 Cash . . . . . . . . . . . . . . . . . 24,000 Utilities expense . . . . . . . . 600 Note payable . . . . . . . . . . 7,200

Accounts receivable . . . . . . . . $10,500 Common stock . . . . . . . . . . . . 34,800 Dividends . . . . . . . . . . . . . . . . 6,000 Office supplies . . . . . . . . . . . . 4,500 Rental revenue . . . . . . . . . . . . 1,500 Advertising expense . . . . . . . . 1,200

Prepaid insurance . . . . . . . $3,000 Accounts payable . . . . . . . 3,900 Note receivable . . . . . . . . 7,500 Rent expense . . . . . . . . . . 6,000 Unearned revenue . . . . . . 900

Required

1. Prepare a July income statement for the business. 2. Prepare a July statement of retained earnings. The Retained Earnings account balance at July 1 was $0,

and the owner invested $34,800 cash in the company on July 2 in exchange for common stock. 3. Prepare a July 31 balance sheet. Hint: Use the Retained Earnings account balance calculated in part 2.

SERIAL PROBLEM Business Solutions

A1 P1 P2

This serial problem started in Chapter 1 and continues through most of the chapters. If the Chapter 1 seg- ment was not completed, the problem can begin at this point.

SP 2 On October 1, 2019, Santana Rey launched a computer services company called Business Solutions, which provides consulting services, computer system installations, and custom program devel- opment. Rey adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2019. The company’s initial chart of accounts follows.

Account No. Account No.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . 307

Accounts Receivable . . . . . . . . . . . . 106 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

Computer Supplies . . . . . . . . . . . . . . 126 Computer Services Revenue . . . . . . . . . . . . . 403

Prepaid Insurance . . . . . . . . . . . . . . . 128 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . 623

Prepaid Rent . . . . . . . . . . . . . . . . . . . 131 Advertising Expense . . . . . . . . . . . . . . . . . . . . 655

Office Equipment . . . . . . . . . . . . . . . 163 Mileage Expense . . . . . . . . . . . . . . . . . . . . . . 676

Computer Equipment . . . . . . . . . . . . 167 Miscellaneous Expenses . . . . . . . . . . . . . . . . 677

Accounts Payable . . . . . . . . . . . . . . . 201 Repairs Expense—Computer . . . . . . . . . . . . . 684 ©Alexander Image/Shutterstock

Required

1. Prepare journal entries to record each of the following transactions for Business Solutions.

Oct. 1 S. Rey invested $45,000 cash, a $20,000 computer system, and $8,000 of office equipment in the company in exchange for common stock.

2 The company paid $3,300 cash for four months’ rent. Hint: Debit Prepaid Rent for $3,300. 3 The company purchased $1,420 of computer supplies on credit from Harris Office Products. 5 The company paid $2,220 cash for one year’s premium on a property and liability insurance

policy. Hint: Debit Prepaid Insurance for $2,220. 6 The company billed Easy Leasing $4,800 for services performed in installing a new web server.

Chapter 2 Accounting for Business Transactions 81

8 The company paid $1,420 cash for the computer supplies purchased from Harris Office Prod- ucts on October 3.

10 The company hired Lyn Addie as a part-time assistant. 12 The company billed Easy Leasing another $1,400 for services performed. 15 The company received $4,800 cash from Easy Leasing as partial payment on its account. 17 The company paid $805 cash to repair computer equipment that was damaged when moving it. 20 The company paid $1,728 cash for advertisements published in the local newspaper. 22 The company received $1,400 cash from Easy Leasing on its account. 28 The company billed IFM Company $5,208 for services performed. 31 The company paid $875 cash for Lyn Addie’s wages for seven days’ work. 31 The company paid a $3,600 cash dividend. Nov. 1 The company reimbursed S. Rey in cash for business automobile mileage allowance (Rey

logged 1,000 miles at $0.32 per mile). 2 The company received $4,633 cash from Liu Corporation for computer services performed. 5 The company purchased computer supplies for $1,125 cash from Harris Office Products. 8 The company billed Gomez Co. $5,668 for services performed. 13 The company agreed to perform future services for Alex’s Engineering Co. No work has yet

been performed. 18 The company received $2,208 cash from IFM Company as partial payment of the October 28 bill. 22 The company paid $250 cash for miscellaneous expenses. Hint: Debit Miscellaneous Expenses

for $250. 24 The company completed work and sent a bill for $3,950 to Alex’s Engineering Co. 25 The company sent another bill to IFM Company for the past-due amount of $3,000. 28 The company reimbursed S. Rey in cash for business automobile mileage (1,200 miles at $0.32

per mile). 30 The company paid $1,750 cash for Lyn Addie’s wages for 14 days’ work. 30 The company paid a $2,000 cash dividend. 2. Open ledger accounts (in balance column format) and post the journal entries from part 1 to them. 3. Prepare a trial balance as of the end of November.

Check (2) Cash, Nov. 30 bal., $38,264 (3) Trial bal. totals, $98,659

GENERAL LEDGER PROBLEM

Using transactions from the following assignments along with the General Ledger tool, prepare journal entries for each transaction and identify the financial statement impact of each entry. The financial state- ments are automatically generated based on the journal entries recorded.

GL 2-1 Transactions from the FastForward illustration in this chapter GL 2-2 Based on Exercise 2-9 GL 2-3 Based on Exercise 2-12 GL 2-4 Based on Problem 2-1A Using transactions from the following assignments, record journal entries, create financial statements, and assess the impact of each transaction on financial statements.

GL 2-5 Based on Problem 2-2A GL 2-7 Based on Problem 2-4A GL 2-6 Based on Problem 2-3A GL 2-8 Based on the Serial Problem SP 2

COMPANY ANALYSIS A1 A2

Accounting Analysis

AA 2-1 Refer to Apple’s financial statements in Appendix A for the following questions.

Required

1. What amount of total liabilities does Apple report for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016?

2. What amount of total assets does it report for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016?

3. Compute its debt ratio for each of the fiscal years ended (a) September 30, 2017, and (b) September 24, 2016. (Report ratio in percent and round it to one decimal.)

4. In which fiscal year did it employ more financial leverage: September 30, 2017, or September 24, 2016? Explain.

APPLE

82 Chapter 2 Accounting for Business Transactions

AA 2-2 Key comparative figures for Apple and Google follow.COMPARATIVE ANALYSIS A1 A2 Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Total liabilities . . . . . . . . . . . . . . . . . . . $241,272 $193,437 $ 44,793 $ 28,461 Total assets . . . . . . . . . . . . . . . . . . . . . 375,319 321,686 197,295 167,497

1. What is the debt ratio for Apple in the current year and for the prior year? 2. What is the debt ratio for Google in the current year and for the prior year? 3. Which of the two companies has the higher degree of financial leverage in the current year?

APPLE GOOGLE

BTN 2-2 Lila Corentine is an aspiring entrepreneur and your friend. She is having difficulty understand- ing the purposes of financial statements and how they fit together across time.

Required

Write a one-page memorandum to Corentine explaining the purposes of the four financial statements and how they are linked across time.

COMMUNICATING IN PRACTICE C1 C2 A1 P3

AA 2-3 Key comparative figures for Apple, Google, and Samsung follow.GLOBAL ANALYSIS A2 Samsung Apple Google

In millions Current Year Prior Year Current Year Current Year

Total liabilities . . . . . . . . . . . ₩ 87,260,662 ₩ 69,211,291 $241,272 $ 44,793

Total assets . . . . . . . . . . . . . 301,752,090 262,174,324 375,319 197,295

APPLE GOOGLE Samsung

Required

1. Compute Samsung’s debt ratio for the current year and prior year. 2. Is Samsung on a trend toward increased or decreased financial leverage? 3. Looking at the current-year debt ratio, is Samsung a more risky or less risky investment than (a) Apple

and (b) Google?

ETHICS CHALLENGE C1

BTN 2-1 Assume that you are a cashier and your manager requires that you immediately enter each sale when it occurs. Recently, lunch hour traffic has increased and the assistant manager asks you to avoid delays by taking customers’ cash and making change without entering sales. The assistant manager says she will add up cash and enter sales after lunch. She says that, in this way, customers will be happy and the register record will always match the cash amount when the manager arrives at three o’clock.

The advantages to the process proposed by the assistant manager include improved customer service, fewer delays, and less work for you. The disadvantage is that the assistant manager could steal cash by simply recording less sales than the cash received and then pocketing the excess cash. You decide to reject her suggestion without the manager’s approval and to confront her on the ethics of her suggestion.

Required

Propose and evaluate two other courses of action you might consider, and explain why.

Beyond the Numbers

BTN 2-3 Access EDGAR online (SEC.gov) and locate the 2016 10-K report of Amazon.com (ticker: AMZN) filed on February 10, 2017. Review its financial statements reported for years ended 2016, 2015, and 2014 to answer the following questions.

Required

1. What are the amounts of Amazon’s net income or net loss reported for each of these three years? 2. Do Amazon’s operating activities provide cash or use cash for each of these three years? Hint: See the

statement of cash flows. 3. If Amazon has 2016 net income of $2,371 million and 2016 operating cash flows of $16,443 million,

how is it possible that its cash balance at December 31, 2016, increases by only $3,444 million relative to its balance at December 31, 2015?

TAKING IT TO THE NET A1

Chapter 2 Accounting for Business Transactions 83

BTN 2-4 The expanded accounting equation consists of assets, liabilities, common stock, dividends, revenues, and expenses. It can be used to reveal insights into changes in a company’s financial position.

Required

1. Form learning teams of six (or more) members. Each team member must select one of the six compo- nents, and each team must have at least one expert on each component: (a) assets, (b) liabilities, (c) common stock, (d ) dividends, (e) revenues, and ( f ) expenses.

2. Form expert teams of individuals who selected the same component in part 1. Expert teams are to draft a report that each expert will present to his or her learning team addressing the following: a. Identify for its component the (i) increase and decrease side of the account and (ii) normal balance

side of the account. b. Describe a transaction, with amounts, that increases its component. c. Using the transaction and amounts in (b), verify the equality of the accounting equation and then

explain any effects on the income statement and statement of cash flows. d. Describe a transaction, with amounts, that decreases its component. e. Using the transaction and amounts in (d), verify the equality of the accounting equation and then

explain any effects on the income statement and statement of cash flows. 3. Each expert should return to his/her learning team. In rotation, each member presents his/her expert

team’s report to the learning team. Team discussion is encouraged.

TEAMWORK IN ACTION C1 C2 C4 A1

BTN 2-5 Assume that James Park and Eric Friedman of Fitbit plan on expanding their business to accommodate more product lines. They are considering financing expansion in one of two ways: (1) con- tributing more of their own funds to the business or (2) borrowing the funds from a bank.

Required

Identify at least two issues that James and Eric should consider when trying to decide on the method for financing their expansion.

ENTREPRENEURIAL DECISION A1 A2 P3

BTN 2-6 Angel Martin is a young entrepreneur who operates Martin Music Services, offering singing lessons and instruction on musical instruments. Martin wishes to expand but needs a $30,000 loan. The bank requests that Martin prepare a balance sheet and key financial ratios. Martin has not kept formal records but is able to provide the following accounts and their amounts as of December 31.

ENTREPRENEURIAL DECISION A1 A2 P3

Cash . . . . . . . . . . . . . . . . . . $ 3,600 Accounts receivable . . . . . . $ 9,600 Prepaid insurance . . . . . . . $ 1,500 Prepaid rent . . . . . . . . . . . . 9,400 Store supplies . . . . . . . . . . . 6,600 Equipment . . . . . . . . . . . . . 50,000 Accounts payable . . . . . . . 2,200 Unearned lesson fees . . . . . 15,600 Total equity* . . . . . . . . . . . . 62,900 Annual net income . . . . . . . 40,000

*The total equity amount reflects all owner investments, dividends, revenues, and expenses as of December 31.

Required

1. Prepare a balance sheet as of December 31 for Martin Music Services. (Report only the total equity amount on the balance sheet.)

2. Compute Martin’s debt ratio and its return on assets (the latter ratio is defined in Chapter 1). Assume average assets equal its ending balance.

3. Do you believe the prospects of a $30,000 bank loan are good? Why or why not?

BTN 2-7 Obtain a recent copy of the most prominent newspaper distributed in your area. Research the classified section and prepare a report answering the following questions (attach relevant printouts to your report). Alternatively, you may want to search the web for the required information. One suitable website is CareerOneStop (CareerOneStop.org). For documentation, print copies of websites accessed. 1. Identify the number of listings for accounting positions and the various accounting job titles. 2. Identify the number of listings for other job titles, with examples, that require or prefer accounting

knowledge/experience but are not specifically accounting positions. 3. Specify the salary range for the accounting and accounting-related positions if provided. 4. Indicate the job that appeals most to you, the reason for its appeal, and its requirements.

HITTING THE ROAD C1

Learning Objectives

CONCEPTUAL C1 Explain the importance of periodic

reporting and the role of accrual accounting.

C2 Identify steps in the accounting cycle.

C3 Explain and prepare a classified balance sheet.

ANALYTICAL A1 Compute profit margin and describe its

use in analyzing company performance.

A2 Compute the current ratio and describe what it reveals about a company’s financial condition.

P6 Prepare financial statements from an adjusted trial balance.

P7 Describe and prepare closing entries.

P8 Explain and prepare a post-closing trial balance.

P9 Appendix 3A—Explain the alternatives in accounting for prepaids.

P10 Appendix 3B—Prepare a work sheet and explain its usefulness.

P11 Appendix 3C—Prepare reversing entries and explain their purpose.

PROCEDURAL P1 Prepare adjusting entries for deferral of

expenses.

P2 Prepare adjusting entries for deferral of revenues.

P3 Prepare adjusting entries for accrued expenses.

P4 Prepare adjusting entries for accrued revenues.

P5 Explain and prepare an adjusted trial balance.

Chapter Preview

3 Adjusting Accounts for Financial Statements

NTK 3-4

ACCRUED REVENUE

P4 Framework Examples

Summary

NTK 3-3

ACCRUED EXPENSE

P3 Framework Examples

NTK 3-2

DEFERRAL OF REVENUE

P2 Framework Examples

DEFERRAL OF EXPENSE

C1 Timing Accrual vs. cash

3-Step process

P1 Framework Examples

NTK 3-1 NTK 3-5, 6

REPORTING

P5 Adjusted trial balance

P6 Financial statements

P7 Closing process

P8 Post-closing trial balance

NTK 3-7

CLASSIFICATION AND ANALYSIS

C2 Accounting cycle C3 Classified

balance sheet

A1 Profit margin A2 Current ratio

“Creativity creates value”—Evan Spiegel

Snap!

VENICE, CA—Evan Spiegel met his future co-founder Bobby Murphy in college. “We weren’t cool,” recalls Bobby, “so we tried to build things to be cool!” One of their cool projects was an app that could send messages that disappeared after a few seconds. This app would later be called Snapchat (Snapchat.com).

The first headquarters of Snapchat was the home of Evan’s dad. However, within a matter of months, their app had over a million users.

As Snapchat grew, Evan and Bobby knew an effective ac- counting system was key to attracting investors. “One of the things I did underestimate,” admits Evan, “was how much more important communication becomes [when seeking investors].”

Investors wanted to know revenues, costs, assets, and liabilities for Snapchat. “You really need to explain . . . how your business works,” insists Evan.

To communicate “the Snap story,” the entrepreneurs learned how to defer and accrue revenues and expenses and to prepare financial statements for investors. This included learning the

accounting cycle. With accounting reports in hand, Evan and Bobby were able to secure additional financing. Exclaims Evan: “That was the greatest feeling of all time!”

Sources: Snapchat website, January 2019; Vanity Fair, October 2017; LA Times, March 2017; Forbes, January 2014

The Accounting Period The value of information is linked to its timeliness. Useful information must reach decision makers frequently. To provide timely information, accounting systems prepare reports at regular intervals. The time period assumption presumes that an organization’s activities can be divided into specific time periods such as a month, a three-month quarter, a six- month interval, or a year. Exhibit 3.1 shows various accounting, or reporting, periods. Most organizations use a year as their primary accounting period. Reports covering a one-year period are known as annual finan- cial statements. Many organizations also prepare interim financial statements covering one, three, or six months of activity.

TIMING AND REPORTING

C1 Explain the importance of periodic reporting and the role of accrual accounting.

$0 2019 2018 2017 2016 2015

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

Apple

“Apple announces annual income of . . .”

Jan. Mar. May June July Aug. Sept. Oct. Nov. TimeDec.

1 2 3 4

2 3 4 5 6 7 8 9 10 11 12 Monthly

Quarterly

1 2 Semiannually

1 Annually

Feb. Apr.

EXHIBIT 3.1 Accounting Periods

The annual reporting period is not always a calendar year ending on December 31. An organization can use a fiscal year consisting of any 12 consecutive months or 52 weeks. For example, Gap’s fiscal year consistently ends the final week of January or the first week of February each year.

©J. Emilio Flores/Corbis/Getty Images

86 Chapter 3 Adjusting Accounts for Financial Statements

Companies with little seasonal variation in sales often use the calendar year as their fiscal year. Facebook uses calendar-year reporting. Companies that have seasonal variations in sales often use a natural business year end, which is when sales are at their lowest level for the year. The natural business year for retailers such as Target and Dick’s Sporting Goods ends around January 31, after the holidays.

Accrual Basis versus Cash Basis After external transactions and events are recorded, several accounts require adjustments before their balances appear in financial statements. This is needed because internal transactions and events are not yet recorded. Accrual basis accounting records revenues when services and products are delivered and

records expenses when incurred (matched with revenues). Cash basis accounting records revenues when cash is received and records expenses when

cash is paid. Cash basis income is cash receipts minus cash payments.

Most agree that accrual accounting better reflects business performance than cash basis accounting. Accrual accounting also increases the comparability of financial statements from period to period.

Accrual Basis To compare these two systems, let’s consider FastForward’s Prepaid Insurance account. FastForward paid $2,400 for 24 months of insurance coverage that began on December 1, 2019. Accrual accounting requires that $100 of insurance expense be reported each month, from December 2019 through November 2021. (This means expenses are $100 in 2019, $1,200 in 2020, and $1,100 in 2021.) Exhibit 3.2 shows this allocation of insurance cost across the three years. Any unexpired premium is reported as a Prepaid Insurance asset on the accrual basis balance sheet.

©Vixit/Shutterstock

Insurance Expense 2021 Jan

$100

May $100

Sept $100

Feb $100

June $100

Oct $100

Mar $100

July $100

Nov $100

Apr $100

Aug $100

Dec $0

Insurance Expense 2019

2019 2020 2021

Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $100

Insurance Expense 2020 Jan

$100

May $100

Sept $100

Feb $100

June $100

Oct $100

Mar $100

July $100

Nov $100

Apr $100

Aug $100

Dec $100

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2019

Transaction:

EXHIBIT 3.2 Accrual Accounting for Allocating Prepaid Insurance to Expense

Cash Basis A cash basis income statement for December 2019 reports insurance ex- pense of $2,400, as shown in Exhibit 3.3. The cash basis income statements for years 2020 and 2021 report no insurance expense. The cash basis balance sheet never reports a prepaid insurance asset because it is immediately expensed. Also, cash basis income for 2019–2021 does not match the cost of insurance with the insurance benefits received for those years and months.

Insurance Expense 2021 Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $0

Insurance Expense 2020 Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $0

Insurance Expense 2019 Jan $0

May $0

Sept $0

Feb $0

June $0

Oct $0

Mar $0

July $0

Nov $0

Apr $0

Aug $0

Dec $2,400

2019 2020 2021

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2019

Transaction:

EXHIBIT 3.3 Cash Accounting for Allocating Prepaid Insurance to Expense

Recognizing Revenues and Expenses We divide a company’s activities into time periods, but not all activities are complete when financial statements are prepared. Thus, adjustments are required to get proper account balances.

Point: Annual income statements for Exhibit 3.3 follow: Cash Basis 2019 2020 2021

Revenues . . . . . . . $ # $# $# Insurance exp . . . . $2,400 $0 $0

Point: Annual income statements for Exhibit 3.2 follow: Accrual Basis 2019 2020 2021

Revenues . . . . . . . $ # $ # $ # Insurance exp . . . . $100 $1,200 $1,100

Chapter 3 Adjusting Accounts for Financial Statements 87

We use two principles in the adjusting process: revenue recognition and expense recognition. Revenue recognition principle requires that revenue be recorded when goods or services

are provided to customers and at an amount expected to be received from customers. Adjustments ensure revenue is recognized (reported) in the time period when those services and products are provided.

Expense recognition (or matching) principle requires that expenses be recorded in the same accounting period as the revenues that are recognized as a result of those expenses.

Point: Recording revenue early overstates current-period income; recording it late understates current-period income.

Point: Recording expense early understates current-period in- come; recording it late overstates current-period income.

Framework for Adjustments Four types of adjustments exist for transactions and events that extend over more than one period.

Deferral of expense Deferral of revenue Accrued expense Accrued revenue

Adjustments are made using a 3-step process, as shown in Exhibit 3.4.

Clawbacks from Accounting Fraud Former executives at Saba Software, a cloud-based talent management sys- tem, were charged with accounting fraud by the SEC for falsifying revenue to boost income. This alleged overstate- ment of income led to a payback of millions of dollars to the company by the former CEO and former CFO. See SEC release 2015–28. ■

Ethical Risk

©Marco Marchi/Getty Images

Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record an adjusting entry to get from step 1 to step 2.

EXHIBIT 3.4 Three-Step Process for Adjusting Entries

Each adjusting entry made at the end of an accounting period reflects a transaction or event that is not yet recorded. An adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never the Cash account).

Prepaid expenses, or deferred expenses, are assets paid for in advance of receiving their bene- fits. When these assets are used, those advance payments become expenses.

Framework Adjusting entries for prepaid expenses increase expenses and decrease assets, as shown in the T-accounts of Exhibit 3.5. This adjustment shows the using up of prepaid ex- penses. To demonstrate accounting for pre- paid expenses, we look at prepaid insurance, supplies, and depreciation. In each case we decrease an asset (balance sheet) account and increase an expense (income statement) account.

Prepaid Insurance Prepaid insurance expires with time. We use our three-step process.

Step 1: We determine that the current balance of FastForward’s prepaid insurance is equal to its $2,400 payment for 24 months of insurance benefits that began on December 1, 2019. Step 2: As time passes, the benefits of the insurance gradually expire and a portion of the Prepaid Insurance asset becomes expense. For instance, one month’s insurance coverage expires by December 31, 2019. This expense is $100, or 1/24 of $2,400, which leaves $2,300.

DEFERRAL OF EXPENSE P1 Prepare adjusting entries for deferral of expenses.

Asset

Unadjusted balance

overstated

Expense

Dr. Expense… # Cr. Asset….. #

Decrease it Increase it EXHIBIT 3.5 Adjusting for Prepaid Expenses (decrease an asset and record an expense)

Insurance Dec. 1 Pay insurance premium and record asset Prepaid Insurance....... 2,400 Cash......................... 2,400

Dec. 31 Coverage expires and record expense

Two-Year Insurance Policy Total cost is $2,400 Monthly cost is $100

88 Chapter 3 Adjusting Accounts for Financial Statements

Supplies We count supplies at period-end and make an adjusting entry.

Step 1: FastForward purchased $9,720 of supplies in December, some of which were used during that same month. When financial statements are prepared at December 31, the cost of supplies used during December is expensed. Step 2: When FastForward computes (physically counts) its remaining unused supplies at December 31, it finds $8,670 of supplies remaining of the $9,720 total supplies. The $1,050 difference between these two amounts is December’s supplies expense. Step 3: The adjusting entry to record this expense and reduce the Supplies asset account, along with T-account postings, follows.

Step 3: The adjusting entry to record this expense and reduce the asset, along with T-account postings, follows.

Explanation After adjusting and posting, the $100 balance in Insurance Expense and the $2,300 balance in Prepaid Insurance are ready for reporting in financial statements. Not making the adjustment on or before December 31 would Understate expenses by $100 for the December income statement. Overstate prepaid insurance (assets) by $100 in the December 31 balance sheet.

The following highlights the adjustment for prepaid insurance.

Prepaid Insurance = $2,400

Reports $2,400 policy for 24 months’ coverage .

Deduct $100 from Prepaid Insurance Add $100 to Insurance Expense

Record current month’s $100 insurance expense and $100 reduction in prepaid .

Prepaid Insurance = $2,300

Reports $2,300 in coverage for remaining 23 months .

Before Adjustment Adjustment After Adjustment

Supplies Dec. 2,6,26 Purchase supplies and record asset

Dec. 31 Physical count Dec. 31 Record expense

Explanation The balance of the Supplies account is $8,670 after posting—equaling the cost of the remaining supplies. Not making the adjustment on or before December 31 would Understate expenses by $1,050 for the December income statement. Overstate supplies by $1,050 in the December 31 balance sheet.

Assets = Liabilities + Equity −100 −100

Adjustment (a) Dec . 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Record first month’s expired insurance.

Dec. 31 100

Insurance Expense 637

Dec . 1 2,400

Balance 2,300

Dec. 31 100

Prepaid Insurance 128

Assets = Liabilities + Equity −1,050 −1,050

Adjustment (b) Dec . 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Record supplies used.

Dec. 31 1,050

Supplies Expense 652

Dec . 2 2,500

6 7,100

26 120

Balance 8,670

Dec. 31 1,050

Supplies 126

Chapter 3 Adjusting Accounts for Financial Statements 89

The following highlights the adjustment for supplies.

Supplies = $9,720

Reports $9,720 in supplies .

Deduct $1,050 from Supplies Add $1,050 to Supplies Expense

Record $1,050 in supplies used and $1,050 as supplies expense .

Supplies = $8,670

Reports $8,670 in supplies .

Before Adjustment Adjustment After Adjustment

Other Prepaid Expenses Other prepaid expenses, such as Prepaid Rent and Prepaid Advertising, are accounted for exactly as insurance and supplies are.

Some prepaid expenses are both paid for and fully used up within a single period. One exam- ple is when a company pays monthly rent on the first day of each month. In this case, we record the cash paid with a debit to Rent Expense instead of an asset account.

Investor A publisher signs an Olympic skier to write a book. The company pays the skier $500,000 to sign plus future book royalties. A note to the company’s financial statements says that “prepaid expenses include $500,000 in author signing fees to be matched against future expected sales.” How does this affect your analysis? ■ Answer: Prepaid expenses are assets paid for in advance of receiving their benefits–they are expensed as they are used up. As an investor, you are concerned about the risk of future book sales. The riskier the likelihood of future book sales is, the more likely your analysis is to treat the $500,000, or a portion of it, as an expense, not a prepaid expense (asset).

Decision Maker

©Don Hammond/Design Pics

Depreciation A special category of prepaid expenses is plant assets, which are long-term tangible assets used to produce and sell products and services. Plant assets provide benefits for more than one period. Examples of plant assets are buildings, machines, vehicles, and fixtures. All plant assets (exclud- ing land) eventually wear out or become less useful. The costs of plant assets are gradually reported as expenses in the income statement over the assets’ useful lives (benefit periods). Depreciation is the allocation of the costs of these assets over their expected useful lives. Depre- ciation expense is recorded with an adjusting entry similar to that for other prepaid expenses.

Step 1: FastForward purchased equipment for $26,000 in early December to use in earning revenue. This equipment’s cost must be depreciated. Step 2: The equipment is expected to have a useful life (benefit period) of five years and to be worth about $8,000 at the end of five years. This means the net cost of this equipment over its useful life is $18,000 ($26,000 − $8,000). FastForward depreciates it using straight-line depreciation, which allocates equal amounts of the asset’s net cost to depreciation during its useful life. Dividing the $18,000 net cost by the 60 months (5 years) in the asset’s useful life gives a monthly cost of $300 ($18,000∕60). Step 3: The adjusting entry to record monthly depreciation expense, along with T-account postings, follows.

Point: Plant assets are also called Plant & Equipment or Property, Plant & Equipment (PP&E ).

Point: Depreciation does not necessarily measure decline in market value.

Point: An asset’s expected value at the end of its useful life is called salvage value.

Depreciation Dec. 3 Purchase equipment and record asset Equipment........... 26,000 Cash................ 26,000

Dec. 31 Allocate asset cost and record depreciation

Explanation After posting the adjustment, the Equipment account ($26,000) minus its Accumulated Depreciation ($300) account equals the $25,700 net cost. The $300 balance in the

Assets = Liabilities + Equity −300 −300

Adjustment (c) Dec . 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Accumulated Depreciation—Equipment . . . . . . . . . . . . 300

Record monthly equipment depreciation.

Dec. 31 300

Depreciation Expense—Equipment 612

Dec . 3 26,000

Equipment 167

Dec. 31 300

Accumulated Depreciation—Equipment 168

90 Chapter 3 Adjusting Accounts for Financial Statements

Depreciation Expense account is reported in the December income statement. Not making the adjustment at December 31 would Understate expenses by $300 for the December income statement. Overstate assets by $300 in the December 31 balance sheet.

The following highlights the adjustment for depreciation.

Equipment, net = $26,000

Reports $26,000 in equipment .

Deduct $300 from Equipment, net Add $300 to Depreciation Expense

Record $300 in depreciation and $300 as accumulated depreciation .

Equipment, net = $25,700

Reports $25,700 in equipment, net of accumulated depreciation .

Before Adjustment Adjustment After Adjustment

Dec . 3 26,000

Equipment 167 Accumulated Depreciation—Equipment 168

Dec . 31 300

Jan . 31 300

Feb . 28 300

Balance 900

EXHIBIT 3.6 Accounts after Three Months of Depreciation Adjustments

Accumulated Depreciation is a separate contra account. A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance. FastForward’s contra account of Accumulated Depreciation— Equipment is subtracted from the Equipment account in the balance sheet.

The Accumulated Depreciation contra account includes total depreciation expense for all prior periods for which the asset was used. To demonstrate, on February 28, 2020, after three months of adjusting entries, the Equipment and Accumulated Depreciation accounts appear as in Exhibit 3.6. The $900 balance in the Accumulated Depreciation account is subtracted from its related $26,000 asset cost. The difference ($25,100) between these two balances is called book value, or net amount, which is the asset’s costs minus its accumulated depreciation.

Point: Accumulated Depreciation has a normal credit balance; it decreases the asset’s reported value.

Point: The net cost of equipment is also called depreciable basis.

These account balances are reported in the assets section of the February 28 balance sheet in Exhibit 3.7. This presentation shows the full cost of assets and accumulated depreciation.

EXHIBIT 3.7 Equipment and Accumulated Depreciation on February 28 Balance Sheet

Assets (at February 28, 2020)

Cash $ .... Equipment $26,000 Less accumulated depreciation 900 25,100 Total Assets $

Commonly titled Equipment, net

For each separate case below, follow the three-step process for adjusting the prepaid asset account at December 31. Assume no other adjusting entries are made during the year.

1. Prepaid Insurance. The Prepaid Insurance account has a $5,000 debit balance to start the year, and no insurance payments were made during the year. A review of insurance policies shows that $1,000 of unexpired insurance remains at its December 31 year-end.

2. Prepaid Rent. On October 1 of the current year, the company prepaid $12,000 for one year of rent for facilities being occupied from that day forward. The company debited Prepaid Rent and credited Cash for $12,000. December 31 year-end statements must be prepared.

3. Supplies. The Supplies account has a $1,000 debit balance to start the year. Supplies of $2,000 were purchased during the current year and debited to the Supplies account. A December 31 physical count shows $500 of supplies remaining.

Prepaid Expenses

NEED-TO-KNOW 3-1

Chapter 3 Adjusting Accounts for Financial Statements 91

4. Accumulated Depreciation. The company has only one fixed asset (equipment) that it purchased at the start of this year. That asset had cost $38,000, had an estimated life of 10 years, and is expected to be valued at $8,000 at the end of the 10-year life. December 31 year-end statements must be prepared.

Solution

1. Step 1: Prepaid Insurance equals $5,000 (before adjustment) Step 2: Prepaid Insurance should equal $1,000 (the unexpired part) Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Record expired insurance coverage ($5,000 − $1,000).

Dec . 31 Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Record expired prepaid rent. *$12,000 − $3,000 = $9,000, where $3,000 is from: ($12,000∕12 months) × 3 months

2. Step 1: Prepaid Rent equals $12,000 (before adjustment) Step 2: Prepaid Rent should equal $9,000 (the unexpired part)* Step 3: Adjusting entry to get from step 1 to step 2

3. Step 1: Supplies equal $3,000 (from $1,000 + $2,000; before adjustment) Step 2: Supplies should equal $500 (what’s left) Step 3: Adjusting entry to get from step 1 to step 2*

4. Step 1: Accumulated Depreciation equals $0 (before adjustment) Step 2: Accumulated Depreciation should equal $3,000 (after current-period depreciation of $3,000)* Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Depreciation Expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Accumulated Depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Record depreciation for period. *($38,000 − $8,000)∕10 years Do More: QS 3-5, QS 3-6,

QS 3-7, QS 3-8, QS 3-9

Unearned revenue is cash received in advance of providing products and services. Unearned revenues, or deferred revenues, are liabilities. When cash is accepted, an obligation to provide products or services is accepted.

Framework As products or services are provided, the liability decreases and the unearned revenues become earned reve- nues. Adjusting entries for unearned reve- nue decrease the unearned revenue (balance sheet) account and increase the revenue (income statement) account, as shown in Exhibit 3.8.

DEFERRAL OF REVENUE P2 Prepare adjusting entries for deferral of revenues.

Point: To defer is to postpone. We postpone reporting amounts received as revenues until the product or service is provided.

Dr. Liability….. # Cr. Revenue… #

Liability Revenue

Decrease it Increase it EXHIBIT 3.8 Adjusting for Unearned Revenues (decrease a liability and record revenue)

Dec . 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Record supplies used. *$1,000 + $2,000 purchased − $ 2,500 supplies used = $500 remaining

92 Chapter 3 Adjusting Accounts for Financial Statements

Unearned revenues are common in sporting and concert events. When the Boston Celtics receive cash from advance ticket sales, they record it in an unearned revenue account called Deferred Game Revenues. The Celtics record revenue as games are played.

Unearned Consulting Revenue FastForward has unearned revenues. The company agreed on December 26 to provide consult- ing services to a client for 60 days for a fixed fee of $3,000.

Step 1: On December 26, the client paid the 60-day fee in advance, covering the period December 27 to February 24. The entry to record the cash received in advance is

This advance payment increases cash and creates a liability to do consulting work over the next 60 days (5 days this year and 55 days next year). Step 2: As time passes, FastForward earns this payment through consulting. By December 31, it has provided five days’ service and earned 5∕60 of the $3,000 unearned revenue. This amounts to $250 ($3,000 × 5∕60). The revenue recognition principle requires that $250 of unearned revenue be reported as revenue on the December income statement. Step 3: The adjusting entry to reduce the liability account and recognize earned revenue, along with T-account postings, follows.

Unearned Revenues

Thanks for cash in advance. I’ll work now

through Feb. 24

Dec. 26 Cash received in advance and record liability

Dec. 31 Provided 5 days of services and record revenue

Assets = Liabilities + Equity +3,000 +3,000

Dec . 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . 3,000

Received advance payment for services over the next 60 days.

Explanation The adjusting entry transfers $250 from unearned revenue (a liability account) to a revenue account. Not making the adjustment Understates revenue by $250 in the December income statement. Overstates unearned revenue by $250 on the December 31 balance sheet.

The following highlights the adjustment for unearned revenue.

Unearned Consulting Revenue = $3,000

Reports $3,000 in unearned revenue for consulting services promised for

60 days ($50 per day) .

Deduct $250 from Unearned Consulting Revenue

Add $250 to Consulting Revenue

Record 5 days of earned consulting revenue, which is 5∕60 of

unearned amount .

Unearned Consulting Revenue = $2,750

Reports $2,750 in unearned revenue for consulting services owed over next

55 days (55 days × $50 = $2,750) .

Before Adjustment Adjustment After Adjustment

Assets = Liabilities + Equity −250 +250

Adjustment (d) Dec . 31 Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . . 250

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Record earned revenue that was received in advance ($3,000 × 5∕60).

Dec . 5 4,200

12 1,600

31 250

Balance 6,050

Consulting Revenue 403

Dec. 31 250 Dec . 26 3,000

Balance 2,750

Unearned Consulting Revenue 236

Chapter 3 Adjusting Accounts for Financial Statements 93

For each separate case below, follow the three-step process for adjusting the unearned revenue liability account at December 31. Assume no other adjusting entries are made during the year.

a. Unearned Rent Revenue. The company collected $24,000 rent in advance on September 1, debiting Cash and crediting Unearned Rent Revenue. The tenant was paying 12 months’ rent in advance and moved in on September 1.

b. Unearned Services Revenue. The company charges $100 per month to spray a house for insects. A customer paid $600 on November 1 in advance for six treatments, which was recorded with a debit to Cash and a credit to Unearned Services Revenue. At year-end, the company has applied two treatments for the customer.

Solution

a. Step 1: Unearned Rent Revenue equals $24,000 (before adjustment) Step 2: Unearned Rent Revenue should equal $16,000 (current-period earned revenue is $8,000*) Step 3: Adjusting entry to get from step 1 to step 2

Unearned Revenues

NEED-TO-KNOW 3-2

b. Step 1: Unearned Services Revenue equals $600 (before adjustment) Step 2: Unearned Services Revenue should equal $400 (current-period earned revenue is $200*) Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Unearned Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . 200

Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Record earned portion of revenue received in advance. *$100 × 2 treatments = Services revenue Do More: QS 3-10, QS 3-11

Dec . 31 Unearned Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

Record earned portion of rent received in advance. *($24,000∕12 months) × 4 months’ rental usage

Accrued expenses are costs that are incurred in a period that are both unpaid and unrecorded. Accrued expenses are reported on the income statement for the period when incurred.

Framework Adjusting entries for recording accrued expenses increase the expense (income statement) account and increase a liability (balance sheet) account, as shown in Exhibit 3.9. This adjustment recognizes expenses in- curred in a period but not yet paid. Common examples of accrued expenses are salaries, interest, rent, and taxes. We use salaries and interest to show how to adjust accounts for accrued expenses.

Accrued Salaries Expense FastForward’s employee earns $70 per day, or $350 for a five-day workweek beginning on Monday and ending on Friday. Step 1: Its employee is paid every two weeks on Friday. On December 12 and 26, the wages are paid, recorded in the journal, and posted to the ledger. Step 2: The calendar in Exhibit 3.10 shows three working days after the December 26 payday (29, 30, and 31). This means the employee has earned three days’ salary by the close of business on Wednesday, December 31, yet this salary cost has not been paid or recorded. FastForward must report the added expense and liability for unpaid salary from December 29, 30, and 31.

ACCRUED EXPENSE

Point: Accrued expenses are also called accrued liabilities.

Dr. Expense….. # Cr. Liability… #

Expense Liability

Increase it Increase it EXHIBIT 3.9 Adjusting for Accrued Expenses (increase a liability and record an expense)

P3 Prepare adjusting entries for accrued expenses.

94 Chapter 3 Adjusting Accounts for Financial Statements

Step 3: The adjusting entry for accrued salaries, along with T-account postings, follows.

PaydayPaydaySalary expense incurred

Pay period begins

S M T W T F S 1 2 3 4 5 6

7 8 9 10 11 12 13

14 15 16 17 18 19 20

21 22 23 24 25 26 27

28 29 30 31

S M T W T F S 1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 27 28 29 30 31

December January

EXHIBIT 3.10 Salary Accrual and Paydays

Salaries Payable = $0

Reports $0 from employee salaries incurred but not yet paid in cash .

Add $210 to Salaries Payable Add $210 to Salaries Expense

Record 3 days’ salaries owed, but not yet paid, at $70 per day .

Salaries Payable = $210

Reports $210 salaries payable to employee but not yet paid .

Before Adjustment Adjustment After Adjustment

Explanation Salaries expense of $1,610 is reported on the December income statement, and $210 of salaries payable (liability) is reported in the balance sheet. Not making the adjustment Understates salaries expense by $210 in the December income statement. Understates salaries payable by $210 on the December 31 balance sheet.

The following highlights the adjustment for salaries incurred.

Accrued Interest Expense Companies accrue interest expense on notes payable (loans) and other long-term liabilities at the end of a period. Interest expense is incurred as time passes. Unless interest is paid on the last day of an accounting period, we need to adjust for interest expense incurred but not yet paid. This means we must accrue interest cost from the most recent payment date up to the end of the period. The formula for computing accrued interest is

Principal amount owed × Annual interest rate × Fraction of year since last payment

If a company has a $6,000 loan from a bank at 5% annual interest, then 30 days’ accrued interest expense is $25—computed as $6,000 × 0.05 × 30∕360. The adjusting entry debits Interest Expense for $25 and credits Interest Payable for $25.

Future Cash Payment of Accrued Expenses Accrued expenses at the end of one accounting period result in cash payment in a future period(s). Recall that FastForward recorded accrued salaries of $210. On January 9, the first

Point: Interest computations use a 360-day year, called the bankers’ rule.

Assets = Liabilities + Equity +210 −210

Adjustment (e) Dec . 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Record three days’ accrued salary (3 × $70).

Dec . 12 700

26 700

31 210

Balance 1,610

Salaries Expense 622

Dec. 31 210

Salaries Payable 209

©Plus One Pix/Alamy Stock Photo

Chapter 3 Adjusting Accounts for Financial Statements 95

payday of the next period, the following entry settles the accrued liability (salaries payable) and records salaries expense for seven days of work in January.

The $210 debit is the payment of the liability for the three days’ salary accrued on December 31. The $490 debit records the salary for January’s first seven working days (including the New Year’s Day holiday) as an expense of the new accounting period. The $700 credit records the total amount of cash paid to the employee.

For each separate case below, follow the three-step process for adjusting the accrued expense account at December 31. Assume no other adjusting entries are made during the year.

a. Salaries Payable. At year-end, salaries expense of $5,000 has been incurred by the company but is not yet paid to employees.

b. Interest Payable. At its December 31 year-end, the company holds a mortgage payable that has incurred $1,000 in annual interest that is neither recorded nor paid. The company intends to pay the interest on January 3 of the next year.

Solution

a. Step 1: Salaries Payable equals $0 (before adjustment) Step 2: Salaries Payable should equal $5,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Accrued Expenses

NEED-TO-KNOW 3-3

b. Step 1: Interest Payable equals $0 (before adjustment) Step 2: Interest Payable should equal $1,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Dec . 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Record employee salaries earned but not yet paid.

Do More: QS 3-12, QS 3-13

Dec . 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Record interest incurred but not yet paid.

Accrued revenues are revenues earned in a period that are both unrecorded and not yet received in cash (or other assets). An example is a technician who bills customers after the job is done. If one-third of a job is complete by the end of a period, then the technician must record one-third of the expected billing as revenue in that period—even though there is no billing or collection.

Framework The adjusting entries for ac- crued revenues increase a revenue (income statement) account and increase an asset (balance sheet) account, as shown in Exhibit 3.11. Accrued revenues usually come from services, products, interest, and rent. We use service fees and interest to show how to adjust for accrued revenues.

ACCRUED REVENUE P4 Prepare adjusting entries for accrued revenues.

Point: Accrued revenues are also called accrued assets.

Dr. Asset…........ # Cr. Revenue… #

Asset Revenue

Increase it Increase it EXHIBIT 3.11 Adjusting for Accrued Revenues (increase an asset and record revenue)

Jan . 9 Salaries Payable (3 days at $70 per day) . . . . . . . . . . . . . . . . 210

Salaries Expense (7 days at $70 per day) . . . . . . . . . . . . . . . . 490

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Paid two weeks’ salary including three days accrued.

Assets = Liabilities + Equity −700 −210 −490

96 Chapter 3 Adjusting Accounts for Financial Statements

Accrued Services Revenue Accrued revenues are recorded when adjusting entries are made at the end of the accounting period. These accrued revenues are earned but unrecorded because either the buyer has not yet paid or the seller has not yet billed the buyer. FastForward provides an example.

Step 1: In the second week of December, FastForward agreed to provide 30 days of con- sulting services to a fitness club for a fixed fee of $2,700 (or $90 per day). FastForward will provide services from December 12 through January 10, or 30 days of service. The club agrees to pay FastForward $2,700 on January 10 when the service is complete. Step 2: At December 31, 20 days of services have already been provided. Because the con- tracted services have not yet been entirely provided, FastForward has neither billed the club nor recorded the services already provided. Still, FastForward has earned two-thirds of the 30-day fee, or $1,800 ($2,700 × 20∕30). The revenue recognition principle requires FastForward to report the $1,800 on the December income statement. The balance sheet reports that the club owes FastForward $1,800. Step 3: The adjusting entry for accrued services, along with T-account postings, follows.

Accrued Revenues

Jan. 10 Receive cash and reduce receivable

Dec. 31 Record revenue and receivable for services provided but unbilled

Pay me when I'm done

Explanation Accounts receivable are reported on the balance sheet at $1,800, and the $7,850 total of consulting revenue is reported on the income statement. Not making the adjustment Understates consulting revenue by $1,800 in the December income statement. Understates accounts receivable by $1,800 on the December 31 balance sheet.

The following highlights the adjustment for accrued revenue.

Example: What is the adjusting entry if the 30-day consulting period began on December 22? Answer: One-third of the fee is earned: Accounts Receivable . . . . . . . . 900 Consulting Revenue . . . . . . 900

Accounts Receivable = $0

Reports $0 from revenue earned but not yet received in cash .

Add $1,800 to Accounts Receivable Add $1,800 to Consulting Revenue

Record 20 days of earned revenue, which is 20∕30 of total contract .

Accounts Receivable = $1,800

Reports $1,800 in accounts receivable from services provided .

Before Adjustment Adjustment After Adjustment

Accrued Interest Revenue If a company is holding notes receivable that produce interest revenue, we must adjust the accounts to record any earned and yet uncollected interest revenue. The adjusting entry is similar to the one for accruing services revenue. Specifically, debit Interest Receivable (asset) and credit Interest Revenue.

Future Cash Receipt of Accrued Revenues Accrued revenues at the end of one accounting period result in cash receipts in a future period(s). Recall that FastForward made an adjusting entry for $1,800 to record 20 days’ accrued revenue earned from its consulting contract. When FastForward receives $2,700 cash on January 10 for the entire contract amount, it makes the following entry to remove the accrued asset (accounts receivable) and record revenue earned in January. The $2,700 debit is the cash received. The $1,800 credit is the removal of the receivable, and the $900 credit is revenue earned in January.

Assets = Liabilities + Equity +1,800 +1,800

Adjustment (f ) Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Record 20 days’ accrued revenue.

Dec . 12 1,900

31 1,800

Balance 1,800

Dec . 22 1,900

Accounts Receivable 106

Dec . 5 4,200

12 1,600

31 250

31 1,800

Balance 7,850

Consulting Revenue 403

Chapter 3 Adjusting Accounts for Financial Statements 97

Loan Officer The owner of a home theater store applies for a business loan. The store’s financial statements reveal large increases in current-year revenues and income. Increases are due to a promotion that let consumers buy now and pay nothing until January 1 of next year. The store recorded these sales as accrued revenue. Does your analysis raise any concerns? ■ Answer: While increased revenues and income are fine, your concern is with collectibility of these promotional sales. If the store sold products to customers with poor records of paying bills, then collectibility of these sales is low. Your analysis must assess this possibility and estimate losses.

Decision Maker

For each separate case below, follow the three-step process for adjusting the accrued revenue account at December 31. Assume no other adjusting entries are made during the year.

a. Accounts Receivable. At year-end, the company has completed services of $1,000 for a client, but the client has not yet been billed for those services.

b. Interest Receivable. At year-end, the company has earned, but not yet recorded, $500 of interest earned from its investments in government bonds.

Solution

a. Step 1: Accounts Receivable equals $0 (before adjustment) Step 2: Accounts Receivable should equal $1,000 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Accrued Revenues

NEED-TO-KNOW 3-4

Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Record services revenue earned but not yet received.

b. Step 1: Interest Receivable equals $0 (before adjustment) Step 2: Interest Receivable should equal $500 (not yet recorded) Step 3: Adjusting entry to get from step 1 to step 2

Do More: QS 3-3, QS 3-14

Dec . 31 Interest Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Record interest earned but not yet received.

Links to Financial Statements Exhibit 3.12 summarizes the four adjustments. Each adjusting entry affects one or more income statement (revenue or expense) accounts and one or more balance sheet (asset or liability) accounts, but never the Cash account.

Jan . 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700 Accounts Receivable (20 days at $90 per day) . . . . . . . 1,800 Consulting Revenue (10 days at $90 per day) . . . . . . . 900 Received cash for accrued asset and recorded earned

consulting revenue for January.

Assets = Liabilities + Equity +2,700 +900 −1,800

©Yin Yang/Getty Images

Paid (or received) cash before expense

(or revenue) recognized

Accrued expense

Accruals

Accrued revenue

Deferral of revenue†

Deferral of expense†

Deferrals

Dr. (increase) Expense Cr. (decrease) Asset*

Dr. (decrease) Liability Cr. (increase) Revenue

Dr. (increase) Expense Cr. (increase) Liability

Dr. (increase) Asset Cr. (increase) Revenue

Adjusting Entry

*For depreciation, the credit is to Accumulated Depreciation (contra asset). †Exhibit assumes that deferred expenses are initially recorded as assets and that deferred revenues are initially recorded as liabilities.

Paid (or received) cash after expense

(or revenue) recognized

Expense understated Asset overstated

Expense understated Liability understated

Liability overstated Revenue understated

Asset understated Revenue understated

BEFORE AdjustingFour Adjustments

EXHIBIT 3.12 Summary of Adjustments and Financial Statement Links

98 Chapter 3 Adjusting Accounts for Financial Statements

Adjusted Trial Balance An unadjusted trial balance is a list of accounts and balances before adjustments are recorded. An adjusted trial balance is a list of accounts and balances after adjusting entries have been recorded and posted to the ledger.

Exhibit 3.13 shows both the unadjusted and the adjusted trial balances for FastForward at December 31, 2019. The order of accounts in the trial balance usually matches the order in the chart of accounts. Several new accounts usually arise from adjusting entries.

Each adjustment (see middle columns) has a letter that links it to an adjusting entry explained earlier. Each amount in the Adjusted Trial Balance columns is computed by taking that account’s amount from the Unadjusted Trial Balance columns and adding or subtracting any adjustment(s). To demonstrate, Supplies has a $9,720 Dr. balance in the unadjusted columns. Subtracting the $1,050 Cr. amount shown in the Adjustments columns equals an adjusted $8,670 Dr. balance for Supplies. An account can have more than one adjustment, such as for Consulting Revenue. Also, some accounts might not require adjustment for this period, such as Accounts Payable.

TRIAL BALANCE AND FINANCIAL STATEMENTS P5 Explain and prepare an adjusted trial balance.

Dr. Cr. Dr. Cr.Cr. Dr.

FASTFORWARD Trial Balances

December 31, 2019

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

(f) $1,800

(d) 250

$ 0

0 0

6,200

3,000 30,000

$45,300

5,800

300

0 $ 4,275

9,720 2,400

26,000

1,400

1,000

305 $45,300 $3,710

(b) 1,050

1,800 $ 4,275

8,670 2,300

26,000

300 1,610

100 1,000 1,050

305 $47,610

(b) $1,050 (a) 100

(e) 210

$3,710

(d) 250 (f) 1,800

$ 300 6,200

210 2,750

30,000

$47,610

7,850

300

Acct. No.

Cash Account Title

Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock

101 106 126 128 167 168 201 209 236 307 318 319 403

406 612 622 637 640 652 690

Retained earnings Dividends 200 200 Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals

EXHIBIT 3.13 Unadjusted and Adjusted Trial Balances

FASTForward

Financial Officer At year-end, the president instructs you, the financial officer, not to record accrued expenses until next year because they will not be paid until then. The president also directs you to record in current-year sales a recent purchase order from a customer that requires merchandise to be delivered two weeks after the year-end. Your company would report a net income instead of a net loss if you follow these instructions. What do you do? ■ Answer: Omitting accrued expenses and recognizing revenue early mislead financial statement users. One action is to explain to the president what is required. If the president persists, you might talk to lawyers and any auditors involved.

Decision Ethics

Information for some adjustments is not available until after the period-end. This means that some adjusting and closing entries are recorded later than, but dated as of, the last day of the period. One example is a company that receives a December utility bill on January 10. When it receives the bill, the company records the expense and the payable as of December 31. The income statement and balance sheet include these adjustments even though amounts were not known at period-end.

Chapter 3 Adjusting Accounts for Financial Statements 99

Preparing Financial Statements We can prepare financial statements directly from information in the adjusted trial balance. Exhibit 3.14 shows how revenue and expense balances are transferred from the adjusted trial balance to the income statement (red lines). The net income and dividends amounts are then used to prepare the statement of retained earnings (black lines). Asset and liability balances are

Steps to Prepare Financial Statements Prepare income statement using revenue and expense accounts from trial balance

Prepare balance sheet using asset and liability accounts along with common stock from trial balance; pull updated retained earnings from step 2

Prepare statement of retained earnings using retained earnings and dividends from trial balance; pull net income from step 1

Prepare statement of cash flows from changes in cash flows for the period (illustrated later in the book)

Step 1

Step 2

Step 4

Step 3

$47,610

Acct. No. Account Title Debit

8,670 2,300

1,800 $ 4,275

26,000

300 1,610

100 1,000 1,050

305

101 Cash ........................................................... Accounts receivable .............................. Supplies .................................................... Prepaid insurance .................................. Equipment ................................................ Accumulated depreciation—Equip..... Accounts payable .................................. Salaries payable .....................................

106 126 128 167 168 201 209

Unearned consulting revenue ............236

Consulting revenue ...............................403 Rental revenue ........................................ 406 Depreciation expense—Equip. ..........612 Salaries expense ....................................622 Insurance expense ................................637 Rent expense ..........................................640 Supplies expense ...................................652 Utilities expense ..................................... Totals .........................................................

690

$ 300

210 6,200

2,750 30,000

300 7,850

$47,610

Credit

Common stock ....................................... Retained earnings .................................

307 318 0

200Dividends .................................................319

Step 2 Prepare statement of retained earnings

$ 3,785

200 $3,585

3,785 Less: Dividends .................................. . . . Retained earnings, December 31 ......

Retained earnings, December 1......... Plus: Net income ................................. . . ..

Assets

Liabilities

Equity

Cash ..................................................... $ 4,275

Accounts payable .............................

Accounts receivable ........................ 1,800

Unearned consulting revenue ....... 2,750 Salaries payable ................................ 210

8,670 2,300

Supplies .............................................. Prepaid insurance .............................

Total assets ........................................ $ 42,745 25,700

$26,000

6,200

Equipment .......................................... 300Less accumulated depreciation......

Common stock ................................... Retained earnings .............................. Total equity ......................................... Total liabilities and equity ...............

3,585

Total liabilities ....................................... 9,160

30,000

$ 42,745 33,585

Step 1 Prepare income statement

Revenues Consulting revenue ............................. $7,850

300 Rental revenue ..................................... Total revenues ......................................

Depreciation expense—Equip.......... Expenses

Salaries expense................................... Insurance expense............................... Rent expense......................................... Supplies expense ................................. Utilities expense.................................... Total expenses........................................ Net income................................................

300 1,610 100

305

1,000 1,050

4,365 $3,785

$8,150

Step 3 Prepare balance sheet

FASTFORWARD Balance Sheet

December 31, 2019

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

FASTFORWARD Income Statement

For Month Ended December 31, 2019

FASTFORWARD Adjusted Trial Balance

December 31, 2019

EXHIBIT 3.14 Preparing Financial Statements (Adjusted Trial Balance from Exhibit 3.13)FASTForward

P6 Prepare financial statements from an adjusted trial balance.

100 Chapter 3 Adjusting Accounts for Financial Statements

then transferred to the balance sheet (blue lines). The ending retained earnings is computed in the statement of retained earnings and transferred to the balance sheet (green line).

We prepare financial statements in the following order: (1) income statement, (2) state- ment of retained earnings, and (3) balance sheet. This order makes sense because the balance sheet uses information from the statement of retained earnings, which in turn uses information from the income statement. The statement of cash flows is usually the final statement prepared.

Point: Each trial balance amount is used in only one financial statement.

Use the following adjusted trial balance of Magic Company to prepare its December 31 year-end (1) in- come statement, (2) statement of retained earnings, and (3) balance sheet (unclassified). The Retained Earnings account balance was $45,000 on December 31 of the prior year.Preparing Financial

Statements from a Trial Balance

NEED-TO-KNOW 3-5

Do More: QS 3-22, E 3-8, P 3-4

Solution

MAGIC COMPANY Adjusted Trial Balance

December 31

Account Title Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . 33,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . 8,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $199,000 $199,000

MAGIC COMPANY Income Statement

For Year Ended December 31

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . $79,000 Expenses Salaries expense . . . . . . . . . . . . . . . . . . $56,000 Office supplies expense . . . . . . . . . . . . 8,000 Total expenses . . . . . . . . . . . . . . . . . . . . 64,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . $15,000

Step 1

MAGIC COMPANY Statement of Retained Earnings

For Year Ended December 31

Retained earnings, December 31 prior year-end . . . . . . $45,000 Add: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 60,000 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained earnings, December 31 current year-end . . . . $40,000

Step 2

MAGIC COMPANY Balance Sheet December 31

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000 Accounts receivable . . . . . . . . . . . . . . . . 17,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Total assets . . . . . . . . . . . . . . . . . . . . . . $115,000

Liabilities

Accounts payable . . . . . . . . . . . . . . . . . $ 12,000 Long-term notes payable . . . . . . . . . . . . 33,000 Total liabilities . . . . . . . . . . . . . . . . . . . . 45,000

Equity

Common stock . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . 40,000 Total equity . . . . . . . . . . . . . . . . . . . . . . . 70,000 Total liabilities and equity . . . . . . . . . . . $115,000

Step 3

The closing process occurs at the end of an accounting period after financial statements are completed. In the closing process we (1) identify accounts for closing, (2) record and post the closing entries, and (3) prepare a post-closing trial balance. The closing process has two pur- poses. First, it resets revenue, expense, and dividends account balances to zero at the end of each

CLOSING PROCESS P7 Describe and prepare closing entries.

Chapter 3 Adjusting Accounts for Financial Statements 101

period (which updates the Retained Earnings account for inclusion on the balance sheet). This is done so that these accounts can properly measure income and divi- dends for the next period. Second, it helps summarize a period’s revenues and expenses. This section explains the closing process.

Temporary and Permanent Accounts Temporary accounts relate to one accounting period. They include all income statement accounts, the dividends account, and the Income Sum- mary account. They are temporary because the accounts are opened at the beginning of a period, used to record transactions and events for that period, and then closed at the end of the period. The closing process applies only to temporary accounts.

Permanent accounts report on activities related to one or more future accounting periods. They include asset, liability, and equity accounts (all balance sheet accounts). Permanent accounts are not closed each period and carry their ending balance into future periods.

Recording Closing Entries Closing entries transfer the end-of-period balances in revenue, expense, and dividends accounts to the permanent Retained Earnings account. Closing entries are necessary at the end of each period after financial statements are prepared because Revenue, expense, and dividends accounts must begin each period with zero balances. Retained Earnings must reflect prior periods’ revenues, expenses, and dividends.

An income statement reports revenues and expenses for a specific accounting period. Divi- dends are also for a specific accounting period. Because revenue, expense, and dividends accounts record information separately for each period, they must start each period with zero balances.

Exhibit 3.15 uses the adjusted account balances of FastForward (from the Adjusted Trial Balance columns of Exhibit 3.14 or from the left side of Exhibit 3.16) to show the four steps to close its temporary accounts.

1 2 To close revenue and expense accounts, we transfer their balances to Income Summary. Income Summary is a temporary account only used for the closing process that contains a credit for total revenues (and gains) and a debit for total expenses (and losses).

Point: If Apple did not make closing entries, prior-year revenue from iPhone sales would be in- cluded with current-year revenue.

TEMPORARY

PERMANEN T

Revenues Expenses Dividends Income Summary

Temporary Accounts (closed at period-end)

Assets Liabilities Common Stock Retained Earnings

Permanent Accounts (not closed at period-end)

Consulting Revenue

Rental Revenue

Balance 7,850

Balance 300

4,365 8,150

Balance 3,785

7,850

300

Balance 200 200

Close income statement credit balances1

Close income statement debit balances2

Close Income Summary account3

Close dividends account4

Four-Step Closing Process

Balance 30,000

200 3,785

Balance 33,585

Income Summary

Dividends

Revenue Accounts

Retained Earnings

Expense Accounts Depreciation Expense—Equip.

Balance

Salaries Expense

Balance

Insurance Expense

Balance

Rent Expense

Balance

Supplies Expense

Balance

Utilities Expense

Balance

300

1,610

100

1,000

1,050

305

3,785

300

1,610

100

1,000

1,050

305

Point: Retained Earnings is the only permanent account in Exhibit 3.15— meaning it is not closed, but it does have Income Summary closed to it.

EXHIBIT 3.15 Four-Step Closing Process

102 Chapter 3 Adjusting Accounts for Financial Statements

$47,610

8,670 2,300

1,800 $ 4,275

26,000

300 1,610

100 1,000 1,050

305

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid insurance . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . . . Accumulated depreciation—Equip. . . Accounts payable . . . . . . . . . . . . . . . . .

Common stock . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . .

200Dividends . . . . . . . . . . . . . . . . . . . . . . . Consulting revenue . . . . . . . . . . . . . . . . Rental revenue . . . . . . . . . . . . . . . . . . . . Depreciation expense—Equip. . . . . . . Salaries expense . . . . . . . . . . . . . . . . . . Insurance expense . . . . . . . . . . . . . . . . Rent expense . . . . . . . . . . . . . . . . . . . . . Supplies expense . . . . . . . . . . . . . . . . . Utilities expense . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . .

FASTFORWARD Adjusted Trial Balance

December 31, 2019 Dec. 31 Consulting Revenue . . . . . . . . . . . . . . . . . Rental Revenue . . . . . . . . . . . . . . . . . . . . . Income Summary . . . . . . . . . . . . . . . . .

Close revenue accounts.

Close Income Summary account.

7,850 300

1,610

8,150

Step 1:

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . .

Salaries Expense . . . . . . . . . . . . . . . . . Depreciation Expense—Equip. . . . . .

Insurance Expense . . . . . . . . . . . . . . . Rent Expense . . . . . . . . . . . . . . . . . . . . Supplies Expense . . . . . . . . . . . . . . . . Utilities Expense . . . . . . . . . . . . . . . . .

4,365 300

100 1,000 1,050

305

Step 2:

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . .

3,785 3,785

Step 3:

$ 300 6,200

Salaries payable . . . . . . . . . . . . . . . . . . . 210 Unearned consulting revenue . . . . . . . 2,750

30,000 0

300 7,850

$47,610

Close expense accounts.

CreditDebit

Retained Earnings . . . . . . . . . . . . . . . . . . .

Close dividends account.

Dec. 31 Dividends . . . . . . . . . . . . . . . . . . . . . . .

200 200

Step 4:

General Journal

3 The Income Summary balance, which equals net income or net loss, is transferred to the Retained Earnings account.

4 The Dividends account balance is transferred to the Retained Earnings account. After closing entries are posted, the revenue, expense, dividends, and Income Summary accounts have zero bal- ances and are said to be closed or cleared.

Exhibit 3.16 shows the four closing journal entries to apply the closing process of Exhibit 3.15. EXHIBIT 3.16 Preparing Closing Entries

Step 1: Close Credit Balances in Revenue Accounts to Income Summary The first closing entry transfers credit balances in revenue (and gain) accounts to the Income Summary account. We bring accounts with credit balances to zero by debiting them. For FastForward, this is step 1 in Exhibit 3.16. The $8,150 credit entry to Income Summary equals total revenues for the period. This leaves revenue accounts with zero balances, and they are now ready to record revenues for next period.

Step 2: Close Debit Balances in Expense Accounts to Income Summary The second closing entry transfers debit balances in expense (and loss) accounts to the Income Summary account. We bring expense accounts’ debit balances to zero by crediting them. With a balance of zero, these accounts are ready to record expenses for next period. This second clos- ing entry for FastForward is step 2 in Exhibit 3.16.

Step 3: Close Income Summary to Retained Earnings After steps 1 and 2, the balance of Income Summary equals December net income of $3,785 ($8,150 credit less $4,365 debit). The third closing entry transfers the balance of the Income Summary account to the Retained Earnings account. This entry closes the Income Summary account—see step 3 in Exhibit 3.16. (If a net loss occurred because expenses exceeded revenues, the third entry is re- versed: debit Retained Earnings and credit Income Summary.)

Step 4: Close Dividends Account to Retained Earnings The fourth closing entry transfers any debit balance in the Dividends account to the Retained Earnings account— see step 4 in Exhibit 3.16. This entry gives the Dividends account a zero balance, and the ac- count is now ready to record next period’s dividends.

Exhibit 3.17 shows the entire ledger of FastForward as of December 31 after adjusting and closing entries are posted. The temporary accounts (revenues, expenses, and dividends) have ending balances equal to zero.

103

Asset Accounts

Cash Acct . No . 101

Date Explan . PR Debit Credit Balance

2019

Dec . 1 (1) G1 30,000 30,000

2 (2) G1 2,500 27,500

3 (3) G1 26,000 1,500

5 (5) G1 4,200 5,700

6 (13) G1 2,400 3,300

12 (6) G1 1,000 2,300

12 (7) G1 700 1,600

22 (9) G1 1,900 3,500

24 (10) G1 900 2,600

24 (11) G1 200 2,400

26 (12) G1 3,000 5,400

26 (14) G1 120 5,280

26 (15) G1 305 4,975

26 (16) G1 700 4,275

Supplies Acct . No . 126

Date Explan . PR Debit Credit Balance

2019

Dec . 2 (2) G1 2,500 2,500

6 (4) G1 7,100 9,600

26 (14) G1 120 9,720

31 Adj.(b) G1 1,050 8,670

Accounts Receivable Acct . No . 106

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (8) G1 1,900 1,900

22 (9) G1 1,900 0

31 Adj.(f) G1 1,800 1,800

Accumulated Depreciation— Equipment Acct . No . 168

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(c) G1 300 300

Equipment Acct . No . 167

Date Explan . PR Debit Credit Balance

2019

Dec . 3 (3) G1 26,000 26,000

Prepaid Insurance Acct . No . 128

Date Explan . PR Debit Credit Balance

2019

Dec . 6 (13) G1 2,400 2,400

31 Adj.(a) G1 100 2,300

Revenue and Expense Accounts (Including Income Summary)

Depreciation Expense— Equipment Acct . No . 612

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(c) G1 300 300 31 Clos.(2) G1 300 0

Rental Revenue Acct . No . 406

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (8) G1 300 300 31 Clos.(1) G1 300 0

Consulting Revenue Acct . No . 403

Date Explan . PR Debit Credit Balance

2019

Dec . 5 (5) G1 4,200 4,200

12 (8) G1 1,600 5,800

31 Adj.(d) G1 250 6,050 31 Adj.(f) G1 1,800 7,850 31 Clos.(1) G1 7,850 0

Rent Expense Acct . No . 640

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (6) G1 1,000 1,000 31 Clos.(2) G1 1,000 0

Insurance Expense Acct . No . 637

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(a) G1 100 100 31 Clos.(2) G1 100 0

Salaries Expense Acct . No . 622

Date Explan . PR Debit Credit Balance

2019

Dec . 12 (7) G1 700 700

26 (16) G1 700 1,400

31 Adj.(e) G1 210 1,610 31 Clos.(2) G1 1,610 0

Income Summary Acct . No . 901

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Clos.(1) G1 8,150 8,150 31 Clos.(2) G1 4,365 3,785 31 Clos.(3) G1 3,785 0

Utilities Expense Acct . No . 690

Date Explan . PR Debit Credit Balance

2019

Dec . 26 (15) G1 305 305 31 Clos.(2) G1 305 0

Supplies Expense Acct . No . 652

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(b) G1 1,050 1,050 31 Clos.(2) G1 1,050 0

EXHIBIT 3.17 General Ledger after the Closing Process for FastForward

FASTForward

Liability and Equity Accounts

Unearned Consulting Revenue Acct . No . 236

Date Explan . PR Debit Credit Balance

2019

Dec . 26 (12) G1 3,000 3,000

31 Adj.(d) G1 250 2,750

Accounts Payable Acct . No . 201

Date Explan . PR Debit Credit Balance

2019

Dec . 6 (4) G1 7,100 7,100

24 (10) G1 900 6,200

Salaries Payable Acct . No . 209

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Adj.(e) G1 210 210

Common Stock Acct . No . 307

Date Explan . PR Debit Credit Balance

2019

Dec . 1 (1) G1 30,000 30,000

Dividends Acct . No . 319

Date Explan . PR Debit Credit Balance

2019

Dec . 24 (11) G1 200 200

31 Clos.(4) G1 200 0

Retained Earnings Acct . No . 318

Date Explan . PR Debit Credit Balance

2019

Dec. 31 Clos.(3) G1 3,785 3,785 31 Clos.(4) G1 200 3,585

104 Chapter 3 Adjusting Accounts for Financial Statements

Post-Closing Trial Balance A post-closing trial balance is a list of permanent accounts and their balances after all closing entries. It lists the balances for all accounts not closed. A post-closing trial balance verifies that (1) total debits equal total credits for permanent accounts and (2) all temporary accounts have zero balances. FastForward’s post-closing trial balance is in Exhibit 3.18 and often is the last step in the accounting process.

P8 Explain and prepare a post-closing trial balance.

Point: Only balance sheet (permanent) accounts are on a post-closing trial balance.

EXHIBIT 3.18 Post-Closing Trial Balance

FASTFORWARD Post-Closing Trial Balance

December 31, 2019 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,275 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,670 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 Accumulated depreciation—Equipment . . . . . . . . . . $ 300 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,200 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 Unearned consulting revenue . . . . . . . . . . . . . . . . . 2,750 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,585 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $43,045 $43,045

©IM_photo/Shutterstock

Staff Accountant A friend shows you the post-closing trial balance she is working on. You review the statement and see a line item for rent expense. How do you know that an error exists? ■ Answer: This error is apparent in a post-closing trial balance because Rent Expense is a temporary account. Post-closing trial balances only contain permanent accounts.

Decision Maker

C2 Identify steps in the accounting cycle.

The accounting cycle is the steps in preparing financial statements. It is called a cycle because the steps are repeated each reporting period. Exhibit 3.19 shows the 10 steps in the cycle. Steps 1 through 3 occur regularly as a company enters into transactions. Steps 4 through 9 are done at the end of a period. Reversing entries in step 10 are optional and are explained in Appendix 3C.

ACCOUNTING CYCLE

Use the adjusted trial balance solution for Magic Company from Need-to-Know 3-5 to prepare its closing entries—the accounts are also listed here for convenience.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 Dr . Accounts receivable . . . . . . . . . . . . . . . . . 17,000 Dr . Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Dr . Accounts payable . . . . . . . . . . . . . . . . . . . 12,000 Cr . Long-term notes payable . . . . . . . . . . . . . 33,000 Cr . Common stock . . . . . . . . . . . . . . . . . . . . . 30,000 Cr .

Retained earnings . . . . . . . . . . . . . . . . . . . . $45,000 Cr . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Dr . Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 79,000 Cr . Salaries expense . . . . . . . . . . . . . . . . . . . . . 56,000 Dr . Office supplies expense . . . . . . . . . . . . . . . 8,000 Dr .

Solution

Dec . 31 Fees Earned . . . . . . . . . . . . . . . . . . . . . . . 79,000 Income Summary . . . . . . . . . . . . . . 79,000 Close revenue account. Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . 64,000 Salaries Expense . . . . . . . . . . . . . . . 56,000 Office Supplies Expense . . . . . . . . . 8,000 Close expense accounts.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . 15,000 Retained Earnings . . . . . . . . . . . . . . 15,000 Close Income Summary. Dec . 31 Retained Earnings . . . . . . . . . . . . . . . . . . 20,000 Dividends . . . . . . . . . . . . . . . . . . . . 20,000 Close Dividends account.

Closing Entries

NEED-TO-KNOW 3-6

Do More: QS 3-18, E 3-9, E 3-10

Chapter 3 Adjusting Accounts for Financial Statements 105

EXHIBIT 3.19 Steps in the Accounting Cycle*

33,785

$33,585 200Less: Withdrawals by owner .............

Retained earnings, December 31 .......

Retained earnings, December 1.......... Plus: Investments by owner ............... $30,000

Net income .................................. 3,785

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Assets Liabilities Equity

Cash

+ $1,500Old Bal. +

+ Supplies Equipment =

Accounts Payable

Common Stock

+ +

$2,500 $26,000 =

$30,000

(4) 7,100 +$7,100 New Bal. $9,600 $ 7,100$1,500 $26,000 $30,000

Date Account Titles and Explanation PR Debit Credit

(4) Supplies 126 7,100 Accounts Payable 201 7,100

(4) 7,100

201

2,500 (4) 7,100

Supplies 126

General Ledger

Accounts Payable

(2)

Cash Accounts receivable Supplies Prepaid insurance Equipment Accounts payable Unearned consulting revenue

6,200 3,000

FASTFORWARD Trial Balance

December 31, 2019

Debit Credit

4,275 0

9,720 2,400

26,000

Adjustment (b) Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Dec. 31 1,050

652

Dec. 2 2,500 6 7,100

26 120

Balance 8,670

Dec. 31 1,050

126Supplies Expense Supplies

Dec. 31 1,050 1,050

Record supplies used.

Dr. Cr. Dr. Cr.Cr. Dr.

FASTFORWARD Trial Balances

December 31, 2019

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

(f) $1,800

$ 0

0 6,200

0 $ 4,275

9,720 2,400

26,000

1,800 $ 4,275

8,670 2,300

26,000

(b) $1,050 (a) 100

(e) 210

$ 300 6,200

210

Acct. No.

101 106 126 128 167 168 201 209

Cash Account Title

Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable

Dec. 31 Consulting Revenue................................ Rental Revenue........................................ Income Summary................................ Close revenue accounts.

7,850 300

1,610

8,150

Step 1:

Dec. 31 Income Summary.....................................

Salaries Expense................................ Depreciation Expense—Equip. .....

Insurance Expense............................ Rent Expense...................................... Supplies Expense.............................. Utilities Expense.................................

4,365 300

100 1,000 1,050

305

Step 2:

Step 3: Close expense accounts.

General Journal

FASTFORWARD Post-Closing Trial Balance

December 31, 2019

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated depreciation—Equipment . . . . . . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . S l i bl

$ 4,275 1,800 8,670 2,300

26,000 $ 300

6,200 210

Reversing entry recorded on Jan. 1, 2020

Salaries Expense

Salaries Payable

Date 2020

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 2020 Jan. 1

210210

210 0

Expl. Debit BalanceCredit

Salaries Payable 210 Salaries Expense 210

Jan. 1 210 210

Revenues Consulting revenue .............................. $7,850

300 Rental revenue ....................................... Total revenues .......................................

Depreciation expense—Equip............ Expenses

Salaries expense.................................... Insurance expense................................ Rent expense.......................................... Supplies expense................................... Utilities expense..................................... Total exenses

300 1,610 100

305

1,000 1,050

$8,150

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Assets Cash ........................................................ $ 4,275 Accounts receivable ........................... 1,800

8,670 2,300

Supplies ................................................. Prepaid insurance ...............................

FASTFORWARD Balance Sheet

December 31, 2019

Explanations 1. Analyze transactions Analyze transactions to prepare for journalizing. 2. Journalize Record accounts, including debits and credits, in a journal. 3. Post Transfer debits and credits from the journal to the ledger. 4. Prepare unadjusted trial balance Summarize unadjusted ledger accounts and amounts. 5. Adjust and post Record adjustments to bring account balances up to date; journalize and post adjustments. 6. Prepare adjusted trial balance Summarize adjusted ledger accounts and amounts. 7. Prepare financial statements Use adjusted trial balance to prepare financial statements. 8. Close accounts Journalize and post entries to close temporary accounts. 9. Prepare post-closing trial balance Test clerical accuracy of the closing procedures. 10. Reverse and post (optional step) Reverse certain adjustments in the next period—optional step; see Appendix 3C.

* Steps 4, 6, and 9 can be done on a work sheet. A work sheet is useful in planning adjustments, but adjustments (step 5) must always be journalized and posted. Steps 3, 4, 6, and 9 are automatic with a computerized system.

Accounting Cycle

5. Adjust and post accounts

6. Prepare adjusted trial balance7. Prepare financial statements8. Close accounts

9. Prepare post-closing trial balance

10. Reverse and post (optional)

2. Journalize 3. Post

4. Prepare unadjusted trial balance

1. Analyze transactions

C3 Explain and prepare a classified balance sheet.

This section describes a classified balance sheet. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. One example is FastForward’s balance sheet in Exhibit 3.14. A classified balance sheet organizes assets and liabilities into subgroups.

Classification Structure A classified balance sheet typically contains the categories in Exhibit 3.20 (there is no required layout). An important classification is the separation between current and noncurrent for both

CLASSIFIED BALANCE SHEET

106 Chapter 3 Adjusting Accounts for Financial Statements

assets and liabilities. Current items are expected to come due (either collected or owed) within one year or the company’s operating cycle, whichever is longer. The operating cycle is the time span from when cash is used to acquire goods and services until cash is received from the sale

of goods and services. Most operating cycles are less than one year, which means most companies use a one-year period to classify current and noncurrent items. To make it easy, assume an operating cycle of one year, unless we say otherwise.

A balance sheet lists current assets before noncurrent assets and cur- rent liabilities before noncurrent liabilities. Current assets and current liabilities are listed in order of how quickly they will be converted to, or paid in, cash.

Classification Categories The balance sheet for Snowboarding Components in Exhibit 3.21 shows the typical categories. Its assets are classified as either current or noncurrent. Its noncurrent assets include three main categories: long-term investments, plant assets, and intangible assets. Its liabilities are classified as either current or long-term. Not all companies use the same categories. Jarden, a producer of snowboards, reported a balance sheet with five asset classes: current assets; property, plant, and equipment; goodwill; intangibles; and other assets.

Current Assets Current assets are cash and other resources that are expected to be sold, collected, or used within one year or the company’s operating cycle, whichever is longer. Examples are cash, short-term investments, accounts receivable, short-term notes receivable, goods for sale (called merchandise or inventory), and prepaid expenses.

Long-Term Investments Long-term (or noncurrent) investments include notes re- ceivable and investments in stocks and bonds when they are expected to be held for more than the longer of one year or the operating cycle. Land held for future expansion is a long-term in- vestment because it is not used in operations.

EXHIBIT 3.20 Typical Categories in a Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities Noncurrent assets Noncurrent liabilities Long-term investments Equity Plant assets Intangible assets

©Sean Sullivan/Getty Images

Point: Current is also called short- term, and noncurrent is also called long-term.

SNOWBOARDING COMPONENTS Balance Sheet

January 31, 2019

Liabilities Current liabilities Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $15,300

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Notes payable (due within one year) . . . . . . . . . 3,000

Current portion of long-term liabilities . . . . . . . . 7,500

Total current liabilities . . . . . . . . . . . . . . . . . . . . . $ 29,000

Long-term liabilities (net of current portion) . . . . . 150,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179,000

Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 114,800 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164,800

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . $343,800

Assets Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,500

Short-term investments . . . . . . . . . . . . . . . . . 2,100

Accounts receivable, net . . . . . . . . . . . . . . . . 4,400

Merchandise inventory . . . . . . . . . . . . . . . . . . 27,500

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . 2,400

Total current assets . . . . . . . . . . . . . . . . . . . . . $ 42,900

Long-term investments Notes receivable (due in three years) . . . . . . 1,500

Investments in stocks and bonds . . . . . . . . . . 18,000

Land held for future expansion . . . . . . . . . . . 48,000

Total long-term investments . . . . . . . . . . . . . . 67,500

Plant assets Equipment and buildings . . . . . . . . . . . . . . . . 203,200

Less accumulated depreciation . . . . . . . . . . . 53,000

Equipment and buildings, net . . . . . . . . . . . . 150,200

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,200

Total plant assets . . . . . . . . . . . . . . . . . . . . . . 223,400

Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,800

EXHIBIT 3.21 Example of a Classified Balance Sheet

Chapter 3 Adjusting Accounts for Financial Statements 107

Plant Assets Plant assets are tangible assets that are both long-lived and used to produce or sell products and services. Examples are equipment, machinery, buildings, and land that are used to produce or sell products and services.

Intangible Assets Intangible assets are long-term assets that benefit business op- erations but lack physical form. Examples are patents, trademarks, copyrights, franchises, and goodwill. Their value comes from the privileges or rights granted to or held by the owner.

Current Liabilities Current liabilities are liabilities due to be paid or settled within one year or the operating cycle, whichever is longer. They usually are settled by paying out cash. Current liabilities include accounts payable, notes payable, wages payable, taxes payable, inter- est payable, and unearned revenues. Also, any portion of a long-term liability due to be paid within one year or the operating cycle, whichever is longer, is a current liability. Unearned rev- enues are current liabilities when products or services are to be provided within one year or the operating cycle, whichever is longer.

Long-Term Liabilities Long-term liabilities are liabilities not due within one year or the operating cycle, whichever is longer. Notes payable, mortgages payable, bonds payable, and lease obligations are common long-term liabilities. If a company has both short- and long-term items in each of these categories, they are commonly separated into two accounts in the ledger.

Equity Equity is the owner’s claim on assets. For a corporation, this claim is reported in the equity section as common stock and retained earnings.

©Johannes Simon/Getty Images

Point: Only assets and liabilities (not equity) are classified as current or noncurrent.

Use the following account balances for Magic Company from Need-To-Know 3-5 to prepare its classified balance sheet as of December 31.

Solution

MAGIC COMPANY Balance Sheet December 31

Assets Current assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000

Accounts receivable . . . . . . . . . . . . . . . . . 17,000

Total current assets . . . . . . . . . . . . . . . . . . 30,000

Plant assets

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Total plant assets . . . . . . . . . . . . . . . . . . . . 85,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000

Liabilities Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . $ 12,000

Total current liabilities . . . . . . . . . . . . . . . . . . 12,000

Long-term notes payable . . . . . . . . . . . . . . . . . . 33,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Equity

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 40,000

Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000

Total liabilities and equity . . . . . . . . . . . . . . . . . $115,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000 Dr .

Accounts receivable . . . . . . . . . . . . . . . . . . . . 17,000 Dr .

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Dr .

Accounts payable . . . . . . . . . . . . . . . . . . . . . . 12,000 Cr .

Long-term notes payable . . . . . . . . . . . . . . . . 33,000 Cr .

Common stock . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Cr .

Retained earnings . . . . . . . . . . . . . . . . . . . . . . $40,000 Cr .

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Dr .

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000 Cr .

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . 56,000 Dr .

Office supplies expense . . . . . . . . . . . . . . . . . 8,000 Dr .

Classified Balance Sheet

NEED-TO-KNOW 3-7

Do More: QS 3-21, QS 3-23, E 3-12, P 3-7

Point: Plant assets are also called fixed assets; property, plant and equipment (PP&E); or long-lived assets.

Profit Margin A useful measure of a company’s operating results is the ratio of its net income to net sales. This ratio is called profit margin, or return on sales, and is computed as in Exhibit 3.22. This ratio shows the percent of profit in each dollar of sales.

A1 Compute profit margin and describe its use in analyzing company performance.

CFO Your health care equipment company consistently reports a 9% profit margin, which is similar to that of com- petitors. The treasurer argues that profit margin can be increased to 20% if the company cuts marketing expenses. Do you cut those expenses? ■ Answer: Cutting those expenses increases profit margin in the short run. However, over the long run, cutting such expenses can hurt current and future sales. You must explain that the company can cut the “fat” (expenses that do not create sales) but should be careful if cutting those that create sales.

Decision Maker

Profit margin = Net income

Net sales

EXHIBIT 3.22 Profit Margin

Visa’s profit margins are shown in Exhibit 3.23. Visa’s profit margin is superior to Mastercard’s in each of the last three years. For Mastercard to improve its profit margin, it must either reduce expenses or increase revenues at a relatively greater amount than expenses.

108 Chapter 3 Adjusting Accounts for Financial Statements

Profit Margin and Current RatioDecision Analysis

EXHIBIT 3.23 Computation and Analysis using Profit Margin

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Visa Net income . . . . . . . . . . . . . . . . . $ 6,699 $ 5,991 $ 6,328 Net sales . . . . . . . . . . . . . . . . . . $18,358 $15,082 $13,880

Profit margin . . . . . . . . . . . . . . . 36% 40% 46% Mastercard Profit margin . . . . . . . . . . . . . . . 31% 38% 39%

Company Figure ($ millions) Current Year 1 Year Ago 2 Years Ago

Costco Current assets . . . . . . . . . . . . . . . $17,317 $15,218 $16,779 Current liabilities . . . . . . . . . . . . $17,495 $15,575 $16,539

Current ratio . . . . . . . . . . . . . . . 0.99 0.98 1.01 Walmart Current ratio . . . . . . . . . . . . . . . . 0 .86 0 .93 0 .97

Current Ratio An important use of financial statements is to help assess a company’s ability to pay its debts in the near future. Such analysis affects decisions by suppliers when allowing a company to buy on credit. It also affects decisions by creditors when lending money to a company, including loan terms such as interest rate and due date. The current ratio is one measure of a company’s ability to pay its short-term obligations. It is defined in Exhibit 3.24.

A2 Compute the current ratio and describe what it reveals about a company’s financial condition.

Current ratio = Current assets

Current liabilities

EXHIBIT 3.24 Current Ratio

Costco’s current ratio for each of the last three years is in Exhibit 3.25. A current ratio of over 1.0 means that current obligations can be covered with current assets. For the recent two years, Costco’s current ratio was slightly below 1.0. This means Costco could face challenges in covering current liabilities. Although Costco has a better ratio than Walmart in each of the last three years, management must continue to monitor current assets and liabilities.

EXHIBIT 3.25 Computation and Analysis using Current Ratio

Analyst You are analyzing a dirt bike company’s ability to meet upcoming loan payments. You compute its current ratio as 1.2. You find that a major portion of accounts receivable is due from one client who has not made any pay- ments in the past 12 months. Removing this receivable from current assets lowers the current ratio to 0.7. What do you conclude? ■ Answer: A current ratio of 1.2 suggests that current assets are sufficient to cover current liabilities. Removing the past-due receiv- able reduces the current ratio to 0.7. You conclude that the company will have difficulty meeting its loan payments.

Decision Maker

©sgpage902/Getty Images

Chapter 3 Adjusting Accounts for Financial Statements 109

The following information relates to Fanning’s Electronics on December 31, 2019. The company, which uses the calendar year as its annual reporting period, initially records prepaid and unearned items in bal- ance sheet accounts (assets and liabilities, respectively).

a. The company’s weekly payroll is $8,750, paid each Friday for a five-day workweek. Assume December 31, 2019, falls on a Monday, but the employees will not be paid their wages until Friday, January 4, 2020.

b. Eighteen months earlier, on July 1, 2018, the company purchased equipment that cost $20,000. Its useful life is predicted to be five years, at which time the equipment is expected to be worthless (zero salvage value).

c. On October 1, 2019, the company agreed to work on a new housing development. The company is paid $120,000 on October 1 in advance of future installation of similar alarm systems in 24 new homes. That amount was credited to the Unearned Services Revenue account. Between October 1 and December 31, work on 20 homes was completed.

d. On September 1, 2019, the company purchased a 12-month insurance policy for $1,800. The transac- tion was recorded with an $1,800 debit to Prepaid Insurance.

e. On December 29, 2019, the company completed a $7,000 service that has not been billed or recorded as of December 31, 2019.

Required

1. Prepare any necessary adjusting entries on December 31, 2019, in relation to transactions and events a through e.

2. Prepare T-accounts for the accounts affected by adjusting entries, and post the adjusting entries. Determine the adjusted balances for the Unearned Revenue and the Prepaid Insurance accounts.

3. Complete the following table and determine the amounts and effects of your adjusting entries on the year 2019 income statement and the December 31, 2019, balance sheet. Use up (down) arrows to indicate an increase (decrease) in the Effect columns.

COMPREHENSIVE 1

Preparing Year-End Accounting Adjustments

NEED-TO-KNOW 3-8

Amount in Effect on Effect on Effect on Effect on Entry the Entry Net Income Total Assets Total Liabilities Total Equity

PLANNING THE SOLUTION Analyze each situation to determine which accounts need to be updated with an adjustment. Calculate the amount of each adjustment and prepare the necessary journal entries. Show the amount of each adjustment in the designated accounts, determine the adjusted balance, and

identify the balance sheet classification of the account. Determine each entry’s effect on net income for the year and on total assets, total liabilities, and total

equity at the end of the year.

SOLUTION 1. Adjusting journal entries.

(a) Dec . 31 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 Accrue wages for last day of year ($8,750 × 1∕5) . (b) Dec . 31 Depreciation Expense—Equipment . . . . . . . . . . . . . . . . . . . . . 4,000 Accumulated Depreciation—Equipment . . . . . . . . . . . . . 4,000 Record depreciation expense for year

($20,000/5 years = $4,000 per year) . (c) Dec . 31 Unearned Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Record revenue earned ($120,000 × 20∕24) . (d) Dec . 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Adjust for expired portion of insurance ($1,800 × 4∕12) . (e) Dec . 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Record services revenue earned.

110 Chapter 3 Adjusting Accounts for Financial Statements

2. T-accounts for adjusting journal entries a through e.

(a) 1,750

Wages ExpenseWages Payable

(a) 1,750

Accounts Receivable

(e) 7,000

(d ) 600

Insurance ExpenseUnearned Services Revenue

Unadj . Bal . 120,000

Adj . Bal . 20,000

Unadj . Bal . 1,800

(d ) 600

Adj . Bal . 1,200

Prepaid Insurance

(b) 4,000

Depreciation Expense — EquipmentServices Revenue

(e) 7,000

Adj . Bal . 107,000

Accumulated Depreciation — Equipment

(b) 4,000

3. Financial statement effects of adjusting journal entries.

Amount in Effect on Effect on Effect on Effect on Entry the Entry Net Income Total Assets Total Liabilities Total Equity

a $ 1,750 $ 1,750 ↓ No effect $ 1,750 ↑ $ 1,750 ↓ b 4,000 4,000 ↓ $4,000 ↓ No effect 4,000 ↓ c 100,000 100,000 ↑ No effect $100,000 ↓ 100,000 ↑ d 600 600 ↓ $ 600 ↓ No effect 600 ↓ e 7,000 7,000 ↑ $7,000 ↑ No effect 7,000 ↑

Use the following year-end adjusted trial balance to answer questions 1–3.

COMPREHENSIVE 2

Preparing Financial Statements from Adjusted Account Balances

NEED-TO-KNOW 3-9 CHOI COMPANY

Adjusted Trial Balance December 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 910 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,200 Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . $ 29,100 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,480 Unearned rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,340 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,450 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . 5,970 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $281,880 $281,880

Chapter 3 Adjusting Accounts for Financial Statements 111

1. Prepare the annual income statement from the adjusted trial bal- ance of Choi Company.

Answer:

CHOI COMPANY Income Statement

For Year Ended December 31

Revenues Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,500 Expenses Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,450 Depreciation expense—Equipment . . . . . . . . . . . . . . 5,970 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,320 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,180

2. Prepare a statement of retained earnings from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Statement of Retained Earnings

For Year Ended December 31

Retained earnings, December 31 prior year-end . . . . . . $30,340 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,180

48,520 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Retained earnings, December 31 current year-end . . . . $27,520

3. Prepare a balance sheet (unclassified) from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Balance Sheet December 31

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050 Accounts receivable . . . . . . . . . . . . . . . . . . . . 400 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . 910 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . $217,200 Less accumulated depreciation . . . . . . . . . . . . 29,100 188,100 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $192,460

Liabilities Interest payable . . . . . . . . . . . . . . . . . . . . . . . . $ 4,480 Unearned rent . . . . . . . . . . . . . . . . . . . . . . . . . 460 Long-term notes payable . . . . . . . . . . . . . . . . 150,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 154,940

Equity Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 27,520 Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,520 Total liabilities and equity . . . . . . . . . . . . . . . . . $192,460

APPENDIX

Alternative Accounting for Prepayments 3A This appendix explains alternative accounting for deferred expenses and deferred revenues.

RECORDING PREPAYMENT OF EXPENSES IN EXPENSE ACCOUNTS An alternative method is to record all prepaid expenses with debits to expense accounts. If any prepaids remain unused or unexpired at the end of an accounting period, then adjusting entries transfer the cost of the unused portions from expense accounts to prepaid expense (asset) accounts. The financial statements are identical under either method, but the adjusting entries are different. To demonstrate the differences between these two methods, let’s look at FastForward’s cash payment on December 1 for 24 months of insurance coverage beginning on December 1. FastForward recorded that payment with a debit to an as- set account, but it could have recorded a debit to an expense account. These alternatives are shown in Exhibit 3A.1.

P9 Explain the alternatives in accounting for prepaids.

Payment Recorded as Asset

Dec . 1 Prepaid Insurance . . . . . . . 2,400 Cash . . . . . . . . . . . . . . 2,400

Payment Recorded as Expense

Dec . 1 Insurance Expense . . . . . . 2,400 Cash . . . . . . . . . . . . . 2,400

EXHIBIT 3A.1 Alternative Initial Entries for Prepaid Expenses

112 Chapter 3 Adjusting Accounts for Financial Statements

Payment Recorded as Asset

Dec . 31 Insurance Expense . . . . . . . . 100 Prepaid Insurance . . . . 100

Payment Recorded as Expense

Dec . 31 Prepaid Insurance . . . . . . . 2,300 Insurance Expense . . 2,300

EXHIBIT 3A.2 Adjusting Entry for Prepaid Expenses for the Two Alternatives

When these entries are posted, we see in Exhibit 3A.3 that the two methods give identical results.

EXHIBIT 3A.3 Account Balances under Two Alternatives for Recording Prepaid Expenses

Payment Recorded as Asset

Prepaid Insurance 128

Dec . 1 2,400 Dec . 31 100

Balance 2,300

Prepaid Insurance 128

Dec . 31 2,300

Payment Recorded as Expense

Insurance Expense 637

Dec . 31 100

Insurance Expense 637

Dec . 1 2,400 Dec . 31 2,300

Balance 100

RECORDING PREPAYMENT OF REVENUES IN REVENUE ACCOUNTS An alternative method is to record all unearned revenues with credits to revenue accounts. If any revenues are unearned at the end of an accounting period, then adjusting entries transfer the unearned portions from revenue accounts to unearned revenue (liability) accounts. The adjusting entries are different for these two alternatives, but the financial statements are identical. To demonstrate the differences between these two methods, let’s look at FastForward’s December 26 receipt of $3,000 for consulting services covering the period December 27 to February 24. FastForward recorded this transaction with a credit to a liability account. The alternative is to record it with a credit to a revenue account, as shown in Exhibit 3A.4.

Receipt Recorded as Liability

Dec . 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Unearned Consulting Revenue . . . 3,000

Receipt Recorded as Revenue

Dec . 26 Cash . . . . . . . . . . . . . . . . . . . 3,000 Consulting Revenue . . 3,000

EXHIBIT 3A.4 Alternative Initial Entries for Unearned Revenues

By the end of its accounting period on December 31, FastForward has earned $250 of this revenue. This means $250 of the liability has been satisfied. Depending on how the initial receipt is recorded, the adjust- ing entry is as shown in Exhibit 3A.5.

After adjusting entries are posted, the two alternatives give identical results, as shown in Exhibit 3A.6.

Receipt Recorded as Revenue

Dec . 31 Consulting Revenue . . . . . . . . . . . . . . . 2,750 Unearned Consulting Revenue . . 2,750

Receipt Recorded as Liability

Dec . 31 Unearned Consulting Revenue . 250 Consulting Revenue . . . . . . 250

EXHIBIT 3A.5 Adjusting Entry for Unearned Revenues for the Two Alternatives

EXHIBIT 3A.6 Account Balances under Two Alternatives for Recording Unearned Revenues

Unearned Consulting Revenue 236

Dec . 31 2,750

Unearned Consulting Revenue 236

Dec . 31 250 Dec . 26 3,000

Balance 2,750

Receipt Recorded as RevenueReceipt Recorded as Liability

Consulting Revenue 403

Dec . 31 2,750 Dec . 26 3,000

Balance 250

Consulting Revenue 403

Dec . 31 250

At the end of its accounting period on December 31, insurance protection for one month has expired. This means $100 ($2,400∕24) of insurance coverage expired and is an expense for December. The adjusting entry depends on how the original payment was recorded. This is shown in Exhibit 3A.2.

Chapter 3 Adjusting Accounts for Financial Statements 113

APPENDIX

Work Sheet as a Tool 3B Benefits of a Work Sheet (Spreadsheet) A work sheet is a document that is used internally by companies to help with adjusting and closing accounts and with preparing financial state- ments. It is an internal accounting aid and is not a substitute for journals, ledgers, or financial statements. A work sheet

Helps in preparing financial statements. Reduces the risk of errors when working with many accounts and adjustments. Links accounts and adjustments to financial statements. Shows the effects of proposed or “what-if” transactions.

Use of a Work Sheet When a work sheet is used to prepare financial statements, it is con- structed at the end of a period before the adjusting process. The complete work sheet includes a list of the accounts, their balances and adjustments, and their sorting into financial statement columns. It provides two columns each for the unadjusted trial balance, the adjustments, the adjusted trial balance, the income statement, and the balance sheet. To describe and interpret the work sheet, we use the information from FastForward. Preparing the work sheet has five steps.

1 Step 1. Enter Unadjusted Trial Balance Refer to Exhibit 3B.1—green section. The first step in preparing a work sheet is to list the title of every account and its account number that appears on its financial statements. This includes all accounts in the ledger plus any new ones from adjusting entries. The unadjusted balance for each account is then entered in the correct Debit or Credit column of the Unadjusted Trial Balance columns. The totals of these two columns must be equal. The light green section of Exhibit 3B.1 shows FastForward’s work sheet after completing this first step (dark green rows show accounts that arise because of the adjustments). Sometimes an account can require more than one adjustment, such as for Consulting Revenue. The addi- tional adjustment can be added to a blank line below (as in Exhibit 3B.1), squeezed on one line, or com- bined into one adjustment amount.

2 Step 2. Enter Adjustments Exhibit 3B.1—yellow section. The second step is to enter adjustments in the Adjustments columns. The adjustments shown are the same ones shown in Exhibit 3.13. An identifying letter links the debit and credit of each adjustment. This is called keying the adjustments. After preparing a work sheet, adjust- ments must still be entered in the journal and posted to the ledger. The Adjustments columns provide the information for adjusting entries in the journal.

3 Step 3. Prepare Adjusted Trial Balance Exhibit 3B.1—blue section. The adjusted trial balance is prepared by combining the adjustments with the unadjusted balances for each account. As an example, the Prepaid Insurance account has a $2,400 debit balance in the Unadjusted Trial Balance columns. This $2,400 debit is combined with the $100 credit in the Adjustments columns to give Prepaid Insurance a $2,300 debit in the Adjusted Trial Balance columns. The totals of the Adjusted Trial Balance columns confirm debits and credits are equal.

4 Step 4. Sort Adjusted Trial Balance Amounts to Financial Statements Exhibit 3B.1—orange section. This step involves sorting account balances from the adjusted trial balance to their proper financial statement columns. Expenses go to the Income Statement Debit column and rev- enues to the Income Statement Credit column. Assets and dividends go to the Balance Sheet Debit col- umn. Liabilities, retained earnings, and common stock go to the Balance Sheet Credit column.

5 Step 5. Total Statement Columns, Compute Income or Loss, and Balance Columns Exhibit 3B.1—purple section. Each financial statement column (from step 4) is totaled. The differ- ence between the Debit and Credit column totals of the Income Statement columns is net income or net loss. This occurs because revenues are entered in the Credit column and expenses in the Debit column. If the Credit total exceeds the Debit total, there is net income. If the Debit total exceeds the Credit total, there is a net loss. For FastForward, the Credit total exceeds the Debit total, giving a $3,785 net income.

P10 Prepare a work sheet and explain its usefulness.

FASTForward

114 Chapter 3 Adjusting Accounts for Financial Statements

8,150

7,850

300

4,365 3,785

8,150

300 1,610

100 1,000 1,050

305

43,245

4,275 1,800 8,670 2,300

26,000

200

39,460 3,785

43,245

300 6,200

210 2,750

30,000 0

300 6,200

210 2,750

30,000 0

7,850 200

300

47,610

4,275 1,800 8,670 2,300

26,000

300 1,610

100 1,000 1,050

305 47,610

(b) (a)

(c)

(e)

1,050 100

300

210

(d) (f)

250 1,800

3,710

(f)

(d)

1,800

250

(b)

300 210 100

1,050

3,710

Account

Unadjusted Trial Balance

Adjusted Trial Balance

Dr.

Adjustments

Cr. Dr. Cr.

Income Statement

Dr. Cr.

Balance Sheet

Dr. Cr.Dr. Cr.No.

1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

Enter all amounts available from ledger accounts. Column totals must be equal.

A work sheet organizes information used to prepare adjusting entries, financial statements, and closing entries.

List all accounts from the ledger; accounts necessary to make accounting adjustments are shaded in dark green.

1a 1b 4a 4b

5a 2

Enter adjustment amounts and use letters to cross-reference debit and credit adjustments. Column totals must be equal.

Combine unadjusted trial balance amounts with the adjustments to get the adjusted trial balance amounts. Column totals must be equal.

Extend all revenue and expense amounts to the income statement columns.

Extend all asset, liability, equity, and dividends amounts to these columns.

Enter two new lines for the (1) Net income or loss. (2) Totals.

Net income (loss) is extended to the credit (debit) column.

First “Totals” row for income statement columns dier by the amount of net income or net loss.

Cash Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock Retained earnings Dividends Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals Net income Totals

101 106 126 128 167

168 201

209 236 307 318 319 403

406 612 622 637 640 652 690

5d Ending balance of retained earnings is computed in the statement of retained earnings.

FastForward Work Sheet

For Month Ended December 31, 2019

A B C D E F G H I J K L M

6,200

3,000

30,000 0

5,800

300

45,300

4,275

9,720 2,400

26,000

200

1,400

1,000

305 45,300

EXHIBIT 3B.1 Work Sheet with Five-Step Process for Completion FASTForward

Chapter 3 Adjusting Accounts for Financial Statements 115

The net income from the Income Statement columns is then entered in the Balance Sheet Credit col- umn. Adding net income to the last Credit column means that it is to be added to retained earnings. If a loss occurs, it is added to the Debit column. This means that it is to be subtracted from retained earnings. The ending balance of retained earnings does not appear in the last two columns as a single amount, but it is computed in the statement of retained earnings using these account balances. When net in- come or net loss is added to the proper Balance Sheet column, the totals of the last two columns must balance. If they do not, one or more errors have occurred.

Work Sheet Applications and Analysis A work sheet does not substitute for financial statements. It is a tool we use to help prepare financial statements. FastForward’s financial statements are shown in Exhibit 3.14. Its income statement amounts are taken from the Income Statement columns of the work sheet. Amounts for its balance sheet and its statement of retained earnings are taken from the Balance Sheet columns of the work sheet. Work sheets are also useful in analyzing the effects of proposed, or what-if, transactions. This is done by entering financial statement amounts in the Unadjusted (what-if) columns. Proposed transactions are then entered in the Adjustments columns. We then compute “adjusted” amounts from these proposed transactions. The extended amounts in the financial statement columns produce pro forma financial statements because they show the statements as if the proposed transactions had occurred.

APPENDIX

Reversing Entries 3C Reversing entries are optional. They are recorded in response to accrued assets and accrued liabilities that were created by adjusting entries at the end of a reporting period. Reversing entries simplify re- cordkeeping. Exhibit 3C.1 shows an example of FastForward’s reversing entries. The top of the exhibit shows the adjusting entry FastForward recorded on December 31 for its employee’s earned but unpaid salary. The entry recorded three days’ salary of $210, which increased December’s total salary expense to $1,610. The entry also recognized a liability of $210. The expense is reported on December’s income statement. The expense account is then closed. The ledger on January 1, 2020, shows a $210 liability and a zero balance in the Salaries Expense account. At this point, the choice is made between using or not using reversing entries.

Accounting without Reversing Entries The path down the left side of Exhibit 3C.1 is described in the chapter. To summarize, when the next payday occurs on January 9, we record payment with a compound entry that debits both the expense and liability accounts and credits Cash. Posting that entry creates a $490 balance in the expense account and reduces the liability account balance to zero because the payable has been settled.

Accounting with Reversing Entries The right side of Exhibit 3C.1 shows reversing entries. A reversing entry is the exact opposite of an adjusting entry. For FastForward, the Salaries Payable liability account is debited for $210, meaning that this account now has a zero balance after the entry is posted on January 1. The Salaries Payable account temporarily understates the liability, but this is not a problem because financial statements are not prepared before the liability is settled on January 9. The credit to the Salaries Expense account is unusual because it gives the account an abnormal credit balance. We highlight an abnormal balance by circling it. Because of the reversing entry, the January 9 entry to record payment debits the Salaries Expense account and credits Cash for the full $700 paid. It is the same as all other entries made to record 10 days’ salary for the employee. We see that after the payment entry is posted, the Salaries Expense account has a $490 balance that reflects seven days’ salary of $70 per day (see the lower right side of Exhibit 3C.1). The zero balance in the Salaries Payable account is now correct. The lower section of Exhibit 3C.1 shows that the expense and liability accounts have exactly the same balances whether reversing entries are used or not.

P11 Prepare reversing entries and explain their purpose.

Point: Adjusting entries that cre- ate new asset or liability accounts likely require reversing.

116 Chapter 3 Adjusting Accounts for Financial Statements

Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Prepaid insurance expires:

Supplies are used up:

Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Depreciation of assets:

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Accumulated Depreciation—Equipment . . . . . . . . . 300

Salaries Expense

Accrue salaries expense on December 31, 2019

No reversing entry recorded on Jan. 1, 2020

WITHOUT Reversing Entries WITH Reversing Entries

Under both approaches, the expense and liability accounts have identical balances after the cash payment on January 9.

210 Salaries Payable 210

Salaries Expense

Salaries Payable

Date 2019 Dec. 12 700 700(7)

26 31

700 1,400 1,610

(16) 210(e)

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 210210

Expl. Debit BalanceCredit

Salaries Expense $490 Salaries Payable $ 0

Reversing entry recorded on Jan. 1, 2020— OR —

*Circled numbers in the Balance column indicate abnormal balances.

Salaries Expense 490 Salaries Payable 210

Cash 700 Salaries Expense

Salaries Payable

Date 2020 Jan. 9 490 490

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 210210

Expl. Debit BalanceCredit

NO ENTRY

Salaries Expense

Salaries Payable

Date 2020

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 2020

210210

2020 Jan. 9 0210

Expl. Debit BalanceCredit

Salaries Expense 700 Cash 700

Salaries Expense*

Salaries Payable

Date 2020 Jan. 1 Jan. 9 700 490

(e)

Expl. Debit

210

BalanceCredit

Date 2019 Dec. 31 210210 2020 Jan. 1 0210

Expl. Debit BalanceCredit

Salaries Expense*

Salaries Payable

Date 2020

(e)

Expl. Debit BalanceCredit

Date 2019 Dec. 31 2020 Jan. 1

210210

210 0

Expl. Debit BalanceCredit

Salaries Payable 210 Salaries Expense 210

Jan. 1 210

210

Pay the accrued and current salaries on January 9, the first payday in 2020

EXHIBIT 3C.1 Reversing Entries for an Accrued Expense

DEFERRAL OF EXPENSE Prepaid expenses: Assets paid for in advance of receiving their benefits. When these assets are used, the advance payments become expenses.

Summary: Cheat Sheet

Accumulated depreciation: A separate contra account. A contra account is an account linked with another account. It has an opposite normal bal- ance and is a subtraction from that other account’s balance.

Chapter 3 Adjusting Accounts for Financial Statements 117

ACCRUED EXPENSE Accrued expenses: Costs incurred in a period that are both unpaid and unrecorded. They are reported on the income statement for the period when incurred.

Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210 Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Salaries expense owed but not yet paid:

Record unearned revenue (cash received in advance):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Unearned Consulting Revenue . . . . . . . . . . . . . . . . 3,000

Reduce unearned revenue (products or services are provided):

Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . 250 Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 250

DEFERRAL OF REVENUE Unearned revenue: Cash received in advance of providing products and services. When cash is accepted, the company has a liability to provide products or services.

Accrued interest formula:

Principal amount owed × Annual interest rate × Fraction of year since last payment

Salaries Payable (3 days at $70 per day) . . . . . . . . . . . . 210 Salaries Expense (7 days at $70 per day) . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700

Payment of accrued expenses:

REPORTING AND ANALYSIS Unadjusted trial balance: A list of ledger accounts and balances before adjustments are recorded. Adjusted trial balance: A list of accounts and balances after adjusting entries have been recorded and posted to the ledger.

Revenue earned but not received in cash:

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Receipt of accrued revenue:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,700 Accounts Receivable (20 days at $90 per day) . . . 1,800 Consulting Revenue (10 days at $90 per day) . . . 900

ACCRUED REVENUE Accrued revenues: Revenues earned in a period that are both unrecorded and not yet received in cash.

Steps to Prepare Financial Statements Prepare income statement using revenue and expense accounts from trial balance

Prepare balance sheet using asset and liability accounts along with common stock from trial balance; pull updated retained earnings from step 2

Prepare statement of retained earnings using retained earnings and dividends from trial balance; pull net income from step 1

Prepare statement of cash flows from changes in cash flows for the period (illustrated later in the book)

Step 1

Step 2

Step 4

Step 3

$47,610

Acct. No. Account Title Debit

8,670 2,300

1,800 $ 4,275

26,000

300 1,610

100 1,000 1,050

305

106 126 128 167 168 201 209

Unearned consulting revenue ............236

690

$ 300

210 6,200

2,750 30,000

300 7,850

$47,610

Credit

Common stock ....................................... Retained earnings .................................

307 318 0

200Dividends .................................................319

Step 2 Prepare statement of retained earnings

$ 3,785

200 $3,585

3,785 Less: Dividends .................................. . . . Retained earnings, December 31 ......

Retained earnings, December 1......... Plus: Net income ................................... . . .

Assets

Liabilities

Equity

Cash ..................................................... $ 4,275

Accounts payable .............................

Accounts receivable ........................ 1,800

Unearned consulting revenue ....... 2,750 Salaries payable ................................ 210

8,670 2,300

Supplies .............................................. Prepaid insurance .............................

Total assets ........................................ $ 42,745 25,700

$26,000

6,200

Equipment .......................................... 300Less accumulated depreciation......

Common stock ................................... Retained earnings .............................. Total equity ......................................... Total liabilities and equity ...............

3,585

Total liabilities ....................................... 9,160

30,000

$ 42,745 33,585

Step 1 Prepare income statement

Revenues Consulting revenue ............................. $7,850

300 Rental revenue ..................................... Total revenues ......................................

Depreciation expense—Equip.......... Expenses

300 1,610 100

305

1,000 1,050

4,365 $3,785

$8,150

Step 3 Prepare balance sheet

FASTFORWARD Balance Sheet

December 31, 2019

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

FASTFORWARD Income Statement

For Month Ended December 31, 2019

FASTFORWARD Adjusted Trial Balance

December 31, 2019

Preparing financial statements from adjusted trial balance:

CLOSING PROCESS Closing process: Occurs at period-end after financial statements have been prepared. Resets revenue, expense, and dividends balances to zero. Temporary accounts: Closed at period-end. They consist of revenue, expense, dividends, and Income Summary. Permanent accounts: Not closed at period-end. They consist of asset, liability, common stock, and retained earnings (all balance sheet accounts). Income Summary: A temporary account only used for the closing process that has a credit for total revenues and a debit for total expenses.

Balance 8,150 8,150

Expense Accounts

4,365 8,150

Balance 3,785

Income Summary

3,785

Balance 30,000

200 3,785

Balance 33,585

Retained Earnings 3 Close income statement credit balances1

Close income statement debit balances2

Close Income Summary account3

Close dividends account4

Four-Step Closing Process

Balance 200 200

Dividends

Balance 4,365 4,365 2

Revenue Accounts

Closing Process Journal Entries by Step

Consulting Revenue . . . . . . . . . . . . . 7,850 Rental Revenue . . . . . . . . . . . . . . . . . 300 Income Summary . . . . . . . . . . . . . 8,150

Income Summary . . . . . . . . . . . . . . . . 4,365 Depreciation Expense—Equip . . . . 300 Salaries Expense . . . . . . . . . . . . . . 1,610 Insurance Expense . . . . . . . . . . . . 100 Rent Expense . . . . . . . . . . . . . . . . 1,000 Supplies Expense . . . . . . . . . . . . . 1,050 Utilities Expense . . . . . . . . . . . . . . 305

Income Summary . . . . . . . 3,785 Retained Earnings . . . . 3,785

Retained Earnings . . . . . . 200 Dividends . . . . . . . . . . . 200

Post-closing trial balance: A list of permanent accounts (assets, liabili- ties, equity) and their balances after all closing entries.

118 Chapter 3 Adjusting Accounts for Financial Statements

CLASSIFIED BALANCE SHEET Classified balance sheet: Organizes assets and liabilities into meaningful subgroups. Current vs. long-term classification: Current items are to be col- lected or owed within one year. Long-term items are expected after one year. Current assets: Assets to be sold, collected, or used within one year. Examples are cash, short-term investments, accounts receivable, short- term notes receivable, merchandise, inventory, and prepaid expenses. Long-term investments: Assets to be held for more than one year. Examples are notes receivable, long-term investments in stock and bonds, and land held for future expansion. Plant assets: Tangible assets used to produce or sell products and services. Examples are equipment, machinery, buildings, and land used in operations. Intangible assets: Long-term assets that lack physical form. Examples are patents, trademarks, copyrights, franchises, and goodwill.

Current liabilities: Liabilities to be paid or settled within one year. Examples are accounts payable, wages payable, taxes payable, interest pay- able, unearned revenues, and current portions of notes or long-term debt. Long-term liabilities: Liabilities not due within one year. Examples are notes payable, mortgages payable, bonds payable, and lease obligations. Equity: The owner’s claim on assets. For a corporation, this is common stock and retained earnings.

Common Layout of Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities Noncurrent assets Noncurrent liabilities Long-term investments Plant assets Equity Intangible assets

Accounting cycle (104) Accounting period (85) Accrual basis accounting (86) Accrued expenses (93) Accrued revenues (95) Accumulated depreciation (90) Adjusted trial balance (98) Adjusting entry (87) Annual financial statements (85) Book value (90) Cash basis accounting (86) Classified balance sheet (105) Closing entries (101) Closing process (100) Contra account (90)

Current assets (106) Current liabilities (107) Current ratio (108) Depreciation (89) Expense recognition (or matching)

principle (87) Fiscal year (85) Income Summary (101) Intangible assets (107) Interim financial statements (85) Long-term investments (106) Long-term liabilities (107) Natural business year (86) Operating cycle (106) Permanent accounts (101)

Plant assets (89) Post-closing trial balance (104) Prepaid expenses (87) Pro forma financial statements (115) Profit margin (108) Revenue recognition principle (87) Reversing entries (115) Straight-line depreciation (89) Temporary accounts (101) Time period assumption (85) Unadjusted trial balance (98) Unclassified balance sheet (105) Unearned revenue (91) Work sheet (113)

Key Terms

Multiple Choice Quiz

1. A company forgot to record accrued and unpaid employee wages of $350,000 at period-end. This oversight would a. Understate net income by $350,000. b. Overstate net income by $350,000. c. Have no effect on net income. d. Overstate assets by $350,000. e. Understate assets by $350,000.

2. Prior to recording adjusting entries, the Supplies account has a $450 debit balance. A physical count of supplies shows $125 of unused supplies still available. The required adjusting entry is

a. Debit Supplies $125; credit Supplies Expense $125. b. Debit Supplies $325; credit Supplies Expense $325. c. Debit Supplies Expense $325; credit Supplies $325. d. Debit Supplies Expense $325; credit Supplies $125. e. Debit Supplies Expense $125; credit Supplies $125.

3. On May 1 of the current year, a two-year insurance policy was purchased for $24,000 with coverage to begin immedi- ately. What is the amount of insurance expense that appears on the company’s income statement for the current year ended December 31? a. $4,000 c. $12,000 e. $24,000 b. $8,000 d. $20,000

Chapter 3 Adjusting Accounts for Financial Statements 119

A(B,C) Superscript letter A, B, or C denotes assignments based on Appendix 3A, 3B, or 3C.

Icon denotes assignments that involve decision making.

1. What is the difference between the cash basis and the accrual basis of accounting?

2. Why is the accrual basis of accounting generally preferred over the cash basis?

3. What type of business is most likely to select a fiscal year that corresponds to its natural business year instead of the calendar year?

4. What is a prepaid expense and where is it reported in the financial statements?

5. What contra account is used when recording and re- porting the effects of depreciation? Why is it used?

6. What is an accrued revenue? Give an example. 7. What are the steps in recording closing entries? 8. What is the purpose of the Income Summary account? 9. Explain whether an error has occurred if a post-closing

trial balance includes a Depreciation Expense account. 10. What is a company’s operating cycle? 11. What classes of assets and liabilities are shown on a typical

classified balance sheet? 12. How is unearned revenue classified on the balance sheet?

13.A If a company initially records prepaid expenses with debits to expense accounts, what type of account is debited in the adjusting entries for those prepaid expenses?

14.C If a company recorded accrued salaries expense of $500 at the end of its fiscal year, what reversing entry could be made? When would it be made?

15. Refer to Apple’s most recent balance sheet in Appendix A. What five main noncurrent as- set categories are used on its classified balance sheet?

16. Refer to Google’s most recent balance sheet in Appendix A. Identify the six accounts listed as current liabilities.

17. Review Google’s balance sheet in Appendix A. Identify the amount for prop- erty and equipment. What adjusting entry is necessary (no numbers required) for this account when preparing finan- cial statements?

18. Refer to Samsung’s financial state- ments in Appendix A. What journal entry was likely recorded as of December 31, 2017, to close its Income Summary account?

Discussion Questions

APPLE

Samsung

GOOGLE

4. On November 1, Stockton Co. receives $3,600 cash from Hans Co. for consulting services to be provided evenly over the period November 1 to April 30—at which time Stockton credits $3,600 to Unearned Consulting Fees. The adjusting entry on December 31 (Stockton’s year-end) would include a a. Debit to Unearned Consulting Fees for $1,200. b. Debit to Unearned Consulting Fees for $2,400. c. Credit to Consulting Fees Earned for $2,400. d. Debit to Consulting Fees Earned for $1,200. e. Credit to Cash for $3,600.

5. The following information is available for a company before closing the accounts. After all of the closing entries are made, what will be the balance in the Retained Earnings account?

a. $360,000 d. $150,000 b. $250,000 e. $60,000 c. $160,000

Total revenues . . $300,000

Total expenses . . 195,000

Retained earnings . . . $100,000

Dividends . . . . . . . . . . 45,000

ANSWERS TO MULTIPLE CHOICE QUIZ

1. b; the forgotten adjusting entry is: dr. Wages Expense, cr. Wages Payable.

2. c; Supplies used = $450 − $125 = $325 3. b; Insurance expense = $24,000 × (8∕24) = $8,000; adjusting entry

is: dr. Insurance Expense for $8,000, cr. Prepaid Insurance for $8,000.

4. a; Consulting fees earned = $3,600 × (2∕6) = $1,200; adjusting entry is: dr. Unearned Consulting Fees for $1,200, cr. Consulting Fees Earned for $1,200.

5. c; $100,000 + $300,000 − $195,000 − $45,000

QUICK STUDY

QS 3-1 Periodic reporting

Choose from the following list of terms and phrases to best complete the statements below. a. Fiscal year c. Accrual basis accounting e. Cash basis accounting b. Timeliness d. Annual financial statements f. Time period assumption 1. presumes that an organization’s activities can be divided into specific time periods. 2. Financial reports covering a one-year period are known as . 3. A(n) consists of any 12 consecutive months. 4. records revenues when services are provided and records expenses when incurred. 5. The value of information is often linked to its .

120 Chapter 3 Adjusting Accounts for Financial Statements

QS 3-2 Computing accrual and cash income

In its first year of operations, Roma Company reports the following.

∙ Earned revenues of $45,000 ($37,000 cash received from customers). ∙ Incurred expenses of $25,500 ($20,250 cash paid toward them). ∙ Prepaid $6,750 cash for costs that will not be expensed until next year.

Compute Roma’s first-year net income under the cash basis and the accrual basis of accounting.

QS 3-3 Identifying accounting adjustments

P1 P2 P3 P4

Classify the following adjusting entries as involving prepaid expenses (PE), unearned revenues (UR), accrued expenses (AE), or accrued revenues (AR).

a. To record revenue earned that was previously received as cash in advance. b. To record wages expense incurred but not yet paid (nor recorded). c. To record revenue earned but not yet billed (nor recorded). d. To record expiration of prepaid insurance. e. To record annual depreciation expense.

QS 3-4 Concepts of adjusting entries

P1 P2 P3 P4

During the year, a company recorded prepayments of expenses in asset accounts and cash receipts of unearned revenues in liability accounts. At the end of its annual accounting period, the company must make three adjusting entries. (1) Accrue salaries expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dr. ___ Cr. ___ (2) Adjust the Unearned Services Revenue account to recognize earned revenue. . . . . . . Dr. ___ Cr. ___ (3) Record services revenue earned for which cash will be received the following period.. . Dr. ___ Cr. ___

For each of the adjusting entries (1), (2), and (3), indicate the account to be debited and the account to be credited—from a through i below. a. Prepaid Insurance d. Unearned Services Revenue g. Accounts Receivable b. Cash e. Salaries Expense h. Accounts Payable c. Salaries Payable f. Services Revenue i. Depreciation Expense

QS 3-5 Prepaid (deferred) expenses adjustments

For each separate case below, follow the three-step process for adjusting the prepaid asset account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Prepaid Insurance. The Prepaid Insurance account has a $4,700 debit balance to start the year. A

review of insurance policies shows that $900 of unexpired insurance remains at year-end. b. Prepaid Insurance. The Prepaid Insurance account has a $5,890 debit balance at the start of the year.

A review of insurance policies shows $1,040 of insurance has expired by year-end. c. Prepaid Rent. On September 1 of the current year, the company prepaid $24,000 for two years of rent

for facilities being occupied that day. The company debited Prepaid Rent and credited Cash for $24,000.

QS 3-6 Prepaid (deferred) expenses adjustments

For each separate case below, follow the three-step process for adjusting the Supplies asset account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Supplies. The Supplies account has a $300 debit balance to start the year. No supplies were purchased

during the current year. A December 31 physical count shows $110 of supplies remaining. b. Supplies. The Supplies account has an $800 debit balance to start the year. Supplies of $2,100 were

purchased during the current year and debited to the Supplies account. A December 31 physical count shows $650 of supplies remaining.

c. Supplies. The Supplies account has a $4,000 debit balance to start the year. During the current year, supplies of $9,400 were purchased and debited to the Supplies account. The inventory of supplies available at December 31 totaled $2,660.

QS 3-7 Adjusting prepaid (deferred) expenses

For each separate case, record the necessary adjusting entry. a. On July 1, Lopez Company paid $1,200 for six months of insurance coverage. No adjustments have

been made to the Prepaid Insurance account, and it is now December 31. Prepare the year-end adjust- ing entry to reflect expiration of the insurance as of December 31.

Chapter 3 Adjusting Accounts for Financial Statements 121

QS 3-8 Accumulated depreciation adjustments

For each separate case below, follow the three-step process for adjusting the Accumulated Depreciation account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Accumulated Depreciation. The Krug Company’s Accumulated Depreciation account has a $13,500

balance to start the year. A review of depreciation schedules reveals that $14,600 of depreciation expense must be recorded for the year.

b. Accumulated Depreciation. The company has only one fixed asset (truck) that it purchased at the start of this year. That asset had cost $44,000, had an estimated life of five years, and is expected to have zero value at the end of the five years.

c. Accumulated Depreciation. The company has only one fixed asset (equipment) that it purchased at the start of this year. That asset had cost $32,000, had an estimated life of seven years, and is expected to be valued at $4,000 at the end of the seven years.

QS 3-9 Adjusting for depreciation

For each separate case, record an adjusting entry (if necessary). a. Barga Company purchases $20,000 of equipment on January 1. The equipment is expected to last five

years and be worth $2,000 at the end of that time. Prepare the entry to record one year’s depreciation expense of $3,600 for the equipment as of December 31.

b. Welch Company purchases $10,000 of land on January 1. The land is expected to last forever. What depreciation adjustment, if any, should be made with respect to the Land account as of December 31?

QS 3-10 Unearned (deferred) revenues adjustments

For each separate case below, follow the three-step process for adjusting the unearned revenue liability account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Unearned Rent Revenue. The Krug Company collected $6,000 rent in advance on November 1, deb-

iting Cash and crediting Unearned Rent Revenue. The tenant was paying 12 months’ rent in advance and occupancy began November 1.

b. Unearned Services Revenue. The company charges $75 per insect treatment. A customer paid $300 on October 1 in advance for four treatments, which was recorded with a debit to Cash and a credit to Unearned Services Revenue. At year-end, the company has applied three treatments for the customer.

c. Unearned Rent Revenue. On September 1, a client paid the company $24,000 cash for six months of rent in advance (the client leased a building and took occupancy immediately). The company recorded the cash as Unearned Rent Revenue.

QS 3-11 Adjusting for unearned (deferred) revenues

For each separate case, record the necessary adjusting entry. a. Tao Co. receives $10,000 cash in advance for four months of evenly planned legal services beginning

on October 1. Tao records it by debiting Cash and crediting Unearned Revenue both for $10,000. It is now December 31, and Tao has provided legal services as planned. What adjusting entry should Tao make to account for the work performed from October 1 through December 31?

b. Caden started a new publication called Contest News. Its subscribers pay $24 to receive 12 monthly issues. With every new subscriber, Caden debits Cash and credits Unearned Subscription Revenue for the amounts received. The company has 100 new subscribers as of July 1. It sends Contest News to each of these subscribers every month from July through December. Assuming no changes in sub- scribers, prepare the year-end journal entry that Caden must make as of December 31 to adjust the Subscription Revenue account and the Unearned Subscription Revenue account.

b. Zim Company has a Supplies account balance of $5,000 at the beginning of the year. During the year, it purchases $2,000 of supplies. As of December 31, a physical count of supplies shows $800 of supplies available. Prepare the adjusting journal entry to correctly report the balance of the Supplies account and the Supplies Expense account as of December 31.

For each separate case below, follow the three-step process for adjusting the accrued expense account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Salaries Payable. At year-end, salaries expense of $15,500 has been incurred by the company but is

not yet paid to employees.

QS 3-12 Accrued expenses adjustments

[continued on next page]

122 Chapter 3 Adjusting Accounts for Financial Statements

Molly Mocha employs one college student every summer in her coffee shop. The student works the five weekdays and is paid on the following Monday. (For example, a student who works Monday through Friday, June 1 through June 5, is paid for that work on Monday, June 8.) The coffee shop adjusts its books monthly, if needed, to show salaries earned but unpaid at month-end. The student works the last week of July, which is Monday, July 28, through Friday, August 1. If the student earns $100 per day, what adjust- ing entry must the coffee shop make on July 31 to correctly record accrued salaries expense for July?

QS 3-13 Accruing salaries

For each separate case below, follow the three-step process for adjusting the accrued revenue account at December 31. Step 1: Determine what the current account balance equals. Step 2: Determine what the current account balance should equal. Step 3: Record the December 31 adjusting entry to get from step 1 to step 2. Assume no other adjusting entries are made during the year. a. Accounts Receivable. At year-end, the L. Cole Company has completed services of $19,000 for a

client, but the client has not yet been billed for those services. b. Interest Receivable. At year-end, the company has earned, but not yet recorded, $390 of interest

earned from its investments in government bonds. c. Accounts Receivable. A painting company bills customers when jobs are complete. The work for one

job is now complete. The customer has not yet been billed for the $1,300 of work.

QS 3-14 Accrued revenues adjustments

Adjusting entries affect at least one balance sheet account and at least one income statement account. For the entries below, identify the account to be debited and the account to be credited from the following ac- counts: Cash; Accounts Receivable; Prepaid Insurance; Equipment; Accumulated Depreciation; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Insurance Expense; and Depreciation Expense. Indicate which of the accounts is the income statement account and which is the balance sheet account. a. Entry to record revenue earned that was previously received as cash in advance. b. Entry to record wage expenses incurred but not yet paid (nor recorded). c. Entry to record revenue earned but not yet billed (nor recorded). d. Entry to record expiration of prepaid insurance. e. Entry to record annual depreciation expense.

QS 3-15 Recording and analyzing adjusting entries

P1 P2 P3 P4

In making adjusting entries at the end of its accounting period, Chao Consulting mistakenly forgot to record: 1. $3,200 of insurance coverage that had expired (this $3,200 cost had been initially debited to the

Prepaid Insurance account). 2. $2,000 of accrued salaries expense. As a result of these two oversights, the financial statements for the reporting period will [choose one]: a. Understate assets by $3,200. c. Understate net income by $2,000. b. Understate expenses by $5,200. d. Overstate liabilities by $2,000.

QS 3-16 Determining effects of adjusting entries

P1 P3

Following are unadjusted balances along with year-end adjustments for Quinlan Company. Complete the adjusted trial balance by entering the adjusted balance for each of the following accounts.

QS 3-17 Preparing an adjusted trial balance

P5 $8,000

2,000 4,500

5,500 0

3,000 6,000

11,000

101 106 126 209 307 318 403 622 652

Cash Accounts receivable Supplies Salaries payable Common stock Retained earnings Consulting revenue Salaries expense Supplies expense

Account Title Dr.

$4,000

400 2,500

Dr.

$2,500

400

4,000

Cr.Cr.No. Unadjusted Trial Balance

Dr. Cr. Adjusted Trial BalanceAdjustments

$ 0

The ledger of Mai Company includes the following accounts with normal balances as of December 31: Common Stock $9,000; Dividends $800; Services Revenue $13,000; Wages Expense $8,400; and Rent Expense $1,600. Prepare its December 31 closing entries.

QS 3-18 Preparing closing entries from the ledger P7

b. Interest Payable. At its December 31 year-end, the company owes $250 of interest on a line-of-credit loan. That interest will not be paid until sometime in January of the next year.

c. Interest Payable. At its December 31 year-end, the company holds a mortgage payable that has in- curred $875 in annual interest that is neither recorded nor paid. The company intends to pay the inter- est on January 7 of the next year.

Chapter 3 Adjusting Accounts for Financial Statements 123

Identify which of the following accounts would be included in a post-closing trial balance. a. Accounts Receivable c. Goodwill e. Income Tax Expense b. Salaries Expense d. Land f. Salaries Payable

QS 3-19 Identifying post-closing accounts P8

The following are common categories on a classified balance sheet. A. Current assets C. Plant assets E. Current liabilities B. Long-term investments D. Intangible assets F. Long-term liabilities

For each of the following items, select the letter that identifies the balance sheet category where the item typically would best appear.

1. Land held for future expansion 5. Accounts payable 2. Notes payable (due in five years) 6. Store equipment 3. Accounts receivable 7. Wages payable 4. Trademarks 8. Cash

QS 3-21 Classifying balance sheet items

List the following steps of the accounting cycle in their proper order. a. Posting the journal entries. b. Journalizing and posting adjusting entries. c. Preparing the adjusted trial balance. d. Journalizing and posting closing entries. e. Analyzing transactions and events.

QS 3-20 Identifying the accounting cycle

f. Preparing the financial statements. g. Preparing the unadjusted trial balance. h. Journalizing transactions and events. i. Preparing the post-closing trial balance.

Use the following adjusted trial balance of Sierra Company to prepare its (1) income statement and (2) statement of retained earnings for the year ended December 31. The Retained Earnings account bal- ance was $5,500 on December 31 of the prior year.

QS 3-22 Preparing financial statements

P6 Cash Prepaid insurance Notes receivable (due in 5 years) Buildings Accumulated depreciation—Buildings Accounts payable Notes payable (due in 3 years) Common stock Retained earnings Dividends Consulting revenue Wages expense Depreciation expense—Buildings Insurance expense

Adjusted Trial Balance Debit Credit

$12,000 2,500 3,000 5,000 5,500

9,500

$37,500

$ 5,000 500

4,000 20,000

3,500 2,000 1,500

$37,500

1,000

Totals

Damita Company reported net income of $48,025 and net sales of $425,000 for the current year. Calculate the company’s profit margin and interpret the result. Assume that its competitors earn an average profit margin of 15%.

QS 3-24 Analyzing profit margin

Use the information in the adjusted trial balance reported in QS 3-22 to prepare Sierra Company’s classi- fied balance sheet as of December 31.

QS 3-23 Preparing a classified balance sheet C3

Compute Chavez Company’s current ratio using the following information. QS 3-25 Identifying current accounts and computing the current ratio

Accounts receivable . . . . . . . . . . . . $18,000 Long-term notes payable . . . . . . . . . . . . . . . $21,000

Accounts payable . . . . . . . . . . . . . . 11,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . 2,800

Buildings . . . . . . . . . . . . . . . . . . . . . 45,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . 3,560

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Unearned services revenue . . . . . . . . . . . . . 3,000

124 Chapter 3 Adjusting Accounts for Financial Statements

QS 3-26A Preparing adjusting entries

Garcia Company had the following selected transactions during the year. (A partial chart of accounts fol- lows: Cash; Accounts Receivable; Prepaid Insurance; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Insurance Expense; Depreciation Expense.)

Jan. 1 The company paid $6,000 cash for 12 months of insurance coverage beginning immediately. Aug. 1 The company received $2,400 cash in advance for 6 months of contracted services beginning on

August 1 and ending on January 31. Dec. 31 The company prepared any necessary year-end adjusting entries related to insurance coverage

and services performed.

a. Record journal entries for these transactions assuming Garcia follows the usual practice of recording a prepayment of an expense in an asset account and recording a prepayment of revenue received in a liability account.

b. Record journal entries for these transactions assuming Garcia follows the alternative practice of re- cording a prepayment of an expense in an expense account and recording a prepayment of revenue received in a revenue account.

QS 3-28C Reversing entries

P11

On December 31, Yates Co. prepared an adjusting entry for $12,000 of earned but unrecorded consulting revenue. On January 16, Yates received $26,700 cash as payment in full for consulting work it provided that began on December 18 and ended on January 16. The company uses reversing entries. a. Prepare the December 31 adjusting entry. c. Prepare the January 16 cash receipt entry. b. Prepare the January 1 reversing entry.

The Adjusted Trial Balance columns of a 10-column work sheet for Planta Company follow. Complete the work sheet by extending the account balances into the appropriate financial statement columns and by entering the amount of net income for the reporting period.

QS 3-27B Extending accounts in a work sheet P10

$ 7,000 27,200 42,000

32,000

15,400

6,500 38,000 13,000 8,700

$189,800

$ 17,500

15,000 4,200 3,600

20,000 45,500

84,000

$189,800

101 106 153 154 183 201 209 233 307 318 319 401 611 622 640 677

Cash Accounts receivable Trucks Accumulated depreciation—Trucks Land Accounts payable Salaries payable Unearned fees Common stock Retained earnings Dividends Plumbing fees earned Depreciation expense—Trucks Salaries expense Rent expense Miscellaneous expenses Totals Net income Totals

Account Title

Unadjusted Trial Balance

Adjusted Trial Balance

Dr. Adjustments

Cr. Dr. Cr.

Income Statement

Dr. Cr. Balance Sheet

Dr. Cr.Dr. Cr.No.

Check Net income, $17,800

EXERCISES

Exercise 3-1 Preparing adjusting entries

P1 P2 P3

Prepare adjusting journal entries for the year ended (date of) December 31 for each of these separate situ- ations. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Supplies; Prepaid Insurance; Prepaid Rent; Equipment; Accumulated Depreciation—Equipment; Wages Payable; Unearned Revenue; Revenue; Wages Expense; Supplies Expense; Insurance Expense; Rent Expense; and Depreciation Expense—Equipment. a. Depreciation on the company’s equipment for the year is computed to be $18,000. b. The Prepaid Insurance account had a $6,000 debit balance at December 31 before adjusting for the

costs of any expired coverage. An analysis of the company’s insurance policies showed that $1,100 of unexpired insurance coverage remains.

c. The Supplies account had a $700 debit balance at the beginning of the year; and $3,480 of supplies were purchased during the year. The December 31 physical count showed $300 of supplies available.

Check (c) Dr. Supplies Expense, $3,880

Chapter 3 Adjusting Accounts for Financial Statements 125

Exercise 3-2 Adjusting and paying accrued wages

Pablo Management has five employees, each of whom earns $250 per day. They are paid on Fridays for work completed Monday through Friday of the same week. Near year-end, the five employees worked Monday, December 31, and Wednesday through Friday, January 2, 3, and 4. New Year’s Day (January 1) was an unpaid holiday. a. Prepare the year-end adjusting entry for wages expense. b. Prepare the journal entry to record payment of the employees’ wages on Friday, January 4.

Exercise 3-3 Adjusting and paying accrued expenses

The following three separate situations require adjusting journal entries to prepare financial statements as of April 30. For each situation, present both: ∙ The April 30 adjusting entry. ∙ The subsequent entry during May to record payment of the accrued expenses. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Salaries Payable; Interest Payable; Legal Services Payable; Unearned Revenue; Revenue; Salaries Expense; Interest Expense; Legal Services Expense; and Depreciation Expense. a. On April 1, the company hired an attorney for a flat monthly fee of $3,500. Payment for April legal

services was made by the company on May 12. b. As of April 30, $3,000 of interest expense has accrued on a note payable. The full interest payment of

$9,000 on the note is due on May 20. c. Total weekly salaries expense for all employees is $10,000. This amount is paid at the end of the day

on Friday of each five-day workweek. April 30 falls on a Tuesday, which means that the employees had worked two days since the last payday. The next payday is May 3.

Check (b) May 20, Dr. Interest Expense, $6,000

Exercise 3-4 Preparing adjusting entries

P1 P3 P4

For each of the following separate cases, prepare adjusting entries required of financial statements for the year ended (date of) December 31. Entries can draw from the following partial chart of accounts: Cash; Interest Receivable; Supplies; Prepaid Insurance; Equipment; Accumulated Depreciation—Equipment; Wages Payable; Interest Payable; Unearned Revenue; Interest Revenue; Wages Expense; Supplies Expense; Insurance Expense; Interest Expense; and Depreciation Expense—Equipment. a. Wages of $8,000 are earned by workers but not paid as of December 31. b. Depreciation on the company’s equipment for the year is $18,000. c. The Supplies account had a $240 debit balance at the beginning of the year. During the year, $5,200 of

supplies are purchased. A physical count of supplies at December 31 shows $440 of supplies available. d. The Prepaid Insurance account had a $4,000 balance at the beginning of the year. An analysis of insur-

ance policies shows that $1,200 of unexpired insurance benefits remain at December 31. e. The company has earned (but not recorded) $1,050 of interest revenue for the year ended December

31. The interest payment will be received 10 days after the year-end on January 10. f. The company has a bank loan and has incurred (but not recorded) interest expense of $2,500 for the

year ended December 31. The company will pay the interest five days after the year-end on January 5.

Check (d) Dr. Insurance Expense, $2,800

(e) Cr. Interest Revenue, $1,050

Exercise 3-5 Preparing adjusting entries—accrued revenues and expenses

P3 P4

Prepare year-end adjusting journal entries for M&R Company as of December 31 for each of the following separate cases. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Interest Receivable; Equipment; Wages Payable; Salary Payable; Interest Payable; Lawn Services Payable; Unearned Revenue; Revenue; Interest Revenue; Wages Expense; Salary Expense; Supplies Expense; Lawn Services Expense; and Interest Expense. a. M&R Company provided $2,000 in services to customers in December, which are not yet recorded.

Those customers are expected to pay the company in January following the company’s year-end. b. Wage expenses of $1,000 have been incurred but are not paid as of December 31. c. M&R Company has a $5,000 bank loan and has incurred (but not recorded) 8% interest expense of

$400 for the year ended December 31. The company will pay the $400 interest in cash on January 2 following the company’s year-end.

d. M&R Company hired a firm that provided lawn services during December for $500. M&R will pay for December lawn services on January 15 following the company’s year-end.

e. M&R Company has earned $200 in interest revenue from investments for the year ended December 31. The interest revenue will be received on January 15 following the company’s year-end.

f. Salary expenses of $900 have been earned by supervisors but not paid as of December 31.

d. Two-thirds of the work related to $15,000 of cash received in advance was performed this period. e. The Prepaid Rent account had a $6,800 debit balance at December 31 before adjusting for the costs of

expired prepaid rent. An analysis of the rental agreement showed that $5,800 of prepaid rent had expired. f. Wage expenses of $3,200 have been incurred but are not paid as of December 31.

(e) Dr. Rent Expense, $5,800

126 Chapter 3 Adjusting Accounts for Financial Statements

For each of the following separate cases, prepare the required December 31 year-end adjusting entries. Entries can draw from this partial chart of accounts: Interest Receivable; Prepaid Insurance; Accumulated Depreciation—Equipment; Wages Payable; Unearned Revenue; Consulting Revenue; Interest Revenue; Wages Expense; Insurance Expense; Interest Expense; and Depreciation Expense—Equipment. a. Depreciation on the company’s wind turbine equipment for the year is $5,000. b. The Prepaid Insurance account for the solar panels had a $2,000 debit balance at December 31 before

adjusting for the costs of any expired coverage. Analysis of prepaid insurance shows that $600 of un- expired insurance coverage remains at year-end.

c. The company received $3,000 cash in advance for sustainability consulting work. As of December 31, one-third of the sustainability consulting work had been performed.

d. As of December 31, $1,200 in wages expense for the organic produce workers has been incurred but not yet paid.

e. As of December 31, the company has earned, but not yet recorded, $400 of interest revenue from in- vestments in socially responsible bonds. The interest revenue is expected to be received on January 12.

Exercise 3-6 Preparing adjusting entries

P1 P2 P3 P4

Income Statements For Year Ended December 31

Unadjusted Adjustments Adjusted

Revenues

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000 a . $25,000

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,500 36,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,500 61,500

Expenses

Depreciation expense—Computers . . . . . . . . . . . . . . . . . . 0 b . 1,600

Depreciation expense—Office furniture . . . . . . . . . . . . . . . 0 c . 1,850

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500 d . 15,750

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 e . 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 3,800

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 f . 580

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 2,500

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,245 g . 1,335

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,045 28,815

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,455 $32,685

Following are two income statements for Alexis Co. for the year ended December 31. The left number col- umn is prepared before adjusting entries are recorded, and the right column is prepared after adjusting en- tries. Analyze the statements and prepare the seven adjusting entries a through g that likely were recorded. Hint: The entry for a refers to fees that have been earned but not yet billed. None of the entries involve cash.

Exercise 3-7 Analyzing and preparing adjusting entries

Following are the accounts and balances (in random order) from the adjusted trial balance of Stark Company. Prepare the (1) income statement and (2) statement of retained earnings for the year ended December 31 and (3) balance sheet at December 31. The Retained Earnings account balance was $14,800 on December 31 of the prior year.

Exercise 3-8 Preparing financial statements from a trial balance

P6 Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . $11,000 Accumulated depreciation—Buildings . . . . . . . . . . . . $15,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . 2,500 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . 500 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300

Accounts payable . . . . . . . . . . . . . . . . . . . . . 1,500 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Wages payable . . . . . . . . . . . . . . . . . . . . . . . 400 Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 7,500 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Insurance expense . . . . . . . . . . . . . . . . . . . . 1,800 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Depreciation expense—Buildings . . . . . . . . . . . . . . . 2,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . 14,800 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Services revenue . . . . . . . . . . . . . . . . . . . . . . 20,000

Chapter 3 Adjusting Accounts for Financial Statements 127

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . ¥504,459

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . 283,494

Advertising expense . . . . . . . . . . . . . . . . . . . . . ¥ 46,636

Other expense, net . . . . . . . . . . . . . . . . . . . . . . 157,811

Following are Nintendo’s revenue and expense accounts for a recent March 31 fiscal year-end (yen in millions). Prepare the company’s closing entries for (1) its revenues and (2) its expenses.

Exercise 3-9 Preparing closing entries

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000

126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

168 Accumulated depreciation—Equipment . . . . . . . . . . . . . $ 7,500

307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,600

319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

404 Services revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000

612 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . 3,000

622 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400

652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $99,100 $99,100

The following adjusted trial balance contains the accounts and year-end balances of Cruz Company as of December 31. (1) Prepare the December 31 closing entries for Cruz Company. Assume the ac- count number for Income Summary is 901. (2) Prepare the December 31 post-closing trial balance for Cruz Company. Note: The Retained Earnings account balance was $37,600 on December 31 of the prior year.

Exercise 3-10 Preparing closing entries and a post-closing trial balance

P7 P8

Use the following adjusted year-end trial balance at December 31 of Wilson Trucking Company to pre- pare the (1) income statement and (2) statement of retained earnings for the year ended December 31. The Retained Earnings account balance was $155,000 at December 31 of the prior year.

Exercise 3-11 Preparing financial statements P6

Account Title Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,000

Accumulated depreciation—Trucks . . . . . . . . . . . . . . $ 36,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . 58,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Trucking fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 130,000

Depreciation expense—Trucks . . . . . . . . . . . . . . . . . 23,500

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,000

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . 8,000

Repairs expense—Trucks . . . . . . . . . . . . . . . . . . . . . . 12,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $410,000 $410,000

128 Chapter 3 Adjusting Accounts for Financial Statements

Use the following information to compute profit margin for each separate company a through e. Which of the five companies is the most profitable according to the profit margin ratio? Interpret the profit margin ratio for company c.

Exercise 3-13 Computing and interpreting profit margin

A1 Net Income Net Sales Net Income Net Sales

a. $ 4,361 $ 44,500 d. $65,646 $1,458,800 b. 97,706 398,800 e. 80,132 435,500 c. 111,281 257,000

Ricardo Construction began operations on December 1. In setting up its accounting procedures, the com- pany decided to debit expense accounts when it prepays its expenses and to credit revenue accounts when customers pay for services in advance. Prepare journal entries for items a through d and the adjusting en- tries as of its December 31 period-end for items e through g. Entries can draw from the following partial chart of accounts: Cash; Accounts Receivable; Interest Receivable; Supplies; Prepaid Insurance; Unearned Remodeling Fees; Remodeling Fees Earned; Supplies Expense; Insurance Expense; and Interest Expense. a. Supplies are purchased on December 1 for $2,000 cash. b. The company prepaid its insurance premiums for $1,540 cash on December 2. c. On December 15, the company receives an advance payment of $13,000 cash from a customer for re-

modeling work. d. On December 28, the company receives $3,700 cash from another customer for remodeling work to be

performed in January. e. A physical count on December 31 indicates that the company has $1,840 of supplies available. f. An analysis of insurance policies in effect on December 31 shows that $340 of insurance coverage had

expired. g. As of December 31, only one remodeling project has been worked on and completed. The $5,570 fee

for this project had been received in advance and recorded as remodeling fees earned.

Check (f ) Cr. Insurance Expense, $1,200

(g) Dr. Remodeling Fees Earned, $11,130

Exercise 3-15A Adjusting for prepaids recorded as expenses and unearned revenues recorded as revenues

Use the information in the adjusted trial balance reported in Exercise 3-11 to prepare Wilson Trucking Company’s classified balance sheet as of December 31.

Exercise 3-12 Preparing a classified balance sheet C3

Calculate the current ratio for each of the following companies (round the ratio to two decimals). Identify the company with the strongest liquidity position. (These companies are competitors in the same industry.)

Current Assets Current Liabilities

Edison . . . . . . . . . . $ 79,040 $ 32,000 MAXT . . . . . . . . . . . 104,880 76,000

Chatter . . . . . . . . . 45,080 49,000

TRU . . . . . . . . . . . . 85,680 81,600

Gleeson . . . . . . . . . 61,000 100,000

Exercise 3-14 Computing and analyzing the current ratio

1. Enter the accounts in proper order and enter their balances in the correct Debit or Credit column of the Unadjusted Trial Balance columns of the 10-column work sheet.

The following data are taken from the unadjusted trial balance of the Westcott Company at December 31. Each account carries a normal balance. Set up a 10-column work sheet to answer the requirements.

Exercise 3-16B Preparing unadjusted and adjusted trial balances, including the adjustments

P10 Accounts Payable . . . . . . . . . . . . . . . . . . . . $ 6 Prepaid Insurance . . . . . . $18 Retained Earnings . . . . . . . . . . . . $32

Accounts Receivable . . . . . . . . . . . . . . . . . 12 Revenue . . . . . . . . . . . . . . 75 Dividends . . . . . . . . . . . . . . . . . . . 6

Accumulated Depreciation—Equip . . . . . . . 15 Salaries Expense . . . . . . . 18 Unearned Revenue . . . . . . . . . . . 12

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Supplies . . . . . . . . . . . . . . 24 Utilities Expense . . . . . . . . . . . . . 12

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 39 Common Stock . . . . . . . . 10

[continued on next page]

Chapter 3 Adjusting Accounts for Financial Statements 129

2. Use the following adjustment information to complete the Adjustments columns of the work sheet from part 1.

a. Depreciation on equipment, $3 d. Supplies available at December 31, $15 b. Accrued salaries, $6 e. Expired insurance, $15 c. The $12 of unearned revenue has been earned 3. Extend the balances in the Adjusted Trial Balance columns of the work sheet to the proper financial

statement columns. Compute totals for those columns, including net income.

PROBLEM SET A

Problem 3-1A Identifying adjusting entries with explanations

P1 P2 P3 P4

For journal entries 1 through 12, enter the letter of the explanation that most closely describes it in the space beside each entry. You can use letters more than once. A. To record receipt of unearned revenue. B. To record this period’s earning of prior

unearned revenue. C. To record payment of an accrued expense. D. To record receipt of an accrued revenue.

E. To record an accrued expense. F. To record an accrued revenue. G. To record this period’s use of a prepaid expense. H. To record payment of a prepaid expense. I. To record this period’s depreciation expense.

______ 1. Interest Expense . . . . . . . . . . . . . . . 1,000 Interest Payable . . . . . . . . . . . 1,000

______ 2. Depreciation Expense . . . . . . . . . . 4,000 Accumulated Depreciation . . 4,000

______ 3. Unearned Professional Fees . . . . . 3,000 Professional Fees Earned . . . 3,000

______ 4. Insurance Expense . . . . . . . . . . . . . 4,200 Prepaid Insurance . . . . . . . . . 4,200

______ 5. Salaries Payable . . . . . . . . . . . . . . . 1,400 Cash . . . . . . . . . . . . . . . . . . . . 1,400

______ 6. Prepaid Rent . . . . . . . . . . . . . . . . . . 4,500 Cash . . . . . . . . . . . . . . . . . . . . 4,500

______ 7. Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Salaries Payable . . . . . . . . . . . . . . . . . . . . 6,000

______ 8. Interest Receivable . . . . . . . . . . . . . . . . . . . . . . 5,000 Interest Revenue . . . . . . . . . . . . . . . . . . . 5,000

______ 9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Accounts Receivable (from consulting) . . 9,000

______ 10. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 Unearned Professional Fees . . . . . . . . . . 7,500

______ 11. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Interest Receivable . . . . . . . . . . . . . . . . . . 2,000

______ 12. Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . 2,000

The following two events occurred for Trey Co. on October 31, the end of its fiscal year. a. Trey rents a building from its owner for $2,800 per month. By a prearrangement, the company de-

layed paying October’s rent until November 5. On this date, the company paid the rent for both October and November.

b. Trey rents space in a building it owns to a tenant for $850 per month. By prearrangement, the tenant delayed paying the October rent until November 8. On this date, the tenant paid the rent for both October and November.

Required

1. Prepare adjusting entries that the company must record for these events as of October 31. 2. Assuming Trey does not use reversing entries, prepare journal entries to record Trey’s payment of rent

on November 5 and the collection of the tenant’s rent on November 8. 3. Assuming that the company uses reversing entries, prepare reversing entries on November 1 and the

journal entries to record Trey’s payment of rent on November 5 and the collection of the tenant’s rent on November 8.

Exercise 3-17C Preparing reversing entries

P11

Arnez Company’s annual accounting period ends on December 31, 2019. The following information con- cerns the adjusting entries to be recorded as of that date. Entries can draw from the following partial chart of accounts: Cash; Rent Receivable; Office Supplies; Prepaid Insurance; Building; Accumulated Depreciation—Building; Salaries Payable; Unearned Rent; Rent Earned; Salaries Expense; Office Supplies Expense; Insurance Expense; and Depreciation Expense—Building.

Problem 3-2A Preparing adjusting and subsequent journal entries

P1 P2 P3 P4

[continued on next page]

130 Chapter 3 Adjusting Accounts for Financial Statements

Wells Technical Institute (WTI), a school owned by Tristana Wells, provides training to individuals who pay tuition directly to the school. WTI also offers training to groups in off-site locations. Its unadjusted trial balance as of December 31 follows, along with descriptions of items a through h that require adjust- ing entries on December 31.

Additional Information

a. An analysis of WTI’s insurance policies shows that $2,400 of coverage has expired. b. An inventory count shows that teaching supplies costing $2,800 are available at year-end. c. Annual depreciation on the equipment is $13,200. d. Annual depreciation on the professional library is $7,200. e. On September 1, WTI agreed to do five courses for a client for $2,500 each. Two courses will start

immediately and finish before the end of the year. Three courses will not begin until next year. The client paid $12,500 cash in advance for all five courses on September 1, and WTI credited Unearned Training Fees.

f. On October 15, WTI agreed to teach a four-month class (beginning immediately) for an executive with payment due at the end of the class. At December 31, $7,500 of the tuition has been earned by WTI.

g. WTI’s two employees are paid weekly. As of the end of the year, two days’ salaries have accrued at the rate of $100 per day for each employee.

h. The balance in the Prepaid Rent account represents rent for December.

Problem 3-3A Preparing adjusting entries, adjusted trial balance, and financial statements

P1 P2 P3 P4 P5 P6

Policy Date of Purchase Months of Coverage Cost

A . . . . . . April 1, 2017 24 $14,400

B . . . . . . April 1, 2018 36 12,960

C . . . . . . August 1, 2019 12 2,400

c. The company has 15 employees, who earn a total of $1,960 in salaries each working day. They are paid each Monday for their work in the five-day workweek ending on the previous Friday. Assume that December 31, 2019, is a Tuesday, and all 15 employees worked the first two days of that week. Because New Year’s Day is a paid holiday, they will be paid salaries for five full days on Monday, January 6, 2020.

d. The company purchased a building on January 1, 2019. It cost $960,000 and is expected to have a $45,000 salvage value at the end of its predicted 30-year life. Annual depreciation is $30,500.

e. Since the company is not large enough to occupy the entire building it owns, it rented space to a ten- ant at $3,000 per month, starting on November 1, 2019. The rent was paid on time on November 1, and the amount received was credited to the Rent Earned account. However, the tenant has not paid the December rent. The company has worked out an agreement with the tenant, who has promised to pay both December and January rent in full on January 15. The tenant has agreed not to fall behind again.

f. On November 1, the company rented space to another tenant for $2,800 per month. The tenant paid five months’ rent in advance on that date. The payment was recorded with a credit to the Unearned Rent account.

Required

1. Use the information to prepare adjusting entries as of December 31, 2019. 2. Prepare journal entries to record the first subsequent cash transaction in 2020 for parts c and e.

Check (1b) Dr. Insurance Expense, $7,120 (1d) Dr. Depreciation Expense, $30,500

a. The Office Supplies account started the year with a $4,000 balance. During 2019, the company pur- chased supplies for $13,400, which was added to the Office Supplies account. The inventory of sup- plies available at December 31, 2019, totaled $2,554.

b. An analysis of the company’s insurance policies provided the following facts. The total premium for each policy was paid in full (for all months) at the purchase date, and the Prepaid Insurance account was debited for the full cost. (Year-end adjusting entries for Prepaid Insurance were properly recorded in all prior years.)

Chapter 3 Adjusting Accounts for Financial Statements 131

WELLS TECHNICAL INSTITUTE Unadjusted Trial Balance

December 31

Cash Accounts receivable Teaching supplies Prepaid insurance Prepaid rent Professional library Accumulated depreciation—Professional library Equipment Accumulated depreciation—Equipment Accounts payable Salaries payable Unearned training fees

Tuition fees earned Training fees earned Depreciation expense—Professional library Depreciation expense—Equipment Salaries expense Insurance expense Rent expense Teaching supplies expense Advertising expense Utilities expense Totals

Common stock Retained earnings 80,000

10,000

Dividends

Debit $ 34,000

0 8,000

12,000 3,000

35,000

80,000

50,000

0 0

50,000 0

33,000 0

6,000 6,400

$317,400

Credit

$317,400

$ 10,000

15,000 26,000

0 12,500

123,900 40,000

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. 2. Prepare the necessary adjusting journal entries for items a through h and post them to the T-accounts.

Assume that adjusting entries are made only at year-end. 3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. 4. Prepare Wells Technical Institute’s income statement and statement of retained earnings for the year

and prepare its balance sheet as of December 31. The Retained Earnings account balance was $80,000 on December 31 of the prior year.

Check (2e) Cr. Training Fees Earned, $5,000 (2f) Cr. Tuition Fees Earned, $7,500 (3) Adj. trial balance totals, $345,700 (4) Net income, $49,600

The adjusted trial balance for Chiara Company as of December 31 follows. Problem 3-4A Preparing financial statements from the adjusted trial balance

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 Notes receivable (due in 90 days) . . . . . . . . . . . . . . . . . . . . . . 168,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Automobiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000 Accumulated depreciation—Automobiles . . . . . . . . . . . . . . . . $ 50,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,000 Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . 18,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 Unearned fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235,800 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000

[continued on next page]

132 Chapter 3 Adjusting Accounts for Financial Statements

Required

Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31; (b) the statement of retained earnings for the year ended December 31 [Note: Retained Earnings at December 31 of the prior year was $235,800]; and (c) the balance sheet as of December 31.

Check Total assets, $600,000

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484,000 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Depreciation expense—Automobiles . . . . . . . . . . . . . . . . . . . . 26,000 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . 18,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188,000 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 Repairs expense—Automobiles . . . . . . . . . . . . . . . . . . . . . . . . 24,800 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,134,800 $1,134,800

[continued from previous page]

On April 1, Jiro Nozomi created a new travel agency, Adventure Travel. The following transactions occurred during the company’s first month.

Apr. 1 Nozomi invested $30,000 cash and computer equipment worth $20,000 in the company in exchange for common stock.

2 The company rented furnished office space by paying $1,800 cash for the first month’s (April) rent.

3 The company purchased $1,000 of office supplies for cash. 10 The company paid $2,400 cash for the premium on a 12-month insurance policy. Coverage

begins on April 11. 14 The company paid $1,600 cash for two weeks’ salaries earned by employees. 24 The company collected $8,000 cash for commissions earned. 28 The company paid $1,600 cash for two weeks’ salaries earned by employees. 29 The company paid $350 cash for minor repairs to the company’s computer. 30 The company paid $750 cash for this month’s telephone bill. 30 The company paid $1,500 cash in dividends.

The company’s chart of accounts follows.

Problem 3-5A Applying the accounting cycle

P1 P2 P3 P4 P5 P6 P7 P8

Required

1. Use the balance column format to set up each ledger account listed in its chart of accounts. 2. Prepare journal entries to record the transactions for April and post them to the ledger accounts. The

company records prepaid and unearned items in balance sheet accounts. 3. Prepare an unadjusted trial balance as of April 30. 4. Use the following information to journalize and post adjusting entries for the month: a. Prepaid insurance of $133 has expired this month. b. At the end of the month, $600 of office supplies are still available. c. This month’s depreciation on the computer equipment is $500. d. Employees earned $420 of unpaid and unrecorded salaries as of month-end. e. The company earned $1,750 of commissions that are not yet billed at month-end. 5. Prepare the adjusted trial balance as of April 30. Prepare the income statement and the statement of

retained earnings for the month of April and the balance sheet at April 30. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

Check (3) Unadj. trial balance totals, $58,000

(4a) Dr. Insurance Expense, $133

(5) Net income, $2,197; Total assets, $51,117

101 Cash 106 Accounts Receivable 124 Office Supplies 128 Prepaid Insurance 167 Computer Equipment 168 Accumulated Depreciation—Computer Equip . 209 Salaries Payable

307 Common Stock 318 Retained Earnings 319 Dividends 405 Commissions Earned 612 Depreciation Expense — Computer Equip . 622 Salaries Expense 637 Insurance Expense

640 Rent Expense 650 Office Supplies Expense 684 Repairs Expense 688 Telephone Expense 901 Income Summary

(7) P-C trial balance totals, $51,617

Chapter 3 Adjusting Accounts for Financial Statements 133

The adjusted trial balance for Tybalt Construction as of December 31, 2019, follows. O. Tybalt invested $5,000 cash in the business in exchange for common stock during year 2019. The December 31, 2018, credit balance of the Retained Earnings account was $121,400.

Problem 3-6A Preparing closing entries and financial statements

P6 P7Adjusted Trial Balance December 31, 2019

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 104 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 168 Accumulated depreciation—Equipment . . . . . . . . . . . . . $ 20,000 173 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 174 Accumulated depreciation—Building . . . . . . . . . . . . . . . 50,000 183 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,500 203 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 208 Rent payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 213 Property taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . 900 233 Unearned professional fees . . . . . . . . . . . . . . . . . . . . . . . 7,500 244 Current portion of long-term note payable . . . . . . . . . . . 7,000 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121,400 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 401 Professional fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 97,000 406 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 407 Dividends earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 409 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,100 606 Depreciation expense—Building . . . . . . . . . . . . . . . . . . . 11,000 612 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . 6,000 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 633 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,400 652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,400 682 Postage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200 683 Property taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 684 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,900 688 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200 690 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $411,900 $411,900

Required

1. Prepare the income statement and the statement of retained earnings for calendar-year 2019 and the classified balance sheet at December 31, 2019.

2. Prepare the necessary closing entries at December 31, 2019.

Check (1) Total assets (12/31/2019), $218,100; Net income, $4,300

In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classifica- tion. If the item should not appear on the balance sheet, enter a Z in the blank. A. Current assets B. Long-term investments C. Plant assets

Problem 3-7A Determining balance sheet classifications

C3 D. Intangible assets E. Current liabilities

F. Long-term liabilities G. Equity

1. Long-term investment in stock 2. Depreciation expense—Building 3. Prepaid rent (2 months of rent) 4. Interest receivable 5. Taxes payable (due in 5 weeks) 6. Automobiles 7. Notes payable (due in 3 years) 8. Accounts payable 9. Cash 10. Common stock

11. Unearned services revenue 12. Accumulated depreciation—Trucks 13. Prepaid insurance (expires in 5 months) 14. Buildings 15. Store supplies 16. Office equipment 17. Land (used in operations) 18. Repairs expense 19. Office supplies 20. Current portion of long-term note payable

134 Chapter 3 Adjusting Accounts for Financial Statements

PROBLEM SET B

Problem 3-1B Identifying adjusting entries with explanations

P1 P2 P3 P4

For each of the following journal entries 1 through 12, enter the letter of the explanation that most closely describes it in the space beside each entry. You can use letters more than once. A. To record payment of a prepaid expense. B. To record this period’s use of a prepaid expense. C. To record this period’s depreciation expense. D. To record receipt of unearned revenue. E. To record this period’s earning of prior

unearned revenue.

F. To record an accrued expense. G. To record payment of an accrued expense. H. To record an accrued revenue. I. To record receipt of accrued revenue.

______ 1. Interest Receivable . . . . . . . . . . . . . 3,500 Interest Revenue . . . . . . . . . . 3,500

______ 2. Salaries Payable . . . . . . . . . . . . . . . 9,000 Cash . . . . . . . . . . . . . . . . . . . . 9,000

______ 3. Depreciation Expense . . . . . . . . . . 8,000 Accumulated Depreciation . . 8,000

______ 4. Cash . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Unearned Professional Fees . 9,000

______ 5. Insurance Expense . . . . . . . . . . . . . 4,000 Prepaid Insurance . . . . . . . . . 4,000

______ 6. Interest Expense . . . . . . . . . . . . . . . 5,000 Interest Payable . . . . . . . . . . . 5,000

______ 7. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accounts Receivable (from services) . . . . 1,500

______ 8. Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Salaries Payable . . . . . . . . . . . . . . . . . . . . 7,000

______ 9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Interest Receivable . . . . . . . . . . . . . . . . . . 1,000

______ 10. Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

______ 11. Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 Prepaid Rent . . . . . . . . . . . . . . . . . . . . . . . 7,500

______ 12. Unearned Professional Fees . . . . . . . . . . . . . . . 6,000 Professional Fees Earned . . . . . . . . . . . . . 6,000

Problem 3-2B Preparing adjusting and subsequent journal entries

P1 P2 P3 P4

Natsu Company’s annual accounting period ends on October 31, 2019. The following information con- cerns the adjusting entries that need to be recorded as of that date. Entries can draw from the following partial chart of accounts: Cash; Rent Receivable; Office Supplies; Prepaid Insurance; Building; Accumulated Depreciation—Building; Salaries Payable; Unearned Rent; Rent Earned; Salaries Expense; Office Supplies Expense; Insurance Expense; and Depreciation Expense—Building. a. The Office Supplies account started the fiscal year with a $600 balance. During the fiscal year, the

company purchased supplies for $4,570, which was added to the Office Supplies account. The sup- plies available at October 31, 2019, totaled $800.

Policy Date of Purchase Months of Coverage Cost

A . . . . . . April 1, 2018 24 $6,000 B . . . . . . April 1, 2019 36 7,200 C . . . . . . August 1, 2019 12 1,320

c. The company has four employees, who earn a total of $1,000 for each workday. They are paid each Monday for their work in the five-day workweek ending on the previous Friday. Assume that October 31, 2019, is a Monday, and all four employees worked the first day of that week. They will be paid salaries for five full days on Monday, November 7, 2019.

d. The company purchased a building on November 1, 2016, that cost $175,000 and is expected to have a $40,000 salvage value at the end of its predicted 25-year life. Annual depreciation is $5,400.

e. Because the company does not occupy the entire building it owns, it rented space to a tenant at $1,000 per month, starting on September 1, 2019. The rent was paid on time on September 1, and the amount received was credited to the Rent Earned account. However, the October rent has not been paid. The company has worked out an agreement with the tenant, who has promised to pay both October and November rent in full on November 15. The tenant has agreed not to fall behind again.

f. On September 1, the company rented space to another tenant for $725 per month. The tenant paid five months’ rent in advance on that date. The payment was recorded with a credit to the Unearned Rent account.

Required

1. Use the information to prepare adjusting entries as of October 31, 2019. 2. Prepare journal entries to record the first subsequent cash transaction in November 2019 for parts c and e.

Check (1b) Dr. Insurance Expense, $4,730 (1d) Dr. Depreciation Expense, $5,400

Chapter 3 Adjusting Accounts for Financial Statements 135

Following is the unadjusted trial balance for Alonzo Institute as of December 31. The Institute provides one-on-one training to individuals who pay tuition directly to the business and offers extension training to groups in off-site locations. Shown after the trial balance are items a through h that require adjusting entries as of December 31.

Problem 3-3B Preparing adjusting entries, adjusted trial balance, and financial statements

P1 P2 P3 P4 P5 P6 ALONZO INSTITUTE

Unadjusted Trial Balance December 31

0 0

$ 60,000 0

70,000 19,000 3,800

12,000

40,000

20,000Dividends

44,200

29,600

19,000 13,400

$331,000

Debit

$331,000

$ 2,500

20,000 11,200

0 28,600 11,000

129,200 68,000

Credit

Retained earnings 60,500

Additional Information

a. An analysis of the Institute’s insurance policies shows that $9,500 of coverage has expired. b. An inventory count shows that teaching supplies costing $20,000 are available at year-end. c. Annual depreciation on the equipment is $5,000. d. Annual depreciation on the professional library is $2,400. e. On November 1, the Institute agreed to do a special two-month course (starting immediately) for

a client. The contract calls for a $14,300 monthly fee, and the client paid the two months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited.

f. On October 15, the Institute agreed to teach a four-month class (beginning immediately) to an execu- tive with payment due at the end of the class. At December 31, $5,750 of the tuition has been earned by the Institute.

g. The Institute’s only employee is paid weekly. As of the end of the year, three days’ salaries have accrued at the rate of $150 per day.

h. The balance in the Prepaid Rent account represents rent for December.

Required

1. Prepare T-accounts (representing the ledger) with balances from the unadjusted trial balance. 2. Prepare the necessary adjusting journal entries for items a through h, and post them to the T-accounts.

Assume that adjusting entries are made only at year-end. 3. Update balances in the T-accounts for the adjusting entries and prepare an adjusted trial balance. 4. Prepare the company’s income statement and statement of retained earnings for the year, and prepare its

balance sheet as of December 31. The Retained Earnings account balance was $60,500 on December 31 of the prior year.

Check (2e) Cr. Training Fees Earned, $28,600 (2f ) Cr. Tuition Fees Earned, $5,750 (3) Adj. trial balance totals, $344,600 (4) Net income, $54,200

136 Chapter 3 Adjusting Accounts for Financial Statements

Problem 3-4B Preparing financial statements from adjusted trial balance

The adjusted trial balance for Speedy Courier as of December 31 follows.

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Notes receivable (due in 90 days) . . . . . . . . . . . . . . . . . 210,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Trucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000 Accumulated depreciation—Trucks . . . . . . . . . . . . . . . . $ 58,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 Accumulated depreciation—Equipment . . . . . . . . . . . . . 200,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Unearned delivery fees . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Delivery fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . 611,800 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 Depreciation expense—Trucks . . . . . . . . . . . . . . . . . . . . 29,000 Depreciation expense—Equipment . . . . . . . . . . . . . . . . 48,000 Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,000 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 31,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,200 Repairs expense—Trucks . . . . . . . . . . . . . . . . . . . . . . . . 35,600 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,530,800 $1,530,800

Required

Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31; (b) the statement of retained earnings for the year ended December 31 [Note: Retained Earnings at Dec. 31 of the prior year was $110,000]; and (c) the balance sheet as of December 31.

Check Total assets, $663,000

101 Cash 307 Common Stock 640 Rent Expense 106 Accounts Receivable 318 Retained Earnings 650 Office Supplies Expense 124 Office Supplies 319 Dividends 684 Repairs Expense 128 Prepaid Insurance 401 Storage Fees Earned 688 Telephone Expense 173 Buildings 606 Depreciation Expense—Buildings 901 Income Summary 174 Accumulated Depreciation—Buildings 622 Salaries Expense 209 Salaries Payable 637 Insurance Expense

On July 1, Lula Plume created a new self-storage business, Safe Storage Co. The following transactions occurred during the company’s first month.

July 1 Plume invested $30,000 cash and buildings worth $150,000 in the company in exchange for common stock.

2 The company rented equipment by paying $2,000 cash for the first month’s (July) rent. 5 The company purchased $2,400 of office supplies for cash. 10 The company paid $7,200 cash for the premium on a 12-month insurance policy. Coverage

begins on July 11. 14 The company paid an employee $1,000 cash for two weeks’ salary earned. 24 The company collected $9,800 cash for storage fees from customers. 28 The company paid $1,000 cash for two weeks’ salary earned by an employee. 29 The company paid $950 cash for minor repairs to a leaking roof. 30 The company paid $400 cash for this month’s telephone bill. 31 The company paid $2,000 cash in dividends.

The company’s chart of accounts follows.

Problem 3-5B Applying the accounting cycle

P1 P2 P3 P4 P5 P6 P7 P8

Chapter 3 Adjusting Accounts for Financial Statements 137

Required

1. Use the balance column format to set up each ledger account listed in its chart of accounts. 2. Prepare journal entries to record the transactions for July and post them to the ledger accounts. Record

prepaid and unearned items in balance sheet accounts. 3. Prepare an unadjusted trial balance as of July 31. 4. Use the following information to journalize and post adjusting entries for the month: a. Prepaid insurance of $400 has expired this month. b. At the end of the month, $1,525 of office supplies are still available. c. This month’s depreciation on the buildings is $1,500. d. An employee earned $100 of unpaid and unrecorded salary as of month-end. e. The company earned $1,150 of storage fees that are not yet billed at month-end. 5. Prepare the adjusted trial balance as of July 31. Prepare the income statement and the statement of

retained earnings for the month of July and the balance sheet at July 31. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

Check (3) Unadj. trial balance totals, $189,800

(4a) Dr. Insurance Expense, $400

(5) Net income, $2,725; Total assets, $180,825

(7) P-C trial balance totals, $182,325

The adjusted trial balance for Anara Co. as of December 31, 2019, follows. P. Anara invested $40,000 cash in the business in exchange for common stock during year 2019. The December 31, 2018, credit bal- ance of the Retained Earnings account was $52,800.

Problem 3-6B Preparing closing entries and financial statements

P6 P7 Adjusted Trial Balance December 31, 2019

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,400 104 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . 11,200 126 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 167 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 168 Accumulated depreciation—Equipment . . . . . . . . . . . . . $ 4,000 173 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 174 Accumulated depreciation—Building . . . . . . . . . . . . . . . 10,000 183 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 203 Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750 208 Rent payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,280 213 Property taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,330 233 Unearned professional fees . . . . . . . . . . . . . . . . . . . . . . . 750 244 Current portion of long-term notes payable . . . . . . . . . . 8,400 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . 31,600 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,800 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 401 Professional fees earned . . . . . . . . . . . . . . . . . . . . . . . . . 59,600 406 Rent earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 407 Dividends earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 409 Interest earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320 606 Depreciation expense—Building . . . . . . . . . . . . . . . . . . . 2,000 612 Depreciation expense—Equipment . . . . . . . . . . . . . . . . . 1,000 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500 633 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,525 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 652 Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 682 Postage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410 683 Property taxes expense . . . . . . . . . . . . . . . . . . . . . . . . . . 4,825 684 Repairs expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679 688 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521 690 Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,920 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $224,230 $224,230

138 Chapter 3 Adjusting Accounts for Financial Statements

SERIAL PROBLEM Business Solutions

P1 P2 P3 P4 P5 P6 P7 P8

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 3 After the success of the company’s first two months, Santana Rey continues to operate Business Solutions. (Transactions for the first two months are described in the Chapter 2 serial problem.) The November 30, 2019, unadjusted trial balance of Business Solutions (reflecting its transactions for October and November of 2019) follows.

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $38,264 106 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,618 126 Computer supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,545 128 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,220 131 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300 163 Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 164 Accumulated depreciation—Office equipment . . . . . . . . . . . . . . . . . . $ 0 167 Computer equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 168 Accumulated depreciation—Computer equipment . . . . . . . . . . . . . . 0 201 Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 236 Unearned computer services revenue . . . . . . . . . . . . . . . . . . . . . . . . 0 307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,000 318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600 403 Computer services revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,659 612 Depreciation expense—Office equipment . . . . . . . . . . . . . . . . . . . . . 0 613 Depreciation expense—Computer equipment . . . . . . . . . . . . . . . . . . 0 623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625 637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 652 Computer supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 655 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,728 676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $98,659 $98,659

Required

1. Prepare the income statement and the statement of retained earnings for calendar-year 2019 and the classified balance sheet at December 31, 2019.

2. Prepare the necessary closing entries at December 31, 2019.

Check (1) Total assets (12/31/2019), $164,700; Net income, $28,890

Problem 3-7B Determining balance sheet classifications

1. Commissions earned 2. Interest receivable 3. Long-term investment in stock 4. Prepaid insurance (4 months of rent) 5. Machinery 6. Notes payable (due in 15 years) 7. Copyrights 8. Current portion of long-term

note payable 9. Accumulated depreciation—Trucks 10. Office equipment

11. Rent receivable 12. Salaries payable 13. Income taxes payable

(due in 11 weeks) 14. Common stock 15. Office supplies 16. Interest payable 17. Rent revenue 18. Notes receivable (due in 120 days) 19. Land (used in operations) 20. Depreciation expense—Trucks

Chapter 3 Adjusting Accounts for Financial Statements 139

Business Solutions had the following transactions and events in December 2019.

Dec. 2 Paid $1,025 cash to Hillside Mall for Business Solutions’s share of mall advertising costs. 3 Paid $500 cash for minor repairs to the company’s computer. 4 Received $3,950 cash from Alex’s Engineering Co. for the receivable from November. 10 Paid cash to Lyn Addie for six days of work at the rate of $125 per day. 14 Notified by Alex’s Engineering Co. that Business Solutions’s bid of $7,000 on a proposed proj-

ect has been accepted. Alex’s paid a $1,500 cash advance to Business Solutions. 15 Purchased $1,100 of computer supplies on credit from Harris Office Products. 16 Sent a reminder to Gomez Co. to pay the fee for services recorded on November 8. 20 Completed a project for Liu Corporation and received $5,625 cash. 22–26 Took the week off for the holidays. 28 Received $3,000 cash from Gomez Co. on its receivable. 29 Reimbursed S. Rey for business automobile mileage (600 miles at $0.32 per mile). 31 The company paid $1,500 cash in dividends.

The following additional facts are collected for use in making adjusting entries prior to preparing financial statements for the company’s first three months. a. The December 31 inventory count of computer supplies shows $580 still available. b. Three months have expired since the 12-month insurance premium was paid in advance. c. As of December 31, Lyn Addie has not been paid for four days of work at $125 per day. d. The computer system, acquired on October 1, is expected to have a four-year life with no salvage value. e. The office equipment, acquired on October 1, is expected to have a five-year life with no salvage value. f. Three of the four months’ prepaid rent have expired.

Required

1. Prepare journal entries to record each of the December transactions and events for Business Solutions. Post those entries to the accounts in the ledger.

2. Prepare adjusting entries to reflect a through f. Post those entries to the accounts in the ledger. 3. Prepare an adjusted trial balance as of December 31, 2019. 4. Prepare an income statement for the three months ended December 31, 2019. 5. Prepare a statement of retained earnings for the three months ended December 31, 2019. 6. Prepare a balance sheet as of December 31, 2019. 7. Record and post the necessary closing entries as of December 31, 2019. 8. Prepare a post-closing trial balance as of December 31, 2019.

Check (3) Adjusted trial balance totals, $109,034

(6) Total assets, $83,460

(8) Post-closing trial balance totals, $85,110

The General Ledger tool in Connect allows students to immediately see the financial statements as of a specific date. Each of the following questions begins with an unadjusted trial balance. Using transactions from the following assignment, prepare the necessary adjustments and determine the impact each adjust- ment has on net income. The financial statements are automatically populated.

GL 3-1 Based on the FastForward illustration in this chapter

Using transactions from the following assignments, prepare the necessary adjustments, create the finan- cial statements, and determine the impact each adjustment has on net income.

GL 3-2 Based on Problem 3-3A

GL 3-3 Extension of Problem 2-1A

GL 3-4 Extension of Problem 2-2A

GL 3-5 Based on Serial Problem SP 3

GENERAL LEDGER PROBLEM

COMPANY ANALYSIS A1 P7

Accounting Analysis

AA 3-1 Use Apple’s financial statements in Appendix A to answer the following. 1. Compute Apple’s profit margin for fiscal years ended (a) September 30, 2017, and (b) September 24, 2016. 2. Is the change in Apple’s profit margin favorable or unfavorable? 3. In 2017, did Apple’s profit margin outperform or underperform the industry (assumed) average of 12%? 4. For the fiscal year ended September 30, 2017, what is the balance of its Income Summary account

before it is closed? APPLE

140 Chapter 3 Adjusting Accounts for Financial Statements

GLOBAL ANALYSIS A1

APPLE Samsung

GOOGLE

AA 3-3 Key comparative figures for Samsung, Apple, and Google follow.

Required

1. Compute profit margin for Samsung, Apple, and Google. 2. Which company has the highest profit margin?

In millions Samsung Apple Google

Net income . . . . . . . . . . . W 42,186,747 $ 48,351 $ 12,662

Net sales . . . . . . . . . . . . 239,575,376 229,234 110,855

Required

1. Compute profit margins for (a) Apple and (b) Google for the two years of data reported above. 2. In the current year, which company is more successful on the basis of profit margin? 3. Compute current ratios for (a) Apple and (b) Google for the two years reported above. 4. In the current year, which company has the better ability to pay short-term obligations according to the

current ratio?

AA 3-2 Key figures for the recent two years of both Apple and Google follow.

Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Net income . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 $ 12,662 $ 19,478

Net sales . . . . . . . . . . . . . . . . . . . 229,234 215,639 110,855 90,272

Current assets . . . . . . . . . . . . . . . 128,645 106,869 124,308 105,408

Current liabilities . . . . . . . . . . . . . 100,814 79,006 24,183 16,756

COMPARATIVE ANALYSIS A1 A2

APPLE GOOGLE

ETHICS CHALLENGE P4 P6

BTN 3-1 On January 20, 2019, Tamira Nelson, the accountant for Picton Enterprises, is feeling pressure to complete the annual financial statements. The company president has said he needs up-to-date financial statements to share with the bank on January 21 at a dinner meeting that has been called to discuss Picton’s obtaining loan financing for a special building project. Tamira knows that she will not be able to gather all the needed information in the next 24 hours to prepare the entire set of adjusting entries. Those entries must be posted before the financial statements accurately portray the company’s performance and financial position for the fiscal period ended December 31, 2018. Tamira ultimately decides to estimate several expense accruals at the last minute. When deciding on estimates for the expenses, she uses low estimates because she does not want to make the financial statements look worse than they are. Tamira finishes the financial statements before the deadline and gives them to the president without mentioning that several account balances are estimates that she provided.

Required

1. Identify several courses of action that Tamira could have taken instead of the one she took. 2. If you were in Tamira’s situation, what would you have done? Briefly justify your response.

Beyond the Numbers

BTN 3-2 One of your classmates states that a company’s books should be ongoing and therefore not closed until that business is terminated. Write a half-page memo to this classmate explaining the concept of the closing process by drawing analogies between (1) a scoreboard for an athletic event and the revenue and expense accounts of a business or (2) a sports team’s record book and the retained earnings account. Hint: Think about what would happen if the scoreboard were not cleared before the start of a new game.

COMMUNICATING IN PRACTICE P7 P8

Chapter 3 Adjusting Accounts for Financial Statements 141

BTN 3-4 Four types of adjustments are described in the chapter: (1) prepaid expenses, (2) unearned revenues, (3) accrued expenses, and (4) accrued revenues.

Required

1. Form learning teams of four (or more) members. Each team member must select one of the four adjustments as an area of expertise (each team must have at least one expert in each area).

2. Form expert teams from the individuals who have selected the same area of expertise. Expert teams are to discuss and write a report that each expert will present to his or her learning team addressing the following: a. Description of the adjustment and why it’s necessary. b. Example of a transaction or event, with dates and amounts, that requires adjustment. c. Adjusting entry(ies) for the example in requirement b. d. Status of the affected account(s) before and after the adjustment in requirement c. e. Effects on financial statements of not making the adjustment.

3. Each expert should return to his or her learning team. In rotation, each member should present his or her expert team’s report to the learning team. Team discussion is encouraged.

TEAMWORK IN ACTION P1 P2 P3 P4

BTN 3-3 Access EDGAR online (SEC.gov) and locate the 10-K report of The Gap, Inc. (ticker: GPS), filed on March 20, 2017. Review its financial statements reported for the year ended January 28, 2017, to answer the following questions.

Required

1. What are Gap’s main brands? 2. When is Gap’s fiscal year-end? 3. What is Gap’s net sales for the period ended January 28, 2017? 4. What is Gap’s net income for the period ended January 28, 2017? 5. Compute Gap’s profit margin for the year ended January 28, 2017. 6. Do you believe Gap’s decision to use a year-end of late January or early February relates to its natural

business year? Explain.

TAKING IT TO THE NET A1

BTN 3-5 Review this chapter’s opening feature involving Evan and Bobby and Snapchat. 1. Explain how a classified balance sheet can help Evan and Bobby know what bills are due when and

whether they have the resources to pay those bills. 2. Why is it important for Evan and Bobby to match costs and revenues in a specific time period? How

do closing entries help them in this regard? 3. What objectives are met when Evan and Bobby apply closing procedures each fiscal year-end?

ENTREPRENEURIAL DECISION C3 P7

BTN 3-6 Select a company that you can visit in person or interview on the telephone. Call ahead to the company to arrange a time when you can interview an employee (preferably an accountant) who helps prepare the annual financial statements. Inquire about the following aspects of its accounting cycle: 1. Does the company prepare interim financial statements? What time period(s) is used for interim

statements? 2. Does the company use the cash or accrual basis of accounting? 3. Does the company use a work sheet in preparing financial statements? Why or why not? 4. Does the company use a spreadsheet program? If so, which software program is used? 5. How long does it take after the end of its reporting period to complete annual statements?

HITTING THE ROAD C1 C2

Learning Objectives

CONCEPTUAL C1 Describe merchandising activities and

identify income components for a merchandising company.

C2 Identify and explain the inventory asset and cost flows of a merchandising company.

ANALYTICAL A1 Compute the acid-test ratio and explain

its use to assess liquidity.

A2 Compute the gross margin ratio and explain its use to assess profitability.

P5 Appendix 4A—Record and compare merchandising transactions using both periodic and perpetual inventory systems.

P6 Appendix 4B—Prepare adjustments for discounts, returns, and allowances per revenue recognition rules.

P7 Appendix 4C—Record and compare merchandising transactions using the gross method and net method.

PROCEDURAL P1 Analyze and record transactions for

merchandise purchases using a perpetual system.

P2 Analyze and record transactions for merchandise sales using a perpetual system.

P3 Prepare adjustments and close accounts for a merchandising company.

P4 Define and prepare multiple-step and single-step income statements.

Chapter Preview

4 Accounting for Merchandising Operations

MERCHANDISING PURCHASES

P1 Accounting for: Purchases discounts

Purchases returns and allowances

Transportation costs

MERCHANDISING SALES

P2 Accounting for: Sales of merchandise

Sales discounts

Sales returns and allowances

MERCHANDISING ACTIVITIES

C1 Income and inventory for merchandisers

C2 Operating cycle Inventory cost flows

NTK 4-1 NTK 4-2 NTK 4-3

MERCHANDISER REPORTING

P3 Adjusting and closing P4 Multiple-step and

single-step income statements

A1 Acid-test analysis A2 Gross margin analysis

NTK 4-4, 4-5

143

“Understand what matters”—Maxine Clark

Bear Up

ST. LOUIS—“When I graduated from college,” explains Maxine Clark, “I felt the retail world had lost its spark. I wanted to be more creative.” Maxine was determined to start a business that would be different. Then she went shopping with the young daughter of a friend. “When we couldn’t find anything new, Katie picked up a Beanie Baby and said we could make one,” recalls Maxine. “Her words gave me the idea to create a company that would allow people to create their own customized stuffed animals.” Build-A-Bear Workshop (BuildaBear.com) was born!

“I did some research and began putting together a plan,” says Maxine. The Build-A-Bear Workshops were an instant success.

As her company grew, Maxine says accounting data on her merchandising operations fell short. “We can’t give up!” was her view. In response, Maxine set up an accounting system to mea- sure, track, summarize, and report on merchandising transac- tions, especially purchases.

Maxine computerized the accounting system, prepared monthly financial statements per store, developed annual bud- gets, and tracked all bank accounts and payables.

Build-A-Bear’s successful use of accounting data has made Maxine a self-made woman. She insists, however, it is not about

the financial rewards. “We’re a family business,” explains Maxine. “It’s important to set an example for children by being a company that does good things and cares about the well-being of others.”

Sources: Build-A-Bear website, January 2019; Fortune, March 2012; LEADERS, April 2011; CSRwire, August 2008

Previous chapters covered accounting for service companies. A merchandising company’s activities differ from those of a service company. Merchandise refers to products, also called goods, that a company buys to resell. A merchandiser earns net income by buying and selling merchandise. Merchandisers are wholesalers or retailers. A wholesaler buys products from manufacturers and sells them to retailers. A retailer buys products from manufacturers or wholesalers and sells them to consumers.

Reporting Income for a Merchandiser Net income for a merchandiser equals revenues from selling merchandise minus both the cost of merchandise sold and other expenses—see Exhibit 4.1. Revenue from selling merchandise is called sales, and the expense of buying and preparing merchandise is called cost of goods sold. (Some service companies use the term sales instead of revenues; cost of goods sold is also called cost of sales.)

MERCHANDISING ACTIVITIES C1 Describe merchandising activities and identify income components for a merchandising company.

EqualsMinusEqualsMinus Expenses

Net income

Net sales

Merchandiser

Expenses Net

income Revenues

Service Company

Minus Equals

Gross profit

Cost of goods sold

EXHIBIT 4.1 Computing Income for a Merchandising Company versus a Service Company

Point: SuperValu and SYSCO are wholesalers. Target and Walmart are retailers.

144 Chapter 4 Accounting for Merchandising Operations

EXHIBIT 4.2 Income Statement for a Service Company and a Merchandising Company

LIBERTY TAX Income Statement ($ millions)

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $174

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12

Service Company Merchandising Company

NORDSTROM INC. Income Statement ($ millions)

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,757

Cost of goods sold . . . . . . . . . . . . . . . . . . 9,440 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . 5,317 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,963

Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 354

Reporting Inventory for a Merchandiser A merchandiser’s balance sheet has a current asset called merchandise inventory, an item not on a service company’s balance sheet. Merchandise inventory, or simply inventory, refers to products that a company owns and intends to sell. Inventory cost includes the cost to buy the goods, ship them to the store, and make them ready for sale.

Operating Cycle for a Merchandiser Exhibit 4.3 shows an operating cycle for a merchandiser with credit sales. The cycle moves from (a) cash purchases of merchandise to (b) inventory for sale to (c) credit sales to (d) accounts receivable to (e) receipt of cash. The length of an operating cycle differs across the types of businesses. Department stores often have operating cycles of two to five months. Operating cycles for grocery stores are usually from two to eight weeks. Companies try to keep their operating cycles short because assets tied up in inventory and receivables are not productive. Cash sales shorten operating cycles.

Inventory Systems Exhibit 4.4 shows that a company’s merchandise available for sale consists of what it begins with (beginning inventory) and what it purchases (net purchases). The merchandise available for sale is either sold (cost of goods sold) or kept for future sales (ending inventory).

Companies account for inventory in one of two ways: perpetual system or periodic system. Perpetual inventory system updates account-

ing records for each purchase and each sale of inventory.

Periodic inventory system updates account- ing records for purchases and sales of inven- tory only at the end of a period.

Technology has dramatically increased the use of the perpetual system. It gives managers immediate access to information on sales and inventory levels, which allows them to strategi- cally react and increase profit. (Some compa-

nies use a hybrid system where the perpetual system is used for tracking units available and the periodic system is used to compute cost of sales.)

C2 Identify and explain the inventory asset and cost flows of a merchandising company.

Cash

(b) Merchandise inventory

(d) Accounts receivable

(a) Purchases

(e ) C

as h

co lle

ctio n

54 6

W9797 Cherry Rd. Antigo, WI 54409

See reverse for terms of sale and returns.

Net of Discount $490

Invoice Date Number

11/2/17 4657-2

P.O. Date Salesperson Terms Freight Ship

Subtotal 500

500

Shipping Tax

Total

6 Freight terms Goods7 Total invoice amount8 Net amount9

1 32 54Seller Invoice date Purchaser Order date Credit termsKey:

INVOICE

CH015 SD099

Toddler–Challenger X7 Boys/Girls–Speed Demon

1 1

150 350

10/30/17 #141 2/10, n/30 FOB Destination Via FedEx

Model No. Description Quantity Price Amount

SOLD TO

Z-Mart

Tom Novak, Purchasing Agent

10 Michigan Street

Chicago

Illinois Zip

3 Firm Name

Attention of

Address

City

State 605212

EXHIBIT 4.3 Merchandiser’s Operating Cycle

Merchandise Inventory

Beg. inventory # Net purchases #

Merchandise avail. for sale # COGS #

End. inventory #

Beginning inventory

Net purchases

= Merchandise available for sale

Cost of goods sold

Ending inventory

EXHIBIT 4.4 Merchandiser’s Cost Flow for a Single Time Period

Point: Merchandise avail. for sale: MAS = EI + COGS,

which can be rewritten as MAS − EI = COGS, or MAS − COGS = EI.

The income statements for a service company, Liberty Tax, and for a merchandiser, Nordstrom, are in Exhibit 4.2. We see that the merchandiser, Nordstrom, reports cost of goods sold, which is not reported by the service company. The merchandiser also reports gross profit, or gross margin, which is net sales minus cost of goods sold.

Chapter 4 Accounting for Merchandising Operations 145

Use the following information (in random order) from a merchandising company and from a service com- pany to complete the requirements. Hint: Not all information may be necessary for the solutions.

C1 C2

Merchandise Accounts and Computations

NEED-TO-KNOW 4-1

1. For the merchandiser only, compute (a) goods available for sale, (b) cost of goods sold, and (c) gross profit. 2. Compute net income for each company.

SaveCo Merchandiser

Supplies . . . . . . . . . . . . . $ 10 Beginning inventory . . . 100 Ending inventory . . . . . . 50

Expenses . . . . . . . $ 20 Net purchases . . . 80 Net sales . . . . . . . 190

Hi-Tech Services

Expenses . . . . . $170 Revenues . . . . . 200 Cash . . . . . . . . . 10

Prepaid rent . . . . . . . . $25 Accounts payable . . . 35 Supplies . . . . . . . . . . . 65

Solution

1. a. Computation of goods available for sale (SaveCo).

b. Computation of cost of goods sold (SaveCo).

c. Computation of gross profit (SaveCo).

2. Computation of net income for each company.

SaveCo Merchandiser

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $190 Less: Cost of goods sold (from part 1b) . . . . . . . . . . 130 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Less: Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40

Hi-Tech Services

Revenues . . . . . . . . . . . . . . . . . . . . . . $200

Less: Expenses . . . . . . . . . . . . . . . . . 170 Net income . . . . . . . . . . . . . . . . . . . . $ 30 Do More: QS 4-3, E 4-1, E 4-2

Beginning inventory . . . . . . . . . . $100 Plus: Net purchases . . . . . . . . . . 80 Goods available for sale . . . . . . $180

Beginning inventory . . . . . . . . . . $100 Plus: Net purchases . . . . . . . . . . 80 Goods available for sale . . . . . . 180 Less: Ending inventory . . . . . . . . 50 Cost of goods sold . . . . . . . . . . . $130

Net sales . . . . . . . . . . . . . . . . . . $190 Less: Cost of goods sold (from part b) . . . . . . . . . 130 Gross profit . . . . . . . . . . . . . . . . $ 60

This section explains how we record purchases under different purchase terms.

Purchases without Cash Discounts Z-Mart records a $500 cash purchase of merchandise on November 2 as follows.

ACCOUNTING FOR MERCHANDISE PURCHASES P1 Analyze and record transactions for merchandise purchases using a perpetual system.

Assets = Liabilities + Equity +500 −500

Nov . 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Purchased goods for cash.

If these goods are instead purchased on credit, and no discounts are offered for early payment, Z-Mart makes the same entry except that Accounts Payable is credited instead of Cash.

Point: Costs recorded in Merchandise Inventory are called inventoriable costs.

Trade Discounts When a manufacturer or wholesaler prepares a catalog of items for sale, each item has a list price, or catalog price. However, an item’s selling price equals list price minus a percent called a trade discount. A wholesaler buying in large quantities gets a larger discount than a retailer buying in small quantities. A buyer re- cords the net amount of list price minus trade discount. If a supplier of Z-Mart lists an item at $625 and gives Z-Mart a 20% trade discount, Z-Mart’s purchase price is $500, computed as $625 − (20% × $625). ■

Decision Insight

Point: Trade discounts are not journalized; purchases are recorded based on the invoice amount.

Purchases with Cash Discounts The purchase of goods on credit requires credit terms. Credit terms include the amounts and timing of payments from a buyer to a seller. To demonstrate, when sellers require payment within 10 days after the end of the month (EOM) of the invoice date, credit terms are “n∕10

146 Chapter 4 Accounting for Merchandising Operations

EOM.” When sellers require payment within 30 days after the invoice date, credit terms are “n∕30,” meaning net 30 days.

Credit Terms Exhibit 4.5 explains credit terms. The amount of time allowed before full pay- ment is due is the credit period. Sellers can grant a cash discount to encourage buyers to pay earlier. A buyer views a cash discount as a purchases discount. A seller views a cash discount as a sales discount. Any cash discounts are described on the invoice. For example, credit terms of “2∕10, n∕60” mean that full payment is due within a 60-day credit period, but the buyer can deduct 2% of the invoice amount if payment is made within 10 days of the invoice date. This reduced payment is only for the discount period.

Amount Due

Due: Invoice priceDue: Invoice price minus discount

Discount period

Credit period

Invoice date

Credit Terms

Time

EXHIBIT 4.5 Credit Terms

Invoice On November 2, Z-Mart purchases $500 of merchandise on credit with terms of 2∕10, n∕30. The invoice for this purchase is shown in Exhibit 4.6. This is a purchase invoice for Z-Mart (buyer) and a sales invoice for Trex (seller). The amount recorded for merchandise in- ventory includes its purchase cost, shipping fees, taxes, and any other costs necessary to make it ready for sale.

54 6

W9797 Cherry Rd. Antigo, WI 54409

See reverse for terms of sale and returns.

Net of Discount $490

Invoice Date Number

11/2/18 4657-2 2

P.O. Date Salesperson Terms Freight Ship

Subtotal 500

500

Shipping Tax

Total

INVOICE

CH015 SD099

Toddler–Challenger X7 Boys/Girls–Speed Demon

1 1

150 350

10/30/18 #141 2/10, n/30 FOB Destination Via FedEx

Model No. Description Quantity Price Amount

Firm Name SOLD TO

Attention of

Address

City

State Zip

Tom Novak, Purchasing Agent

10 Michigan Street

Z-Mart

Chicago

Illinois 60521

6 Freight terms

Goods7

Total invoice amount8

Net amount9

1 Seller

2 Invoice date

3 Purchaser

4 Order date

Credit terms

Key:

EXHIBIT 4.6 Invoice

Point: The invoice date sets the discount and credit periods.

Gross Method Z-Mart purchases $500 of merchandise on credit terms of 2∕10, n∕30. The November 2 invoice offers a 2% discount if paid within 10 days; if not, Z-Mart must pay the full amount within 30 days. The buyer has two options. Pay within discount period (Nov. 2 through Nov. 12): Due = $490.

or Pay after discount period (Nov. 13 through Dec. 2): Due = $500.

The $490 equals the $500 invoice minus $10 discount (computed as $500 × 2%).

Chapter 4 Accounting for Merchandising Operations 147

On the purchase date, we do not know if payment will occur within the discount period. The gross method records the purchase at its gross (full) invoice amount. For Z-Mart, the purchase of $500 of merchandise with terms of 2∕10, n∕30 is recorded at $500. The gross method is used here because it is (1) used more in practice, (2) easier to apply, and (3) less costly.

Purchases on Credit Z-Mart’s entry to record the November 2 purchase of $500 of merchandise on credit follows. (For recording, it can help to add the name to the payable, such as Accounts Payable—Trex.)

Payment within Discount Period Good cash management means that invoices are not paid until the last day of the discount or credit period. This is because the buyer can use that money until payment is required. If Z-Mart pays the amount due on (or before) November 12, the entry is

Nov . 2 500

Bal . 490

Nov . 12 10

Merchandise Inventory

Nov . 12 490

Cash

Nov . 12 500 Nov . 2 500

Bal . 0

Accounts Payable

The Merchandise Inventory account equals the $490 net cost of purchases after these entries, and the Accounts Payable account has a zero balance.

Payment after Discount Period If the invoice is paid after November 12, the dis- count is lost. If Z-Mart pays the gross (full) amount due on December 2 (the n∕30 due date), the entry is

Point: Appendix 4A repeats jour- nal entries a through g using the periodic system.

Purchases with Returns and Allowances Purchases returns are merchandise a buyer purchases but then returns. Purchases allowances refer to a seller granting a price reduction (allowance) to a buyer of defective or unacceptable merchandise.

Purchases Allowances On November 5, Z-Mart (buyer) agrees to a $30 allowance from Trex for defective merchandise (assume allowance is $30 whether paid within the discount period or not). Z-Mart’s entry to update Merchandise Inventory and record the allowance follows. Z-Mart’s allowance for defective merchandise reduces its account payable to the seller. If cash is refunded, Cash is debited instead of Accounts Payable.

Point: When a buyer returns or takes an allowance on merchan- dise, the buyer issues a debit memorandum. This informs the seller of a debit made to the seller’s account payable in the buyer’s records.

(a) Nov . 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Purchased goods, terms 2∕10, n∕30.

Assets = Liabilities + Equity +500 +500

(b1) Nov . 12 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490

Paid for goods within discount period. *$500 × (100% − 2%)

Assets = Liabilities + Equity −490 −500 − 10

(b2) Dec . 2 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500

Paid for goods outside discount period.

Assets = Liabilities + Equity −500 −500

(c1) Nov . 5 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Allowance for defective goods.

Assets = Liabilities + Equity −30 −30

Purchases Returns Returns of inventory are recorded at the amount charged for that inventory. On June 1, Z-Mart purchases $250 of merchandise with terms 2∕10, n∕60—see en- tries below. On June 3, Z-Mart returns $50 of those goods. When Z-Mart pays on June 11, it

148 Chapter 4 Accounting for Merchandising Operations

takes the 2% discount only on the $200 remaining balance ($250 − $50). When goods are re- turned, a buyer takes a discount on only the remaining balance. This means the discount is $4 (computed as $200 × 2%) and the cash payment is $196 (computed as $200 − $4).

Point: Credit terms apply to both partial and full payments.

Assets = Liabilities + Equity +250 +250

Assets = Liabilities + Equity −50 −50

Assets = Liabilities + Equity −196 −200 − 4

June 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Purchased goods, terms 2∕10, n∕60. (c2) June 3 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Returned goods to seller.

June 11 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

Paid for $200 of goods less $4 discount.

These T-accounts show the final $196 in inventory, the zero balance in Accounts Payable, and the $196 cash payment.

Example: If on June 20, Z-Mart returns all goods paid for on June 11, the entry is Cash . . . . . . . . . . . . . . . . . . . . 196 Merchandise Inventory . . . 196

Jun . 1 250

Bal . 196

Jun . 3 50 Jun . 11 4

Merchandise Inventory

Jun . 3 50 Jun . 11 200

Jun . 1 250

Bal . 0

Accounts Payable

Jun . 11 196

Cash

Purchases and Transportation Costs The buyer and seller must agree on who is responsible for paying freight (shipping) costs and who has the risk of loss during transit. This is the same as asking at what point ownership trans- fers from the seller to the buyer. The point of transfer is called the FOB (free on board) point.

Exhibit 4.7 covers two alternative points of transfer.

1. FOB shipping point means the buyer accepts ownership when the goods depart the seller’s place of business. The buyer pays shipping costs and has the risk of loss in transit. The goods are part of the buyer’s inventory when they are in transit because ownership has transferred to the buyer. 1-800-Flowers.com, a floral merchandiser, uses FOB shipping point.

2. FOB destination means ownership of goods transfers to the buyer when the goods arrive at the buyer’s place of business. The seller pays shipping charges and has the risk of loss in transit. The seller does not record revenue until the goods arrive at the destination.

Point: When the party not respon- sible for shipping pays shipping cost, it either bills the other party responsible or adjusts its account payable or account receivable with the other party. Freight pay- ments are not applied in comput- ing discounts.

Destination

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

Goods in transit Shipping point

Seller Buyer

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . . #

EXHIBIT 4.7 Ownership Transfer and Transportation Costs

What’s Your Policy? Return policies are a competitive advantage for businesses. REI offers a 1-year return policy on nearly every product it sells. Amazon picks up returned items at your door. On the other hand, some stores like Best Buy allow only 14 days to return products. ■

Decision Insight

Chapter 4 Accounting for Merchandising Operations 149

Point: If we place an order online and receive free shipping, we have terms FOB destination.

(d) Nov . 24 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Paid freight costs on goods.

Assets = Liabilities + Equity +75 −75

Point: INcoming freight costs are charged to INventory. When inventory EXits, freight costs are charged to EXpense.

Itemized Costs of Merchandise Purchases

Invoice cost of merchandise purchases . . . . . . . . . $ 235,800

Less: Purchases discounts received . . . . . . . . . . . . (4,200)

Purchases returns and allowances . . . . . . . . . (1,500)

Add: Costs of transportation-in . . . . . . . . . . . . . . . . 2,300

Total net cost of merchandise purchases . . . . . . $232,400

EXHIBIT 4.8 Itemized Costs of Merchandise Purchases

Decision Ethics

Prepare journal entries to record each of the following purchases transactions of a merchandising com- pany. Assume a perpetual inventory system using the gross method for recording purchases.

Oct. 1 Purchased $1,000 of goods. Terms of the sale are 4∕10, n∕30, and FOB shipping point; the in- voice is dated October 1.

return on October 7, occurred on October 31.

Solution

P1 Merchandise Purchases

NEED-TO-KNOW 4-2

Oct . 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Purchased goods, terms 4∕10, n∕30. Oct . 3 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Paid freight on purchases FOB shipping point.

[continued on next page]

150 Chapter 4 Accounting for Merchandising Operations

The perpetual accounting system requires that each sales transaction for a merchandiser, whether for cash or on credit, has two entries: one for revenue and one for cost.

1. Revenue received (and asset increased) from the customer. 2. Cost of goods sold incurred (and asset decreased) to the customer.

Sales without Cash Discounts Revenue Side: Inflow of Assets Z-Mart sold $1,000 of merchandise on credit terms n∕60 on November 12. The revenue part of this transaction is recorded as follows. This entry shows an increase in Z-Mart’s assets in the form of accounts receivable. It also shows the in- crease in revenue (Sales). If the sale is for cash, debit Cash instead of Accounts Receivable.

Oct . 7 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Returned goods.

Oct . 11 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Merchandise Inventory* . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Cash† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 912

Paid for goods within discount period. *$950 × 4% †$950 − ($950 × 4%)

Oct . 31 Accounts Payable‡ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950

Paid for goods outside discount period. ‡$1,000 − $50

[continued from previous page]

Do More: QS 4-5, QS 4-6, QS 4-7, E 4-3, E 4-5

Merchandising companies must account for sales, sales discounts, sales returns and allowances, and cost of goods sold. Z-Mart has these items in its gross profit computation—see Exhibit 4.9. This shows that customers paid $314,700 for merchandise that cost Z-Mart $230,400, yielding a gross profit of $84,300.

ACCOUNTING FOR MERCHANDISE SALES P2 Analyze and record transac- tions for merchandise sales using a perpetual system.

EXHIBIT 4.9 Gross Profit Computation

Computation of Gross Profit

Net sales (net of discounts, returns, and allowances) . . . . . . . . . . . . $314,700

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 84,300

Cost Side: Outflow of Assets The cost side of each sale requires that Merchandise Inventory decrease by that item’s cost. The cost of the merchandise Z-Mart sold on November 12 is $300, and the entry to record the cost part of this transaction follows.

Point: Gross profit on Nov. 12 sale:

Net sales . . . . . . . . . . . . . $1,000 Cost of goods sold . . . . . . 300 Gross profit . . . . . . . . . . . $ 700

Assets = Liabilities + Equity +1,000 +1,000

Nov . 12 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold goods on credit.

Assets = Liabilities + Equity −300 −300

Nov . 12 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record cost of Nov. 12 sale.

Chapter 4 Accounting for Merchandising Operations 151

Sales with Cash Discounts Offering discounts on credit sales benefits a seller through earlier cash receipts and reduced col- lection efforts. We use the gross method, which records sales at the full amount and records sales discounts if, and when, they are taken. The gross method requires a period-end adjusting entry to estimate future sales discounts. (The net method records sales at the net amount, which assumes all discounts are taken. This method requires an adjusting entry to estimate future dis- counts lost. See Appendix 4C.)

Sales on Credit Z-Mart makes a credit sale for $1,000 on November 12 with terms of 2∕10, n∕45 (cost of the merchandise sold is $300). The entries to record this sale follow.

Future Demands Large merchandising companies, such as Amazon, bombard suppliers with demands. These in- clude discounts for bar coding and technology support systems and fines for shipping errors. Merchandisers’ goals are to reduce inventories, shorten lead times, and eliminate errors. Colleges offer programs in supply chain manage- ment and logistics to train future employees to help merchandisers meet such goals. ■

Decision Insight

Assets = Liabilities + Equity +1,000 +1,000

Assets = Liabilities + Equity −300 −300

Nov . 12 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold goods, terms 2∕10, n∕45. Nov . 12 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Record cost of Nov. 12 sale.

Buyer Pays within Discount Period One option is for the buyer to pay $980 within the 10-day discount period ending November 22. The $20 sales discount is computed as $1,000 × 2%. If the customer pays on (or before) November 22, Z-Mart records the cash receipt as follows. Sales Discounts is a contra revenue account, meaning the Sales Discounts account is subtracted from the Sales account when computing net sales. The Sales Discounts account has a normal debit balance because it is subtracted from Sales, which has a normal credit balance.

Point: Net sales is the amount received from the customer.

Sales . . . . . . . . . . . . . . . . . $1,000 Sales discounts . . . . . . . . (20 ) Net sales . . . . . . . . . . . . . $ 980

Buyer Pays after Discount Period The customer’s second option is to wait 45 days until December 27 (or at least until after the discount period) and then pay $1,000. Z-Mart records that cash receipt as

Sales with Returns and Allowances If a customer is unhappy with a purchase, many sellers allow the customer to either return the merchandise for a full refund (sales return) or keep the merchandise along with a partial refund (sales allowance). Most sellers can reliably estimate returns and allowances (abbreviated R&A).

Buyer Returns Goods—Revenue Side When a buyer returns goods, it impacts the seller’s revenue and cost sides. When a return occurs, the seller debits Sales Returns and

Assets = Liabilities + Equity + 980 −20 −1,000

Nov . 22 Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 980

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment on Nov. 12 sale less discount. *$1,000 − ($1,000 × 2%)

Assets = Liabilities + Equity +1,000 −1,000

Dec . 27 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment on Nov. 12 sale after discount period.

152 Chapter 4 Accounting for Merchandising Operations

Buyer Returns Goods—Cost Side When a return occurs, the seller must reduce the cost of sales. Continuing the example where the returned items sold for $15 and cost $9, the cost-side entry depends on whether the goods are defective.

Returned Goods Not Defective. If the merchandise returned is not defective and can be resold, there is a cost-side entry. The seller adds the cost of the returned goods back to inven- tory and reduces cost of goods sold as follows. This entry reverses the cost-side entry of November 12 for only $9 of goods returned.

(e1) Nov . 26 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Goods returned from Nov. 12 sale.

Assets = Liabilities + Equity −15 −15

Allowances, a contra revenue account to Sales. Assume that a customer returns merchandise on November 26 that sold for $15 and cost $9; the revenue-side returns entry is

Assets = Liabilities + Equity +9 +9

(e2) Nov . 26 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Returned goods are added back to inventory.

If the seller has already collected cash for the sale, the seller could give the price reduction in cash. For example, instead of crediting the buyer’s Accounts Receivable in the entry above, the seller can credit Cash for $10.

Point: When a seller accepts returns or grants an allowance, the seller issues a credit memo- randum. This informs the buyer of a credit made to the buyer’s account in the seller’s records.

Prepare journal entries to record each of the following sales transactions of a merchandising company. Assume a perpetual inventory system and use of the gross method (beginning inventory equals $9,000).

June 1 Sold 50 units of merchandise to a customer for $150 per unit under credit terms of 2∕10, n∕30, FOB shipping point, and the invoice is dated June 1. The 50 units of merchandise had cost $100 per unit.

7 The customer returns 2 units purchased on June 1 because those units did not fit its needs. The seller restores those units to its inventory (as they are not defective) and credits Accounts Re- ceivable from the customer.

11 The seller receives the balance due from the June 1 sale to the customer less returns and allowances. 14 The customer discovers that 10 units have minor damage but keeps them because the seller

sends a $50 cash payment allowance to compensate.

Merchandise Sales

NEED-TO-KNOW 4-3

Buyer Granted Allowances If a buyer is not satisfied with the goods, the seller might offer a price reduction for the buyer to keep the goods. There is no cost-side entry in this case as the inventory is not returned. On the revenue side, the seller debits Sales Returns and Allowances and credits Cash or Accounts Receivable depending on what’s agreed. Assume that $40 of mer- chandise previously sold is defective. The seller gives a price reduction and credits the buyer’s accounts receivable for $10. The seller records this allowance as follows.

Returned Goods Are Defective. If the merchandise returned is defective, the returned inventory is recorded at its estimated value, not its cost. The following entry assumes the returned goods costing $9 are defective and are worth $2.

Nov . 26 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Loss from Defective Merchandise . . . . . . . . . . . . . . . . . . . . . . . 7

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Returned defective goods to inventory and record loss.

Assets = Liabilities + Equity +2 −7 +9

(f ) Nov . 24 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 10 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Sales allowance granted.

Assets = Liabilities + Equity −10 −10

Chapter 4 Accounting for Merchandising Operations 153

June 1 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Sold goods. 50 units × $150 June 1 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Cost of sale. 50 units × $100 June 7 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 300

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Returns accepted. 2 units × $150 June 7 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Returns added to inventory. 2 units × $100 June 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,056

Sales Discounts* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,200

Received payment. *($7,500 − $300) × 2% June 14 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 50

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Recorded allowance on goods. Do More: QS 4-8, E 4-4,

E 4-6, E 4-7

Exhibit 4.10 shows the flow of merchandising costs during a period and where these costs are reported at period-end. Specifically, beginning inventory plus the net cost of purchases is the merchandise available for sale. As inventory is sold, its cost is recorded in cost of goods sold on the income statement; what remains is ending inventory on the balance sheet. A period’s ending inventory is the next period’s beginning inventory.

ADJUSTING AND CLOSING FOR MERCHANDISERS

Solution

Beginning inventory

From supplier

Net purchases

Ending inventory

Period 2Period 1

Cost of goods sold

Merchandise available for sale

To Income Statement

To Balance Sheet

Beginning inventory

From supplier

Net purchases

Ending inventory

Cost of goods sold

Merchandise available for sale

To Income Statement

To Balance Sheet

EXHIBIT 4.10 Merchandising Cost Flow in the Accounting Cycle

Adjusting Entries for Merchandisers Each of the steps in the accounting cycle described in the prior chapter applies to a merchan- diser. We expand upon three steps of the accounting cycle for a merchandiser—adjustments, statement preparation, and closing.

Inventory Shrinkage—Adjusting Entry A merchandiser using a perpetual inven- tory system makes an adjustment to Merchandise Inventory for any loss of merchandise, includ- ing theft and deterioration. Shrinkage is the loss of inventory, and it is computed by comparing a physical count of inventory with recorded amounts.

P3 Prepare adjustments and close accounts for a mer- chandising company.

154 Chapter 4 Accounting for Merchandising Operations

Dec . 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Adjust for $250 shrinkage.

Assets = Liabilities + Equity −250 −250

These three adjustments produce three new accounts: Allowance for Sales Discounts, Sales Refund Payable, and Inventory Returns Estimated. Appendix 4B covers these accounts and the adjusting entries.

EXHIBIT 4.11 Closing Entries for a Merchandiser

Step 1: Close Credit Balances in Temporary Accounts to Income Summary.

Step 2: Close Debit Balances in Temporary Accounts to Income Summary.

Step 3: Close Income Summary.

Dec . 31 Income Summary . . . . . . 12,900 Retained Earnings . . 12,900

Step 4: Close Dividends.

Dec . 31 Retained Earnings . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . 4,000

Chapter 4 Accounting for Merchandising Operations 155

Sales, having a normal credit balance, is debited in step 1. Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold, having normal debit balances, are credited in step 2.

Summary of Merchandising Entries Exhibit 4.12 summarizes the adjusting and closing entries of a merchandiser (using a perpetual inventory system).

EXHIBIT 4.12 Summary of Key Merchandising Entries (using perpetual system and gross method)

Merchandising Transactions Merchandising Entries Dr. Cr.

Purchasing merchandise for Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . # resale . Cash or Accounts Payable . . . . . . . . . . . . . . #

Paying freight costs on Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . # purchases; FOB shipping point . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Paying within discount period . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Merchandise Inventory . . . . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Paying outside discount period . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Recording purchases returns or Cash or Accounts Payable . . . . . . . . . . . . . . . . . . . # allowances . Merchandise Inventory . . . . . . . . . . . . . . . . . #

Selling merchandise . Cash or Accounts Receivable . . . . . . . . . . . . . . . . # Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . . . . . . #

Receiving payment within Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period . Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . # Accounts Receivable . . . . . . . . . . . . . . . . . . #

Sales Receiving payment outside Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

discount period . Accounts Receivable . . . . . . . . . . . . . . . . . . #

Receiving sales returns Sales Returns and Allowances . . . . . . . . . . . . . . . # of nondefective inventory . Cash or Accounts Receivable . . . . . . . . . . . #

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . #

Recognizing sales allowances . Sales Returns and Allowances . . . . . . . . . . . . . . . # Cash or Accounts Receivable . . . . . . . . . . . #

Paying freight costs on sales; Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . # FOB destination . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjustment for shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . # (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . . . . . . # larger than physical inventory) .

Period-end adjustment for Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . # Adjusting expected sales discounts .* Allowance for Sales Discounts . . . . . . . . . . . #

Period-end adjustment for expected Sales Returns and Allowances . . . . . . . . . . . . . . . # returns—both revenue side and Sales Refund Payable . . . . . . . . . . . . . . . . . . # cost side .* Inventory Returns Estimated . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . #

Closing temporary accounts Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . # with credit balances . Income Summary . . . . . . . . . . . . . . . . . . . . . #

Closing temporary accounts Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . # Closing with debit balances . Sales Returns and Allowances . . . . . . . . . . . # Sales Discounts . . . . . . . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . . . . . . # Delivery Expense . . . . . . . . . . . . . . . . . . . . . # “Other Expenses” . . . . . . . . . . . . . . . . . . . . . #

Merchandise Inventory

Beginning inventory Purchases Pur. returns Freight-in (FOB shp pt) Pur. allowances Pur. discounts Shrinkage

Goods avail. for sale Customer returns COGS

Ending inventory

* Period-end adjustments depend on unadjusted balances, which can reverse the debit and credit in the adjusting entries shown; these three entries are covered in Appendix 4B.

156 Chapter 4 Accounting for Merchandising Operations

A merchandising company’s ledger on May 31, its fiscal year-end, includes the following accounts that have normal balances (it uses the perpetual inventory system). A physical count of its May 31 year-end inventory reveals that the cost of the merchandise inventory still available is $656. (a) Prepare the entry to record any inventory shrinkage. (b) Prepare the four closing entries as of May 31.

Recording Shrinkage and Closing Entries

NEED-TO-KNOW 4-4

Solution

This section covers two income statement formats: multiple-step and single-step. The classified balance sheet of a merchandiser also is covered.

Multiple-Step Income Statement A multiple-step income statement details net sales and expenses and reports subtotals for various types of items. Exhibit 4.13 shows a multiple-step income statement. The statement has three main parts: (1) gross profit, which is net sales minus cost of goods sold; (2) income from operations, which is gross profit minus operating expenses; and (3) net income, which is income from operations plus or minus nonoperating items.

Operating expenses are separated into two sections. Selling expenses are the expenses of advertising merchandise, making sales, and delivering goods to customers. General and admin- istrative expenses support a company’s overall operations and include expenses related to accounting, human resources, and finance. Expenses are allocated between sections when they contribute to more than one. Z-Mart allocates rent expense of $9,000 from its store building between two sections: $8,100 to selling expense and $900 to general and administrative expenses.

Nonoperating activities consist of other expenses, revenues, losses, and gains that are un related to a company’s operations. Other revenues and gains commonly include interest revenue, divi- dend revenue, rent revenue, and gains from asset disposals. Other expenses and losses commonly include interest expense, losses from asset disposals, and casualty losses. When there are no reportable nonoperating activities, its income from operations is simply labeled net income.

MORE ON FINANCIAL STATEMENT FORMATS P4 Define and prepare multiple-step and single- step income statements.

Example: Sometimes interest rev- enue and interest expense are netted and reported on the in- come statement as Interest, net.

Do More: QS 4-9, QS 4-10, E 4-10, E 4-12, P 4-4

May 31 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Adjust for shrinkage ($756 − $656).

May 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Close temporary accounts with credit balances.

May 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 250 Cost of Goods Sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 Other Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . 300 Close temporary accounts with debit balances.

*$2,100 (Unadj. bal.) + $100 (Shrinkage)

May 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Close Income Summary account.

May 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Close Dividends account.

Merchandise inventory . . . . $ 756 Sales . . . . . . . . . . . . . . . . . . . . . $4,300 Depreciation expense . . . . . . . . . $400 Common stock . . . . . . . . . . . 1,000 Sales discounts . . . . . . . . . . . . . 50 Salaries expense . . . . . . . . . . . . . 600 Retained earnings . . . . . . . . 1,300 Other operating expenses . . . . 300 Sales returns and allowances . . . 250 Dividends . . . . . . . . . . . . . . . 150 Cost of goods sold . . . . . . . . . . 2,100

Chapter 4 Accounting for Merchandising Operations 157

Single-Step Income Statement A single-step income statement is shown in Exhibit 4.14. It lists cost of goods sold as another expense and shows only one subtotal for total expenses. Expenses are grouped into few, if any, categories. Many companies use formats that combine features of both single- and multiple-step statements. Management chooses the format that best informs users.

Z-MART Income Statement

For Year Ended December 31, 2019

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000

Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,300

Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . 2,000 6,300

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314,700

Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,300 Operating expenses

Selling expenses

Depreciation expense—Store equipment . . . . . . . . . . . . . . 3,000

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500

Rent expense—Selling space . . . . . . . . . . . . . . . . . . . . . . . . 8,100

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,300

Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,100

General and administrative expenses

Depreciation expense—Office equipment . . . . . . . . . . . . . 700

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,300

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Rent expense—Office space . . . . . . . . . . . . . . . . . . . . . . . . 900

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Total general and administrative expenses . . . . . . . . . . . . . 29,300

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,400

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 Other revenues and gains (expenses and losses)

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Gain on sale of building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,500)

Total other revenues and gains (expenses and losses) . . . . . . 2,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

Nonoperating activities computation

Income from operations computation

Gross profit computation

Beginning inventory. . . . . . $ 19,000 Net cost of purchases . . . . 232,400 Goods available for sale . . . 251,400 Less ending inventory . . . . 21,000 Cost of goods sold . . . . . . . $230,400

*Cost of goods sold:

EXHIBIT 4.13 Multiple-Step Income Statement

EXHIBIT 4.14 Single-Step Income Statement

Z-MART Income Statement

For Year Ended December 31, 2019

Revenues Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $314,700

Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Gain on sale of building . . . . . . . . . . . . . . . . . . . . . . 2,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318,200

Expenses Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . $230,400

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,100

General and administrative expenses . . . . . . . . . . . 29,300

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303,300

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900 Point: Net income is identical under the single-step and multiple-step formats.

Point: Z-Mart did not have any nonoperating activities. Exhibit 4.13 includes some for illustrative purposes.

158 Chapter 4 Accounting for Merchandising Operations

Classified Balance Sheet The classified balance sheet reports merchandise inventory as a current asset, usually after accounts receivable, according to how quickly they can be converted to cash. Inventory is converted less quickly to cash than accounts receivable because inventory first must be sold before cash can be received. Exhibit 4.15 shows the current asset section of Z-Mart’s classified balance sheet (other sections are similar to the previous chapter).

Z-MART Balance Sheet (partial)

December 31, 2019

Current assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,200 Accounts receivable . . . . . . . . . . . . . 11,200 Merchandise inventory . . . . . . . . . 21,000 Office supplies . . . . . . . . . . . . . . . . . 550 Store supplies . . . . . . . . . . . . . . . . . . 250 Prepaid insurance . . . . . . . . . . . . . . . 300 Total current assets . . . . . . . . . . . . . $41,500

EXHIBIT 4.15 Classified Balance Sheet (partial) of a Merchandiser

Shenanigans Accurate invoices are important to both sellers and buyers. Merchandisers use invoices to make sure they receive full payment for products provided. To achieve this, controls are set up. Still, failures occur. A survey reports that 30% of employees in sales and marketing witnessed false or misleading invoices sent to customers. Another 29% observed employees violating contract terms with customers (KPMG). ■

Ethical Risk

Taret’s adjusted trial balance on April 30, its fiscal year-end, is shown here (accounts in random order). (a) Prepare a multiple-step income statement that begins with gross sales and includes separate categories for net sales, cost of goods sold, selling expenses, and gen- eral and administrative expenses. (b) Prepare a single-step income statement that begins with net sales and includes these expense cat- egories: cost of goods sold, selling expenses, and general and administrative expenses.

Multiple- and Single-Step Income Statements

NEED-TO-KNOW 4-5

Solution

a. Multiple-step income statement.

TARET Income Statement

For Year Ended April 30

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,500 Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $260 Sales returns and allowances . . . . . . . . . . . . . . . . . . . . 240 500 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Operating expenses Selling expenses Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . 450 Rent expense—Selling space . . . . . . . . . . . . . . . . . . . . . 400 Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 30 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Total selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 900 General and administrative expenses Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . 420 Rent expense—Office space . . . . . . . . . . . . . . . . . . . . . 72 Office supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 8 Total general and administrative expenses . . . . . . . . . 500 Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,100

TARET Income Statement

For Year Ended April 30

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 Expenses Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $6,500 Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 General and administrative expenses . . . . . . . . . . . 500 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,100

b. Single-step income statement.

Adjusted Trial Balance Debit Credit

Merchandise inventory . . . . . . . . . . . . . . . . . . . $ 800 Other (noninventory) assets . . . . . . . . . . . . . . . 2,600 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 400 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 1,700 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . 260 Sales returns and allowances . . . . . . . . . . . . . 240 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 6,500 Sales salaries expense . . . . . . . . . . . . . . . . . . . 450 Rent expense—Selling space . . . . . . . . . . . . . . 400 Store supplies expense . . . . . . . . . . . . . . . . . . 30 Advertising expense . . . . . . . . . . . . . . . . . . . . 20 Office salaries expense . . . . . . . . . . . . . . . . . . 420 Rent expense—Office space . . . . . . . . . . . . . . 72 Office supplies expense . . . . . . . . . . . . . . . . . 8 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,100 $12,100

Do More: QS 4-11, E 4-11, E 4-15, P 4-3

Chapter 4 Accounting for Merchandising Operations 159

Acid-Test and Gross Margin Ratios Decision Analysis

Acid-Test Ratio One measure of a merchandiser’s ability to pay its current liabilities (referred to as its liquidity) is the acid- test ratio. The acid-test ratio, also called quick ratio, is defined as quick assets (cash, short-term invest- ments, and current receivables) divided by current liabilities—see Exhibit 4.16. It differs from the current ratio by excluding less liquid current assets such as inventory and prepaid expenses that take longer to be converted to cash.

Exhibit 4.17 shows both the acid-test and current ratios of Nike and Under Armour for three recent years. Nike’s acid-test ratio implies that it has enough quick assets to cover current liabilities. It is also on par with its competitor, Under Armour. Nike’s current ratio suggests it has more than enough current assets to cover current liabilities. Analysts might argue that Nike could invest some current assets in more productive assets. An acid-test ratio less than 1.0 means that current liabilities exceed quick assets. A rule of thumb is that the acid-test ratio should have a value near, or higher than, 1.0. Less than 1.0 raises liquid- ity concerns unless a company can get enough cash from sales or if liabilities are not due until late in the next period.

A1 Compute the acid-test ratio and explain its use to as- sess liquidity.

Acid-test ratio = Cash and cash equivalents + Short-term investments + Current receivables

Current liabilities

EXHIBIT 4.16 Acid-Test (Quick) Ratio

Company $ millions Current Year 1 Year Ago 2 Years Ago

Nike Total quick assets . . . . . . . . . . . . . . $ 9,856 $ 8,698 $ 9,282 Total current assets . . . . . . . . . . . . . $16,061 $15,025 $15,587

Total current liabilities . . . . . . . . . . . $ 5,474 $ 5,358 $ 6,332

Acid-test ratio . . . . . . . . . . . . . . . . . 1.8 1.6 1.5 Current ratio . . . . . . . . . . . . . . . . . . 2.9 2.8 2.5 Under Armour Acid-test ratio . . . . . . . . . . . . . . . . . 0 .9 1 .3 1 .2 Current ratio . . . . . . . . . . . . . . . . . . 2 .2 2 .9 3 .1

EXHIBIT 4.17 Acid-Test and Current Ratios for two competitors

Gross Margin Ratio Without enough gross profit, a merchandiser can fail. The gross margin ratio helps understand this link. It differs from the profit margin ratio in that it excludes all costs except cost of goods sold. The gross margin ratio (or gross profit ratio) is defined as gross margin (net sales minus cost of goods sold) divided by net sales—see Exhibit 4.18.

Supplier A retailer requests to purchase supplies on credit from your company. You have no prior experience with this retailer. The retailer’s current ratio is 2.1, its acid-test ratio is 0.5, and inventory makes up most of its current assets. Do you extend credit? ■ Answer: A current ratio of 2.1 suggests sufficient current assets to cover current liabilities. An acid-test ratio of 0.5 suggests, however, that quick assets can cover only about one-half of current liabilities. The retailer depends on money from sales of inventory to pay current liabilities. If sales decline, the likelihood that this retailer will default on its payments increases. You probably do not extend credit.

Decision Maker

Point: Successful use of a just-in- time inventory system can narrow the gap between the acid-test ratio and the current ratio.

A2 Compute the gross margin ratio and explain its use to assess profitability.

EXHIBIT 4.18 Gross Margin RatioGross margin ratio =

Net sales − Cost of goods sold Net sales

Exhibit 4.19 shows the gross margin ratio of Nike for three recent years. For Nike, each $1 of sales in the current year yielded about 44.6¢ in gross margin to cover all expenses and still produce a net income. This 44.6¢ margin is down from 46.2¢ in the prior year. This decrease is unfavorable.

$ millions Current Year 1 Year Ago 2 Years Ago

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,312 $14,971 $14,067

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $34,350 $32,376 $30,601

Gross margin ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44.6% 46.2% 46.0%

EXHIBIT 4.19 Nike’s Gross Margin Ratio

160 Chapter 4 Accounting for Merchandising Operations

Use the following adjusted trial balance and additional information to complete the requirements.

COMPREHENSIVE 1

Single- and Multiple-Step Income Statements, Closing Entries, and Analysis Using Acid-Test and Gross Margin

NEED-TO-KNOW 4-6 KC ANTIQUES

Adjusted Trial Balance December 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Merchandise inventory (ending) . . . . . . . . . . . . . . . 60,000

Store supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,600

Accumulated depreciation—Equipment . . . . . . . . . $ 16,600

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Sales returns and allowances . . . . . . . . . . . . . . . . . 6,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Depreciation expense—Store equipment . . . . . . . 4,100

Depreciation expense—Office equipment . . . . . . . 1,600

Sales salaries expense . . . . . . . . . . . . . . . . . . . . . . 30,000

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . 34,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent expense—Selling space . . . . . . . . . . . . . . . . . . 16,800

Rent expense—Office space . . . . . . . . . . . . . . . . . . 7,200

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . 5,750

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . 31,400

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $449,850 $449,850

160 Chapter 4 Accounting for Merchandising Operations

Financial Officer Your company has a 36% gross margin ratio and a 17% net profit margin ratio. Industry averages are 44% for gross margin and 16% for net profit margin. Do these comparative results concern you? ■ Answer: Your company’s net profit margin is about equal to the industry average. However, gross margin shows that your company is paying far more in cost of goods sold or receiving far less in sales price than competitors. You should try to find the problem with cost of goods sold, sales, or both.

Decision Maker

KC Antiques’s supplementary records for the year reveal the following itemized costs for merchandising activities.

Invoice cost of merchandise purchases . . . . . . . $150,000

Purchases discounts received . . . . . . . . . . . . . . . 2,500 Purchases returns and allowances . . . . . . . . . . . $2,700

Cost of transportation-in . . . . . . . . . . . . . . . . . . . 5,000

Required

1. Use the supplementary records to compute the total cost of merchandise purchases for the year. 2. Prepare a multiple-step income statement for the year. (Beginning inventory was $70,100.) 3. Prepare a single-step income statement for the year. 4. Prepare closing entries for KC Antiques at December 31. 5. Compute the acid-test ratio and the gross margin ratio. Explain the meaning of each ratio and interpret

them for KC Antiques.

Chapter 4 Accounting for Merchandising Operations 161

PLANNING THE SOLUTION Compute the total cost of merchandise purchases for the year. To prepare the multiple-step statement, first compute net sales. Then, to compute cost of goods sold,

add the net cost of merchandise purchases for the year to beginning inventory and subtract the cost of ending inventory. Subtract cost of goods sold from net sales to get gross profit. Then classify expenses as selling expenses or general and administrative expenses.

To prepare the single-step income statement, begin with net sales. Then list and subtract the expenses. The first closing entry debits all temporary accounts with credit balances and opens the Income

Summary account. The second closing entry credits all temporary accounts with debit balances. The third entry closes the Income Summary account to the Retained Earnings account, and the fourth entry closes the Dividends account to the Retained Earnings account.

Identify the quick assets on the adjusted trial balance. Compute the acid-test ratio by dividing quick assets by current liabilities. Compute the gross margin ratio by dividing gross profit by net sales.

SOLUTION 1.

Invoice cost of merchandise purchases . . . . . . . . . . . . $150,000

Less: Purchases discounts received . . . . . . . . . . . . . . . 2,500

Purchases returns and allowances . . . . . . . . . . . 2,700

Add: Cost of transportation-in . . . . . . . . . . . . . . . . . . . . 5,000

Total cost of merchandise purchases . . . . . . . . . . . . . . $149,800

2. Multiple-step income statement. 3. Single-step income statement.

KC ANTIQUES Income Statement

For Year Ended December 31

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $343,250

Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

Sales returns and allowances . . . . . . . . . . . . . . 6,000 11,000

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,250

Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,350

Expenses

Selling expenses

Depreciation expense—Store equipment . . . . . 4,100

Sales salaries expense . . . . . . . . . . . . . . . . . . . . 30,000

Rent expense—Selling space . . . . . . . . . . . . . . . 16,800

Store supplies expense . . . . . . . . . . . . . . . . . . . 5,750

Advertising expense . . . . . . . . . . . . . . . . . . . . . . 31,400

Total selling expenses . . . . . . . . . . . . . . . . . . . . . 88,050

General and administrative expenses

Depreciation expense—Office equipment . . . . . 1,600

Office salaries expense . . . . . . . . . . . . . . . . . . . . 34,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent expense—Office space . . . . . . . . . . . . . . . . 7,200

Total general and administrative expenses . . . . 53,800

Total operating expenses . . . . . . . . . . . . . . . . . . . . 141,850

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,500

*Cost of goods sold also can be directly computed: Beginning merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . $ 70,100 Total cost of merchandise purchases (from part 1) . . . . . . . . . . 149,800 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219,900 Ending merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,900

Tax expense for a corporation appears immediately before Net income in its own category .

KC ANTIQUES Income Statement

For Year Ended December 31

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $332,250

Expenses

Cost of goods sold . . . . . . . . . . . . . . . . . . . $159,900

Selling expenses . . . . . . . . . . . . . . . . . . . . 88,050

General and administrative expenses . . . 53,800

Total expenses . . . . . . . . . . . . . . . . . . . . . . 301,750

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,500

162 Chapter 4 Accounting for Merchandising Operations

5. Acid-test ratio = (Cash and equivalents + Short-term investments + Current receivables)∕ Current liabilities

= (Cash + Accounts receivable)∕(Accounts payable + Salaries payable)

= ($7,000 + $13,000)∕($9,000 + $2,000) = $20,000∕$11,000 = 1.82 Gross margin ratio = Gross profit∕Net sales = $172,350∕$332,250 = 0.52 (or 52%)

KC Antiques has a healthy acid-test ratio of 1.82. This means it has $1.82 in liquid assets to sat- isfy each $1.00 in current liabilities. The gross margin of 0.52 shows that KC Antiques spends 48¢ ($1.00 − $0.52) of every dollar of net sales on the costs of acquiring the merchandise it sells. This leaves 52¢ of every dollar of net sales to cover other expenses incurred in the business and to provide a net profit.

4. Dec . 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250

Close credit balances in temporary accounts.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312,750

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . 6,000

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,900

Depreciation Expense—Store Equipment . . . . . . . . . . . . 4,100

Depreciation Expense—Office Equipment . . . . . . . . . . . 1,600

Sales Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Office Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000

Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000

Rent Expense—Selling Space . . . . . . . . . . . . . . . . . . . . . . 16,800

Rent Expense—Office Space . . . . . . . . . . . . . . . . . . . . . . 7,200

Store Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 5,750

Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,400

Close debit balances in temporary accounts.

Dec . 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500

Close Income Summary account.

Dec . 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Close Dividends account.

Prepare journal entries for the following transactions for both the seller (BMX) and buyer (Sanuk).

May 4 BMX sold $1,500 of merchandise on account to Sanuk, terms FOB shipping point, n∕45, in- voice dated May 4. The cost of the merchandise was $900.

6 Sanuk paid transportation charges of $30 on the May 4 purchase from BMX. 8 BMX sold $1,000 of merchandise on account to Sanuk, terms FOB destination, n∕15, in-

voice dated May 8. The cost of the merchandise was $700. This sale permitted returns for 30 days.

10 BMX paid transportation costs of $50 for delivery of merchandise sold to Sanuk on May 8. 16 BMX issued Sanuk a $200 credit memorandum for merchandise returned. The merchan-

dise was purchased by Sanuk on account on May 8. The cost of the merchandise returned was $140.

18 BMX received payment from Sanuk for the May 8 purchase. 21 BMX sold $2,400 of merchandise on account to Sanuk, terms FOB shipping point, 2∕10,

n∕EOM. The cost of the merchandise was $1,440. This sale permitted returns for 90 days. 31 BMX received payment from Sanuk for the May 21 purchase, less discount.

COMPREHENSIVE 2

Recording Merchandising Transactions—Both Seller and Buyer

NEED-TO-KNOW 4-7

Chapter 4 Accounting for Merchandising Operations 163

Solution BMX (Seller) Sanuk (Buyer)

May 4 Accounts Receivable—Sanuk . . . . . . . . . . 1,500 Merchandise Inventory . . . . . . . . . . . . . . 1,500

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accounts Payable—BMX . . . . . . . . . 1,500

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 900

Merchandise Inventory . . . . . . . . . . . 900

6 No entry . Merchandise Inventory . . . . . . . . . . . . . . 30

Cash . . . . . . . . . . . . . . . . . . . . . . . . . 30

8 Accounts Receivable—Sanuk . . . . . . . . . . 1,000 Merchandise Inventory . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Accounts Payable—BMX . . . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . . . . . . . . 700

Merchandise Inventory . . . . . . . . . . . 700

10 Delivery Expense . . . . . . . . . . . . . . . . . . . . 50 No entry .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 50

16 Sales Returns & Allowances . . . . . . . . . . . 200 Accounts Payable—BMX . . . . . . . . . . . . . 200

Accounts Receivable—Sanuk . . . . . . 200 Merchandise Inventory . . . . . . . . . . 200

Merchandise Inventory . . . . . . . . . . . . . . . 140

Cost of Goods Sold . . . . . . . . . . . . . . 140

18 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Accounts Payable—BMX . . . . . . . . . . . . . 800

Accounts Receivable—Sanuk . . . . . . 800 Cash . . . . . . . . . . . . . . . . . . . . . . . . . 800

21 Accounts Receivable—Sanuk . . . . . . . . . . . 2,400 Merchandise Inventory . . . . . . . . . . . . . . 2,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 2,400 Accounts Payable—BMX . . . . . . . . . 2,400

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 1,440

Merchandise Inventory . . . . . . . . . . . 1,440

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,352 Accounts Payable—BMX . . . . . . . . . . . . . 2,400

Sales Discounts . . . . . . . . . . . . . . . . . . . . . 48 Merchandise Inventory . . . . . . . . . . 48

Accounts Receivable—Sanuk . . . . . . 2,400 Cash . . . . . . . . . . . . . . . . . . . . . . . . . 2,352

APPENDIX

Periodic Inventory System 4A A periodic inventory system requires updating the inventory account only at the end of a period. During the period, the Merchandise Inventory balance remains unchanged and cost of merchandise is recorded in a temporary Purchases account. When a company sells merchandise, it records revenue but not the cost of the goods sold. At the end of the period, it takes a physical count of inventory to get ending inventory. The cost of goods sold is then computed as cost of merchandise available for sale minus ending inventory.

Recording Merchandise Purchases Under a periodic system, the purchases, purchases returns and allowances, purchases discounts, and transportation-in transactions are recorded in separate temporary accounts. At period-end, each of these temporary accounts is closed, which updates the Merchandise Inventory account. To demonstrate, journal entries under the periodic inventory system are shown for the most common transactions (codes a through d link these transactions to those in the chap- ter). For comparison, perpetual system journal entries are shown to the right of each periodic entry. Differences are highlighted.

Credit Purchases with Cash Discounts The periodic system uses a temporary Purchases account that accumulates the cost of all purchase transactions during each period. The Purchases account has a normal debit balance, as it increases the cost of merchandise available for sale. Z-Mart’s November 2 entry to record the purchase of merchandise for $500 on credit with terms of 2∕10, n∕30 is

P5 Record and compare merchandising transactions using both periodic and perpetual inventory systems.

(a) Periodic Perpetual

Purchases . . . . . . . . . . . . . . . . . . 500 Merchandise Inventory . . . . . . . . . . . 500

Accounts Payable . . . . . . . 500 Accounts Payable . . . . . . . . . . . 500

164 Chapter 4 Accounting for Merchandising Operations

Payment of Purchases The periodic system uses a temporary Purchases Discounts account that accumu- lates discounts taken during the period. If payment for transaction a is made within the discount period, the entry is

Purchases Allowances The buyer and seller agree to a $30 purchases allowance for defective goods (whether paid within the discount period or not). In the periodic system, the temporary Purchases Returns and Allowances account accumulates the cost of all returns and allowances during a period. The buyer records the $30 allowance as

If payment for transaction a is made after the discount period expires, the entry is

(b1) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 500

Purchases Discounts* . . . . . 10 Merchandise Inventory* . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490 *$500 × 2% *$500 × 2%

(b2) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 500

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

(c1) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 30 Accounts Payable . . . . . . . . . . . . . . . . 30

Purchases Returns and Allowances . . . . . . . . . . 30 Merchandise Inventory . . . . . . . 30

(c2) Periodic Perpetual

Accounts Payable . . . . . . . . . . . . 50 Accounts Payable . . . . . . . . . . . . . . . . 50

Purchases Returns and Allowances . . . . . . . . . . 50 Merchandise Inventory . . . . . . . 50

(d) Periodic Perpetual

Transportation-In . . . . . . . . . . . . 75 Merchandise Inventory . . . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . . . . 75

Purchases Returns The buyer returns $50 of merchandise within the discount period. The entry is

Point: Purchases Discounts and Purchases Returns and Allowances are contra purchases accounts and have normal credit balances, as they both decrease the cost of merchandise available for sale.

Transportation-In The buyer paid a $75 freight charge to transport goods with terms FOB destination. In the periodic system, this cost is recorded in a temporary Transportation-In account, which has a normal debit balance as it increases the cost of merchandise available for sale.

Recording Merchandise Sales Journal entries under the periodic system are shown for the most common transactions (codes e through h link these transactions to those in the chapter). Perpetual system entries are shown to the right of each periodic entry. Differences are highlighted.

Credit Sales and Receipt of Payments Both the periodic and perpetual systems record sales entries simi- larly, using the gross method. The same holds for entries related to payment of receivables from sales both during and after the discount period. However, under the periodic system, the cost of goods sold is not recorded at the time of each sale (whereas it is under the perpetual system). The entry to record $1,000 in credit sales (costing $300) is

Periodic Perpetual

Accounts Receivable . . . . . . . . . . 1,000 Accounts Receivable . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . 1,000 Sales . . . . . . . . . . . . . . . . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . . . . . 300

No cost-side entry . . . . . . . Merchandise Inventory . . . . . . . 300

Chapter 4 Accounting for Merchandising Operations 165

Returns Received by Seller A customer returned merchandise for a cash refund. The goods sell for $15 and cost $9. (Recall: The periodic system records only the revenue effect, not the cost effect, for sales transactions.) The entry for the seller to take back the return is

Allowances Granted by Seller The seller gives a price reduction and credits the buyer’s accounts receivable for $10. The entry is identical under the periodic and perpetual systems. The seller records this allowance as

Recording Adjusting Entries Shrinkage—Adjusting Entry Adjusting (and closing) entries for the two systems are in Exhibit 4A.1. The $250 shrinkage is only recorded under the perpetual system—see entry z in Exhibit 4A.1. Shrinkage in cost of goods is unknown using a periodic system because inventory is not continually updated and therefore cannot be compared to the physical count.

Periodic Perpetual

(f ) Sales Returns and Allowances . . . . 10 Sales Returns and Allowances . . . . . . 10 Accounts Receivable . . . . . . . 10 Accounts Receivable . . . . . . . . . 10

Periodic Perpetual

(e1) Sales Returns and Allowances . . . . 15 Sales Returns and Allowances . . . . . . 15 Cash . . . . . . . . . . . . . . . . . . . . 15 Cash . . . . . . . . . . . . . . . . . . . . . . 15

(e2) Merchandise Inventory . . . . . . . . . . . 9 No entry . . . . . . . . . . . . . . . . . Cost of Goods Sold . . . . . . . . . . 9

EXHIBIT 4A.1 Comparison of Adjusting and Closing Entries— Periodic and Perpetual

Periodic Perpetual Adjusting Entries Adjusting Entries

(z) None Cost of Goods Sold . . . . . . . . . . . . . . 250 Merchandise Inventory . . . . . . 250

(g) Sales Discounts . . . . . . . . . . . . . . . . 50 Sales Discounts . . . . . . . . . . . . . . . . . 50 Allowance for Sales Discounts 50 Allowance for Sales Discounts . . 50

(h1) Sales Returns and Allowances . . . . 900 Sales Returns and Allowances . . . . . . 900 Sales Refund Payable . . . . . . . 900 Sales Refund Payable . . . . . . . . 900

(h2) Inventory Returns Estimated . . . . . . 300 Inventory Returns Estimated . . . . . . . 300 Purchases . . . . . . . . . . . . . . . . 300 Cost of Goods Sold . . . . . . . . . . 300

Entries in gray are covered in Appendix 4B. Entries in gray are covered in Appendix 4B.

Periodic Perpetual Closing Entries Closing Entries

(1) Sales . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Merchandise Inventory (ending) 21,000 Purchases Discounts . . . . . . . . . . 4,200 Purchases Returns and Allowances 1,500 Income Summary . . . . . . . . . . 347,700 Income Summary . . . . . . . . . . . 321,000

(2) Income Summary . . . . . . . . . . . . . . 334,800 Income Summary . . . . . . . . . . . . . . . . 308,100 Sales Discounts . . . . . . . . . . . 4,300 Sales Discounts . . . . . . . . . . . . 4,300 Sales Returns and Allowances 2,000 Sales Returns and Allowances . . 2,000 Merch. Inven. (beginning) . . . 19,000 Purchases . . . . . . . . . . . . . . . 235,800 Cost of Goods Sold . . . . . . . . . 230,400 Transportation-In . . . . . . . . . 2,300 Depreciation Expense . . . . . . 3,700 Depreciation Expense . . . . . . . 3,700 Salaries Expense . . . . . . . . . . 43,800 Salaries Expense . . . . . . . . . . . 43,800 Insurance Expense . . . . . . . . 600 Insurance Expense . . . . . . . . . . 600 Rent Expense . . . . . . . . . . . . . 9,000 Rent Expense . . . . . . . . . . . . . . 9,000 Supplies Expense . . . . . . . . . 3,000 Supplies Expense . . . . . . . . . . . 3,000 Advertising Expense . . . . . . . 11,300 Advertising Expense . . . . . . . . . 11,300

(3) Income Summary . . . . . . . . . . . . . . 12,900 Income Summary . . . . . . . . . . . . . . . . 12,900 Retained Earnings . . . . . . . . . 12,900 Retained Earnings . . . . . . . . . . . 12,900

(4) Retained Earnings . . . . . . . . . . . . . 4,000 Retained Earnings . . . . . . . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . . . . . . . 4,000

166 Chapter 4 Accounting for Merchandising Operations

Expected Sales Discounts—Adjusting Entry Both the periodic and perpetual methods make a period-end adjusting entry under the gross method to estimate the $50 sales discounts arising from current-period sales that are likely to be taken in future periods. Z-Mart made the period-end adjusting entry g in Exhibit 4A.1 for expected sales discounts.

Expected Returns and Allowances—Adjusting Entry Both the periodic and perpetual inventory systems estimate returns and allowances arising from current-period sales that will occur in future periods. The adjusting entry for both systems is identical for the sales side, but slightly different for the cost side. The period-end entries h1 and h2 in Exhibit 4A.1 are used to record the updates to expected sales refunds of $900 and the cost side of $300. Under both systems, the seller sets up a Sales Refund Payable account, which is a current liability reflecting the amount expected to be refunded to customers, and an Inventory Returns Estimated account, which is a current asset reflecting the inventory estimated to be returned.

Recording Closing Entries Periodic and perpetual inventory systems have slight differ- ences in closing entries. The period-end Merchandise Inventory balance (unadjusted) is $19,000 under the periodic system. Because the periodic system does not update the Merchandise Inventory balance during the period, the $19,000 amount is the beginning inventory. A physical count of inventory taken at the end of the period reveals $21,000 of merchandise available. The adjusting and closing entries for the two systems are in Exhibit 4A.1. Recording the periodic inventory balance is a two-step process. The ending inventory balance of $21,000 is entered by debiting the inventory account in the first closing entry. The beginning inventory balance of $19,000 is deleted by crediting the inventory account in the second closing entry.1 By updating Merchandise Inventory and closing Purchases, Purchases Discounts, Purchases Returns and Allowances, and Transportation-In, the periodic system transfers the cost of sales amount to Income Summary. Review the periodic side of Exhibit 4A.1 and see that the red items affect Income Summary as follows.

1This approach is called the closing entry method. An alternative approach, referred to as the adjusting entry method, would not make any entries to Merchandise Inventory in the closing entries of Exhibit 4A.1, but instead would make two adjusting entries. Using Z-Mart data, the two adjusting entries would be (1) Dr. Income Summary and Cr. Merchandise Inventory for $19,000 each and (2) Dr. Merchandise Inventory and Cr. Income Summary for $21,000 each. The first entry removes the beginning balance of Merchandise Inventory, and the second entry records the actual ending balance.

Credit to Income Summary in the first closing entry includes amounts from

Merchandise inventory (ending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

Purchases discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200

Purchases returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Debit to Income Summary in the second closing entry includes amounts from

Merchandise inventory (beginning) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (19,000)

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (235,800)

Transportation-in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,300)

Net effect on Income Summary (net debit = cost of goods sold) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(230,400)

This $230,400 effect on Income Summary is the cost of goods sold amount (which is equal to cost of goods sold reported in a perpetual inventory system). The periodic system transfers cost of goods sold to the Income Summary account but without using a Cost of Goods Sold account. Also, the periodic system does not separately measure shrinkage. Instead, it computes cost of goods available for sale, subtracts the cost of ending inventory, and defines the difference as cost of goods sold, which includes shrinkage.

Preparing Financial Statements The financial statements of a merchandiser using the periodic system are similar to those for a service company described in prior chapters. The income statement mainly differs by the inclusion of cost of goods sold and gross profit—of course, net sales is affected by dis- counts, returns, and allowances. The cost of goods sold section under the periodic system follows. The balance sheet mainly differs by the inclusion of merchandise inventory, inventory returns estimated, allowance for sales discounts, and sales refund payable. Visit the Additional Student Resource section of the Connect ebook to view sample chart of accounts for periodic and perpetual systems.

Calculation of Cost of Goods Sold

Beginning inventory . . . . . . . . . . . . . . . . . . . $ 19,000

Net cost of purchases . . . . . . . . . . . . . . . . . . 232,400

Cost of goods available for sale . . . . . . . . . 251,400

Less ending inventory . . . . . . . . . . . . . . . . . 21,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . $230,400

Chapter 4 Accounting for Merchandising Operations 167

APPENDIX

Adjusting Entries under New Revenue Recognition Rules 4B

Expected Sales Discounts—Adjusting Entry New revenue recognition rules require sales to be reported at the amount expected to be received. This means that a period-end adjusting entry is made to estimate sales discounts for current-period sales that are expected to be taken in future periods. To demonstrate, assume Z-Mart has the following unadjusted balances.

P6 Prepare adjustments for discounts, returns, and allowances per revenue recognition rules.

Accounts Receivable . . . . . . . . . . $11,250 Allowance for Sales Discounts . . . . . . . . . . $0

Of the $11,250 of receivables, $2,500 of them are within the 2% discount period for which we expect buy- ers to take $50 in future-period discounts (computed as $2,500 × 2%) arising from this period’s sales. The adjusting entry for the $50 update to Allowance for Sales Discounts is

Allow. for Sales Discounts

Beg . bal . 0 Req . adj . 50

Est . bal . 50

Allowance for Sales Discounts is a contra asset account and is reported on the balance sheet as a reduc- tion to the Accounts Receivable asset account. The Allowance for Sales Discounts account has a normal credit balance because it reduces Accounts Receivable, which has a normal debit balance. This adjusting entry results in both accounts receivable and sales being reported at expected amounts.*

Expected Returns and Allowances—Adjusting Entries To avoid overstatement of sales and cost of sales, sellers estimate sales returns and allowances in the period of the sale. Estimating returns and allowances requires companies to maintain the following two balance sheet accounts that are set up with adjusting entries. Two adjusting entries are made: one for the revenue side and one for the cost side.

Current Asset→Inventory Returns Estimated Current Liability→Sales Refund Payable

Balance Sheet—partial

Accounts receivable . . . . . . . . . . . . . . . . $11,250 Less allowance for sales discounts . . . . 50 Accounts receivable, net . . . . . . . . . . . . $11,200

Income Statement—partial

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000 Less sales discounts, returns & allowances . . . . . 6,300 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $314,700

*Next Period Adjustment The Allowance for Sales Discounts balance remains unchanged during a period except for the period-end adjusting entry. At next period-end, assume that Z-Mart computes an $80 balance for the Allowance for Sales Discounts. Using our three-step adjusting process we get: Step 1: Current bal. is $50 credit in Allowance for Sales Discounts. Step 2: Current bal. should be $80 credit in Allowance for Sales Discounts. Step 3: Record entry to get from step 1 to step 2. Sales Discounts . . . . . . . . . . . . . . . . . . 30 Allowance for Sales Discounts. . . . . 30

Revenue Side for Expected R&A When returns and allowances are expected, a seller sets up a Sales Refund Payable account, which is a current liability showing the amount expected to be refunded to customers. Assume that on December 31 the company estimates future sales refunds to be $1,200. Assume also that the unadjusted balance in Sales Refund Payable is a $300 credit. The adjusting entry for the $900 update to Sales Refund Payable follows. The Sales Refund Payable account is updated only during the adjusting entry process. Its balance remains unchanged during the period when actual returns and allowances are recorded.

Assets = Liabilities + Equity −50 −50

(g) Dec . 31 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Allowance for Sales Discounts . . . . . . . . . . . . . . . . . . . . . 50 Adjustment for future discounts.

Assets = Liabilities + Equity +900 −900

Sales Refund Payable

Beg . bal . 300 Req . adj . 900

Est . bal . 1,200

(h1) Dec . 31 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 900 Sales Refund Payable . . . . . . . . . . . . . . . . . . . . . . . . . . 900 Expected refund of sales.*

*This entry uses our three-step adjusting process: Step 1: Current bal. is $300 credit for Sales Refund Payable. Step 2: Current bal. should be $1,200 credit for Sales Refund Payable. Step 3: Record entry to get from step 1 to step 2.

168 Chapter 4 Accounting for Merchandising Operations

Cost Side for Expected R&A On the cost side, some inventory is expected to be returned, which means that cost of goods sold recorded at the time of sale is overstated due to expected returns. A seller sets up an Inventory Returns Estimated account, which is a current asset showing the inventory estimated to be returned. Extending the example above, assume that the company estimates future inventory returns to be $500 (which is the cost side of the $1,200 expected returns and allowances above). Assume also that the (beginning) unadjusted balance in Inventory Returns Estimated is a $200 debit. The adjusting entry for the $300 update to expected returns follows. The Inventory Returns Estimated account is updated only during the adjusting entry process. Its balance remains unchanged during the period when actual returns and allowances are recorded.

Point: If estimates of returns and allowances prove too high or too low, we adjust future estimates accordingly.

Assets = Liabilities + Equity +300 +300

Inventory Returns Est.

Beg . bal . 200 Req . adj . 300

Est . bal . 500

(h2) Dec . 31 Inventory Returns Estimated . . . . . . . . . . . . . . . . . . . . . . . . . 300 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Expected return of inventory.*

*This entry uses our three-step adjusting process: Step 1: Current bal. is $200 debit for Inventory Returns Estimated. Step 2: Current bal. should be $500 debit for Inventory Returns Estimated. Step 3: Record entry to get from step 1 to step 2.

At the current year-end, a company shows the following unadjusted balances for selected accounts.

Estimating Discounts, Returns, and Allowances

NEED-TO-KNOW 4-8 Allowance for Sales Discounts . . . . . . . . . . . . . . $ 75 credit Sales Discounts . . . . . . . . . . . . . . . . . . . . . . $1,850 debit Sales Refund Payable . . . . . . . . . . . . . . . . . . . . . 800 credit Sales Returns and Allowances . . . . . . . . . . 4,825 debit Inventory Returns Estimated . . . . . . . . . . . . . . . 450 debit Cost of Goods Sold . . . . . . . . . . . . . . . . . . . 9,875 debit

a. After an analysis of future sales discounts, the company estimates that the Allowance for Sales Discounts account should have a $275 credit balance. Prepare the current year-end adjusting journal entry for future sales discounts.

b. After an analysis of future sales returns and allowances, the company estimates that the Sales Refund Payable account should have an $870 credit balance (revenue side).

c. After an analysis of future inventory returns, the company estimates that the Inventory Returns Estimated account should have a $500 debit balance (cost side).

Solution

Dec . 31 Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Allowance for Sales Discounts . . . . . . . . . . . . . . . . . . . . . 200 Adjustment for future discounts. $275 Cr. − $75 Cr. Dec . 31 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . 70 Sales Refund Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Adjustment for future sales refund. $870 Cr. − $800 Cr. Dec . 31 Inventory Returns Estimated . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Adjustment for future inventory returns. $500 Dr. − $450 Dr.

Do More: QS 4-19, QS 4-20, E 4-20, E 4-21, E 4-22

APPENDIX

Net Method for Merchandising4C The net method records an invoice at its net amount (net of any cash discount). The gross method, cov- ered earlier in the chapter, initially records an invoice at its gross (full) amount. This appendix records merchandising transactions using the net method. Differences with the gross method are highlighted. When invoices are recorded at net amounts, any cash discounts are deducted from the balance of the Merchandise Inventory account when initially recorded. This assumes that all cash discounts will be taken. If any discounts are later lost, they are recorded in a Discounts Lost expense account reported on the income statement.

P7 Record and compare merchandising transactions using the gross method and net method.

Chapter 4 Accounting for Merchandising Operations 169

If the invoice is paid on (or before) November 12 within the discount period, it records Gross Method—Perpetual Net Method—Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Merchandise Inventory . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490

Gross Method—Perpetual Net Method—Perpetual

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490 Discounts Lost* . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

*For simplicity, we record Discounts Lost on the payment date.

Cost of Goods Sold . . . . . . . . . . . 200 Cost of Goods Sold . . . . . . . . . . . . . . . 200

Merchandise Inventory . . . 200 Merchandise Inventory . . . . . . . 200

Gross Method—Perpetual Net Method—Perpetual

Accounts Receivable . . . . . . . . . . 500 Accounts Receivable . . . . . . . . . . . . . . 490 Sales . . . . . . . . . . . . . . . . . . 500 Sales . . . . . . . . . . . . . . . . . . . . . . 490

If the invoice is paid after the discount period, it records

Gross Method—Perpetual Net Method—Perpetual

Merchandise Inventory . . . . . . . . 500 Merchandise Inventory . . . . . . . . . . . . 490

Accounts Payable . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . 490

SALES—Perpetual A company sells merchandise on November 2 at a $500 invoice price ($490 net) with terms of 2∕10, n∕30. The goods cost $200. Its November 2 entries are

If cash is received on (or before) November 12 within the discount period, it records Gross Method—Perpetual Net Method—Perpetual

Cash . . . . . . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 490

Sales Discounts . . . . . . . . . . . . . . 10

Accounts Receivable . . . . . 500 Accounts Receivable . . . . . . . . . 490

Perpetual Inventory System PURCHASES—Perpetual A company purchases merchandise on November 2 at a $500 invoice price ($490 net) with terms of 2∕10, n∕30. Its November 2 entries under the gross and net methods are

If cash is received after the discount period, it records Gross Method—Perpetual Net Method—Perpetual

Cash . . . . . . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Interest Revenue . . . . . . . . . . . . 10

Accounts Receivable . . . . . 500 Accounts Receivable . . . . . . . . . 490

Periodic Inventory System PURCHASES—Periodic Under the periodic system, the balance of the Merchandise Inventory account remains unchanged during the period and is updated at period-end. During the period, three accounts are used to record purchases of inventory: Purchases; Purchases Discounts; and Purchases Returns and Allowances. The entries below are identical to the perpetual system except that Merchandise Inventory is substituted for each of the three purchases accounts. To demonstrate, we apply the periodic system to purchases transactions. On November 2, a buyer pur- chases goods ($500 gross; $490 net) with terms of 2∕10, n∕30. Its November 2 entries under the gross and net methods are

Gross Method—Periodic Net Method—Periodic

Purchases . . . . . . . . . . . . . . . . . . 500 Purchases . . . . . . . . . . . . . . . . . . . . . . 490 Accounts Payable . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . 490

170 Chapter 4 Accounting for Merchandising Operations

If the invoice is paid on (or before) November 12 within the discount period, it records

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Purchases Discounts . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 490 Cash . . . . . . . . . . . . . . . . . . . . . . 490

Gross Method—Periodic Net Method—Periodic

Accounts Payable . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . . . . . 490

Discounts Lost . . . . . . . . . . . . . . . . . . . 10

Cash . . . . . . . . . . . . . . . . . . 500 Cash . . . . . . . . . . . . . . . . . . . . . . 500

If the invoice is paid after the discount period, it records

APPENDIX

Work Sheet—Perpetual System4D This appendix along with assignments is available online.

EqualsMinusEqualsMinus Expenses Netincome

Net sales

Merchandiser

Expenses NetincomeRevenues

Service Company Minus Equals

Gross profit

Cost of goods sold

Inventory: Costs of merchandise owned, but not yet sold. It is a current asset on the balance sheet. Merchandise Cost Flows:

Net purchases

Merchandise available for sale

Cost of goods sold

Ending inventory

Beginning inventory

Summary: Cheat Sheet

Transportation Costs and Ownership Transfer Rules:

Purchasing merchandise Merchandise Inventory . . . . . . . . 500 on credit Accounts Payable . . . . . . . . 500

Ownership Transfers at

Goods in Transit Owned by

FOB shipping point Shipping point

Transportation Costs Paid byShipping Terms

FOB destination Destination

Buyer

Seller

Buyer Merchandise Inventory . . . # Cash . . . . . . . . . . . . . . . #

Seller Delivery Expense . . . . . . . . # Cash . . . . . . . . . . . . . . . . #

Paying within discount period Accounts Payable . . . . . . . . . . . . 500 (Inventory reduced by Merchandise Inventory . . . 10 discount taken) Cash . . . . . . . . . . . . . . . . . . 490

Paying outside discount Accounts Payable . . . . . . . . . . . . 500 period Cash . . . . . . . . . . . . . . . . . . 500

Recording purchases Cash or Accounts Payable . . . . . 30 returns or allowances Merchandise Inventory . . . 30

Chapter 4 Accounting for Merchandising Operations 171

MERCHANDISING SALES

Sales Discounts: A contra revenue account, meaning Sales Discounts is subtracted from Sales when computing net sales.

If goods are defective, Inventory is debited for estimated value. A loss is recorded for the difference between cost of merchandise and estimated value.

MERCHANDISER REPORTING Inventory shrinkage: An adjusting entry to account for the loss of inven- tory due to theft or deterioration. It is computed by comparing a physical count of inventory with recorded amounts.

Steps 3 and 4: Same entries as those for service companies. Multiple-step income statement: Three parts: (1) gross profit; (2) income from operations, which is gross profit minus operating expenses; and (3) net income, which is income from operations plus or minus nonoperating items. Operating expenses: Separated into selling expenses and general & administrative expenses. Selling expenses: Expenses of advertising merchandise, making sales, and delivering goods to customers. General & administrative expenses: Expenses that support a company’s overall operations, including accounting and human resources. Nonoperating activities: Consist of expenses, revenues, losses, and gains that are unrelated to a company’s main operations. Multiple-Step Income Statement Example

Closing Entries: Differences between merchandisers and service companies in red.

Step 1: Close Credit Balances Sales . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 in Temporary Accounts to Income Summary . . . . . . . . . . . . . 321,000 Income Summary

Adjustment for shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . 250 (occurs when recorded amount Merchandise Inventory . . . . . . . . . 250 larger than physical inventory)

Acid-test ratio (159) Allowance for Sales Discounts (167) Cash discount (146) Cost of goods sold (143) Credit memorandum (152) Credit period (146) Credit terms (145) Debit memorandum (147) Discount period (146)

Discounts Lost (168) EOM (145) FOB (148) General and administrative expenses (156) Gross margin (144) Gross margin ratio (159) Gross method (147, 168) Gross profit (144) Inventory (144)

Inventory Returns Estimated (166) List price (145) Merchandise (143) Merchandise inventory (144) Merchandiser (143) Multiple-step income statement (156) Net method (151, 168) Periodic inventory system (144) Perpetual inventory system (144)

Key Terms

Step 2: Close Debit Balances Income Summary . . . . . . . . . . . . . . . 308,100 in Temporary Accounts to Sales Discounts . . . . . . . . . . . . . 4,300 Income Summary Sales Returns and Allowances . . 2,000 Cost of Goods Sold . . . . . . . . . . . 230,400 Other Expenses . . . . . . . . . . . . . . 71,400

Selling merchandise Accounts Receivable . . . . . . . . . . 1,000 on credit Sales . . . . . . . . . . . . . . . . . . . . 1,000

Cost of Goods Sold . . . . . . . . . . . 300 Merchandise Inventory . . . . . 300

Receiving payment within Cash . . . . . . . . . . . . . . . . . . . . . . . 980 discount period Sales Discounts . . . . . . . . . . . . . . 20 Accounts Receivable . . . . . . . 1,000

Receiving payment outside Cash . . . . . . . . . . . . . . . . . . . . . . . 1,000 discount period Accounts Receivable . . . . . . . 1,000

Customer Merchandise Returns Entries:

Receiving sales returns of Sales Returns and Allowances . . 15 nondefective inventory Cash or Accounts Receivable 15

Merchandise Inventory . . . . . . . . 9 Cost of Goods Sold . . . . . . . . . 9

Receiving sales returns of Merchandise Inventory . . . . . . . . . . . 2 defective inventory Loss from Defective Merchandise . . . 7

Cost of Goods Sold . . . . . . . . . . . . 9

Recognizing sales Sales Returns and Allowances . . 10 allowances Cash or Accounts Receivable 10

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321,000 Less: Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,300 Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . 2,000 6,300 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314,700 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,400 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,300 Operating Expenses Selling expenses† General and administrative expenses† Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 71,400 Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 Total other revenues and gains (expenses and losses) . . . . 2,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

†Must list all individual expenses and amounts—see Exhibit 4.13 (not done here for brevity).

Single-Step Income Statement Example

Revenues Total revenues* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $318,200 Expenses Total expenses* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303,300 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

*Must list all individual items and amounts—see Exhibit 4.14 (not done here for brevity).

Sales allowance: A price reduction agreed to with the buyer if they are unsatisfied with the goods.

172 Chapter 4 Accounting for Merchandising Operations

Purchases discount (146) Retailer (143) Sales discount (146) Sales Refund Payable (166)

Sales Returns and Allowances (151) Selling expenses (156) Shrinkage (153) Single-step income statement (157)

Supplementary records (149) Trade discount (145) Wholesaler (143)

Multiple Choice Quiz

1. A company has $550,000 in net sales and $193,000 in gross profit. This means its cost of goods sold equals a. $743,000. c. $357,000. e. $(193,000). b. $550,000. d. $193,000.

2. A company purchased $4,500 of merchandise on May 1 with terms of 2∕10, n∕30. On May 6, it returned $250 of that merchandise. On May 8, it paid the balance owed for merchandise, taking any discount it is entitled to. The cash paid on May 8 is a. $4,500. c. $4,160. e. $4,410. b. $4,250. d. $4,165.

3. A company has cash sales of $75,000, credit sales of $320,000, sales returns and allowances of $13,700, and sales discounts of $6,000. Its net sales equal

a. $395,000. c. $300,300. e. $414,700. b. $375,300. d. $339,700.

4. A company’s quick assets are $37,500, its current assets are $80,000, and its current liabilities are $50,000. Its acid-test ratio equals a. 1.600. c. 0.625. e. 0.469. b. 0.750. d. 1.333.

5. A company’s net sales are $675,000, its cost of goods sold is $459,000, and its net income is $74,250. Its gross margin ratio equals a. 32%. c. 47%. e. 34%. b. 68%. d. 11%.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; Gross profit = $550,000 − $193,000 = $357,000 2. d; ($4,500 − $250) × (100% − 2%) = $4,165 3. b; Net sales = $75,000 + $320,000 − $13,700 − $6,000 = $375,300

4. b; Acid-test ratio = $37,500∕$50,000 = 0.75 5. a; Gross margin ratio = ($675,000 − $459,000)∕$675,000 = 32%

A(B,C) Superscript letter A, B, or C denotes assignments based on Appendix 4A, 4B, or 4C.

Icon denotes assignments that involve decision making.

1. What items appear in financial statements of merchan- dising companies but not in the statements of service companies?

2. In comparing the accounts of a merchandising company with those of a service company, what additional accounts would the merchandising company likely use, assuming it employs a perpetual inventory system?

3. Explain how a business can earn a positive gross profit on its sales and still have a net loss.

4. Why do companies offer a cash discount? 5. How does a company that uses a perpetual inventory system

determine the amount of inventory shrinkage? 6. Distinguish between cash discounts and trade discounts for

purchases. Is the amount of a trade discount on purchased merchandise recorded in the accounts?

7. What is the difference between a sales discount and a pur- chases discount?

8. Why would a company’s manager be concerned about the quantity of its purchases returns if its suppliers allow unlimited returns?

Discussion Questions

9. Does the sender (maker) of a debit memorandum record a debit or a credit in the recipient’s account? What entry (debit or credit) does the recipient record?

10. What is the difference between the single-step and multiple- step income statement formats?

11. Refer to Apple’s balance sheet and income statement in Appendix A. What does the com- pany title its inventory account? Does the company present a detailed calculation of its cost of goods sold?

12. Refer to Google’s income statement in Appendix A. What title does it use for cost of goods sold?

13. Refer to Samsung’s income statement in Appendix A. What does Samsung title its cost of goods sold account?

14. Refer to Samsung’s income statement in Appendix A. Does its income statement report a gross profit figure? If yes, what is the amount?

15. Buyers negotiate purchase contracts with suppliers. What type of shipping terms should a buyer attempt to negotiate to minimize freight-in costs?

APPLE

Samsung

GOOGLE

Chapter 4 Accounting for Merchandising Operations 173

QUICK STUDY

QS 4-1 Applying merchandising terms

C1 P1

Enter the letter for each term in the blank space beside the definition that it most closely matches. A. Sales discount D. FOB destination G. Merchandise inventory B. Credit period E. FOB shipping point H. Purchases discount C. Discount period F. Gross profit

1. Goods a company owns and expects to sell to its customers. 2. Time period that can pass before a customer’s full payment is due. 3. Seller’s description of a cash discount granted to buyers in return for early payment. 4. Ownership of goods is transferred when the seller delivers goods to the carrier. 5. Purchaser’s description of a cash discount received from a supplier of goods. 6. Difference between net sales and the cost of goods sold. 7. Time period in which a cash discount is available. 8. Ownership of goods is transferred when delivered to the buyer’s place of business.

Costs of $5,000 were incurred to acquire goods and make them ready for sale. The goods were shipped to the buyer (FOB shipping point) for a cost of $200. Additional necessary costs of $400 were incurred to acquire the goods. No other incentives or discounts were available. What is the buyer’s total cost of mer- chandise inventory? a. $5,000 b. $5,200 c. $5,400 d. $5,600

QS 4-2 Identifying inventory costs

Use the following information (in random order) from a merchandising company and from a service com- pany. Hint: Not all information may be necessary for the solutions. a. For the merchandiser only, compute (1) goods available for sale, (2) cost of goods sold, and (3) gross profit. b. Compute net income for each company.

QS 4-3 Merchandise accounts and computations

Kleiner Merchandising Company

Accumulated depreciation . . . $ 700 Expenses . . . . . . . . $1,450

Beginning inventory . . . . . . . . 5,000 Net purchases . . . . 3,900

Ending inventory . . . . . . . . . . . 1,700 Net sales . . . . . . . . 9,500

Krug Service Company

Expenses . . . . . . . . . . . . $12,500 Prepaid rent . . . . . . . . $ 800

Revenues . . . . . . . . . . . . 14,000 Accounts payable . . . . 200

Cash . . . . . . . . . . . . . . . . 700 Equipment . . . . . . . . . . 1,300

Compute the amount to be paid for each of the four separate invoices assuming that all invoices are paid within the discount period.

Merchandise (gross) Terms Merchandise (gross) Terms a. $5,000 2∕10, n∕60 c. $75,000 1∕10, n∕30 b. $20,000 1∕15, EOM d. $10,000 3∕15, n∕45

QS 4-4 Computing net invoice amounts

Prepare journal entries to record each of the following transactions of a merchandising company. The company uses a perpetual inventory system and the gross method.

Nov. 5 Purchased 600 units of product at a cost of $10 per unit. Terms of the sale are 2∕10, n∕60; the invoice is dated November 5.

7 Returned 25 defective units from the November 5 purchase and received full credit. 15 Paid the amount due from the November 5 purchase, minus the return on November 7.

QS 4-5 Recording purchases, returns, and discounts taken

Prepare journal entries to record each of the following transactions. The company records purchases using the gross method and a perpetual inventory system.

Aug. 1 Purchased merchandise with an invoice price of $60,000 and credit terms of 3∕10, n∕30. 11 Paid supplier the amount owed from the August 1 purchase.

QS 4-6 Recording purchases and discounts taken

Prepare journal entries to record each of the following transactions. The company records purchases using the gross method and a perpetual inventory system.

Sep. 15 Purchased merchandise with an invoice price of $35,000 and credit terms of 2∕5, n∕15. 29 Paid supplier the amount owed on the September 15 purchase.

QS 4-7 Recording purchases and discounts missed

174 Chapter 4 Accounting for Merchandising Operations

QS 4-8 Recording sales, returns, and discounts taken

Prepare journal entries to record each of the following sales transactions of a merchandising company. The company uses a perpetual inventory system and the gross method.

Apr. 1 Sold merchandise for $3,000, with credit terms n∕30; invoice dated April 1. The cost of the merchandise is $1,800.

4 The customer in the April 1 sale returned $300 of merchandise for full credit. The merchandise, which had cost $180, is returned to inventory.

8 Sold merchandise for $1,000, with credit terms of 1∕10, n∕30; invoice dated April 8. Cost of the merchandise is $700.

11 Received payment for the amount due from the April 1 sale less the return on April 4.

QS 4-10 Closing entries P3

Refer to QS 4-9 and prepare journal entries to close the balances in temporary revenue and expense ac- counts. Remember to consider the entry for shrinkage from QS 4-9.

QS 4-11 Multiple-step income statement

For each item below, indicate whether the statement describes a multiple-step income statement or a single-step income statement. a. Multiple-step income statement b. Single-step income statement

1. Commonly reports detailed computations of net sales and other costs and expenses. 2. Statement limited to two main categories (revenues and expenses). 3. Reports gross profit on a separate line. 4. Separates income from operations from the other revenues and gains.

QS 4-9 Accounting for shrinkage— perpetual system

Nix’It Company’s ledger on July 31, its fiscal year-end, includes the following selected accounts that have normal balances (Nix’It uses the perpetual inventory system).

Merchandise inventory . . . . . . . . . . $ 37,800 Sales returns and allowances . . . . . . . . $ 6,500

Retained earnings . . . . . . . . . . . . . . 115,300 Cost of goods sold . . . . . . . . . . . . . . . . . 105,000

Dividends . . . . . . . . . . . . . . . . . . . . . 7,000 Depreciation expense . . . . . . . . . . . . . . 10,300

Sales . . . . . . . . . . . . . . . . . . . . . . . . . 160,200 Salaries expense . . . . . . . . . . . . . . . . . . 32,500

Sales discounts . . . . . . . . . . . . . . . . 4,700 Miscellaneous expenses . . . . . . . . . . . . 5,000

A physical count of its July 31 year-end inventory discloses that the cost of the merchandise inventory still available is $35,900. Prepare the entry to record any inventory shrinkage.

Sales discounts . . . . . . . . . . . . . . . . . . . . $ 750 Office supplies expense . . . . . . . . . . . . . . . $ 500

Office salaries expense . . . . . . . . . . . . . 2,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . 9,000

Rent expense—Office space . . . . . . . . . 1,500 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Advertising expense . . . . . . . . . . . . . . . . 500 Insurance expense . . . . . . . . . . . . . . . . . . . 1,000

Sales returns and allowances . . . . . . . . 250 Sales staff salaries . . . . . . . . . . . . . . . . . . . 2,500

QS 4-12 Preparing a multiple-step income statement

Save-the-Earth Co. reports the following income statement accounts for the year ended December 31. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Categorize the following accounts as sell- ing expenses: Sales Staff Salaries and Advertising Expense. Categorize the remaining expenses as general and administrative.

Buildings . . . . . . . . . . . . . . . . . . . . . . . . $25,000 Notes payable (due in 7 years) . . . . . . . . . . $30,000

Accounts receivable . . . . . . . . . . . . . . . 2,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . 1,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . 10,000

Merchandise inventory . . . . . . . . . . . . . 7,000 Retained earnings . . . . . . . . . . . . . . . . . . . . 6,000

Accounts payable . . . . . . . . . . . . . . . . . 5,000 Wages payable . . . . . . . . . . . . . . . . . . . . . . . 3,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000

QS 4-13 Preparing a classified balance sheet for a merchandiser

Clear Water Co. reports the following balance sheet accounts as of December 31. Prepare a classified bal- ance sheet.

Chapter 4 Accounting for Merchandising Operations 175

Compute net sales, gross profit, and the gross margin ratio for each of the four separate companies. Interpret the gross margin ratio for Carrier.

Carrier Lennox Trane York

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 $550,000 $38,700 $255,700

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . 5,000 17,500 600 4,800

Sales returns and allowances . . . . . . . . . . . . 20,000 6,000 5,100 900

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 79,750 329,589 24,453 126,500

QS 4-15 Computing and analyzing gross margin ratio

Identify whether each description best applies to a periodic or a perpetual inventory system. a. Updates the inventory account only at period-end. b. Requires an adjusting entry to record inventory shrinkage. c. Returns immediately affect the account balance of Merchandise Inventory. d. Records cost of goods sold each time a sales transaction occurs. e. Provides more timely information to managers.

QS 4-16A Contrasting periodic and perpetual systems

Refer to QS 4-5 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the gross method and a periodic inventory system.

QS 4-17A Recording purchases, returns, and discounts— periodic & gross methods P5

Refer to QS 4-8 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the gross method and a periodic inventory system.

QS 4-18A Recording sales, returns, and discounts—periodic & gross methods P5

ProBuilder has the following June 30 fiscal-year-end unadjusted balances: Allowance for Sales Discounts, $0; and Accounts Receivable, $10,000. Of the $10,000 of receivables, $2,000 are within a 3% discount period, meaning that it expects buyers to take $60 in future discounts arising from this period’s sales. a. Prepare the June 30 fiscal-year-end adjusting journal entry for future sales discounts. b. Assume the same facts above and that there is a $10 fiscal-year-end unadjusted credit balance in the

Allowance for Sales Discounts. Prepare the June 30 fiscal-year-end adjusting journal entry for future sales discounts.

QS 4-19B Recording estimates of future discounts

QS 4-20B Recording estimates of future returns

ProBuilder reports merchandise sales of $50,000 and cost of merchandise sales of $20,000 in its first year of operations ending June 30. It makes fiscal-year-end adjusting entries for estimated future returns and allowances equal to 2% of sales, or $1,000, and 2% of cost of sales, or $400. a. Prepare the June 30 fiscal-year-end adjusting journal entry for future returns and allowances related to sales. b. Prepare the June 30 fiscal-year-end adjusting journal entry for future returns and allowances related to

cost of sales.

QS 4-21C Recording purchases, returns, and discounts—net & perpetual methods P7

Refer to QS 4-5 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the net method and a perpetual inventory system.

QS 4-22C Recording sales, returns, and discounts—net & perpetual methods P7

Refer to QS 4-8 and prepare journal entries to record each of the merchandising transactions assuming that the company records purchases using the net method and a perpetual inventory system.

Use the following information on current assets and current liabilities to compute and interpret the acid- test ratio. Explain what the acid-test ratio of a company measures.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,490 Prepaid expenses . . . . . . . . . . . . . . . . . . . $ 700

Accounts receivable . . . . . . . . . . . . . . . 2,800 Accounts payable . . . . . . . . . . . . . . . . . . . 5,750

Inventory . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Other current liabilities . . . . . . . . . . . . . . . 850

QS 4-14 Computing and interpreting acid-test ratio

176 Chapter 4 Accounting for Merchandising Operations

QS 4-23 Sales transactions

Prepare journal entries to record each of the following sales transactions of EcoMart Merchandising. EcoMart uses a perpetual inventory system and the gross method. Oct. 1 Sold fair trade merchandise for $1,500, with credit terms n∕30, invoice dated October 1. The

cost of the merchandise is $900. 6 The customer in the October 1 sale returned $150 of fair trade merchandise for full credit. The

merchandise, which had cost $90, is returned to inventory. 9 Sold recycled leather merchandise for $700, with credit terms of 1∕10, n∕30, invoice dated

October 9. Cost of the merchandise is $450. 11 Received payment for the amount due from the October 1 sale less the return on October 6.

Exercise 4-2 Operating cycle for merchandiser

The operating cycle of a merchandiser with credit sales includes the following five activities. Starting with merchandise acquisition, identify the chronological order of these five activities.

a. Prepare merchandise for sale. d. Purchase merchandise. b. Collect cash from customers on account. e. Monitor and service accounts receivable. c. Make credit sales to customers.

Exercise 4-4 Recording sales, sales returns, and sales allowances

Allied Merchandisers was organized on May 1. Macy Co. is a major customer (buyer) of Allied (seller) products. Prepare journal entries to record the following transactions for Allied assuming it uses a per- petual inventory system and the gross method. May 3 Allied made its first and only purchase of inventory for the period on May 3 for 2,000 units at a

price of $10 cash per unit (for a total cost of $20,000). 5 Allied sold 1,500 of the units in inventory for $14 per unit (invoice total: $21,000) to Macy Co.

under credit terms 2∕10, n∕60. The goods cost Allied $15,000. 7 Macy returns 125 units because they did not fit the customer’s needs (invoice amount: $1,750).

Allied restores the units, which cost $1,250, to its inventory. 8 Macy discovers that 200 units are scuffed but are still of use and, therefore, keeps the units.

Allied gives a price reduction (allowance) and credits Macy’s accounts receivable for $300 to compensate for the damage.

15 Allied receives payment from Macy for the amount owed on the May 5 purchase; payment is net of returns, allowances, and any cash discount.

Exercise 4-3 Recording purchases, purchases returns, and purchases allowances

Prepare journal entries to record the following transactions for a retail store. The company uses a perpet- ual inventory system and the gross method. Apr. 2 Purchased $4,600 of merchandise from Lyon Company with credit terms of 2∕15, n∕60, invoice

dated April 2, and FOB shipping point. 3 Paid $300 cash for shipping charges on the April 2 purchase. 4 Returned to Lyon Company unacceptable merchandise that had an invoice price of $600. 17 Sent a check to Lyon Company for the April 2 purchase, net of the discount and the returned mer-

chandise. 18 Purchased $8,500 of merchandise from Frist Corp. with credit terms of 1∕10, n∕30, invoice

dated April 18, and FOB destination. 21 After negotiations over scuffed merchandise, received from Frist a $500 allowance toward the

$8,500 owed on the April 18 purchase. 28 Sent check to Frist paying for the April 18 purchase, net of the allowance and the discount.

Check Apr. 28, Cr. Cash, $7,920

EXERCISES

Exercise 4-1 Computing revenues, expenses, and income

C1 C2

Fill in the blanks in the following separate income statements a through e. Identify any negative amount by putting it in parentheses.

a b c d e

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $62,000 $43,500 $46,000 $ ? $25,600 Cost of goods sold Merchandise inventory (beginning) . . . . . . . . . . . . . . . . 8,000 17,050 7,500 8,000 4,560 Total cost of merchandise purchases . . . . . . . . . . . . . . 38,000 ? ? 32,000 6,600 Merchandise inventory (ending) . . . . . . . . . . . . . . . . . . ? (3,000) (9,000) (6,600) ? Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,050 16,000 ? ? 7,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? ? 3,750 45,600 ? Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,650 12,150 3,600 6,000 Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ? $16,850 $ (8,400) $42,000 $ ?

Chapter 4 Accounting for Merchandising Operations 177

Exercise 4-5 Recording purchases, purchases returns, and purchases allowances P1

Refer to Exercise 4-4 and prepare journal entries for Macy Co. to record each of the May transactions. Macy is a retailer that uses the gross method and a perpetual inventory system; it purchases these units for resale.

Exercise 4-7 Recording sales, purchases, shipping, and returns—buyer and seller

P1 P2

Sydney Retailing (buyer) and Troy Wholesalers (seller) enter into the following transactions. Both Sydney and Troy use a perpetual inventory system and the gross method. May 11 Sydney accepts delivery of $40,000 of merchandise it purchases for resale from Troy: invoice

dated May 11, terms 3∕10, n∕90, FOB shipping point. The goods cost Troy $30,000. Sydney pays $345 cash to Express Shipping for delivery charges on the merchandise.

12 Sydney returns $1,400 of the $40,000 of goods to Troy, who receives them the same day and restores them to its inventory. The returned goods had cost Troy $1,050.

20 Sydney pays Troy for the amount owed. Troy receives the cash immediately. 1. Prepare journal entries that Sydney Retailing (buyer) records for these three transactions. 2. Prepare journal entries that Troy Wholesalers (seller) records for these three transactions.

Check (1) May 20, Cr. Cash, $37,442

Exercise 4-8 Inventory and cost of sales transactions in T-accounts

P1 P2

The following summarizes Tesla’s merchandising activities for the year. Set up T-accounts for Merchandise Inventory and for Cost of Goods Sold. Enter each line item into one of the two T-accounts and compute the T-account balances.

Check Ending Merch. Inventory, $20,000

Cost of merchandise sold to customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $196,000 Merchandise inventory, beginning-year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Cost of merchandise purchases, gross amount . . . . . . . . . . . . . . . . . . . . . . . . . 192,500 Shrinkage on merchandise as of year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Cost of transportation-in for merchandise purchases . . . . . . . . . . . . . . . . . . . . 2,900 Cost of merchandise returned by customers and restored to inventory . . . . . . 2,100 Discounts received from suppliers on merchandise purchases . . . . . . . . . . . . . 1,700 Returns to and allowances from suppliers on merchandise purchases . . . . . . 4,000

Exercise 4-9 Recording purchases, sales, returns, and shipping

P1 P2

Prepare journal entries for the following merchandising transactions of Dollar Store assuming it uses a perpetual inventory system and the gross method. Nov. 1 Dollar Store purchases merchandise for $1,500 on terms of 2∕5, n∕30, FOB shipping point,

invoice dated November 1. 5 Dollar Store pays cash for the November 1 purchase. 7 Dollar Store discovers and returns $200 of defective merchandise purchased on November 1,

and paid for on November 5, for a cash refund. 10 Dollar Store pays $90 cash for transportation costs for the November 1 purchase. 13 Dollar Store sells merchandise for $1,600 with terms n∕30. The cost of the merchandise is $800. 16 Merchandise is returned to the Dollar Store from the November 13 transaction. The returned items

are priced at $160 and cost $80; the items were not damaged and were returned to inventory.

Exercise 4-6 Recording sales, purchases, and cash discounts—buyer and seller

P1 P2

Santa Fe Retailing purchased merchandise “as is” (with no returns) from Mesa Wholesalers with credit terms of 3∕10, n∕60 and an invoice price of $24,000. The merchandise had cost Mesa $16,000. Assume that both buyer and seller use a perpetual inventory system and the gross method. 1. Prepare entries that the buyer records for the (a) purchase, (b) cash payment within the discount

period, and (c) cash payment after the discount period. 2. Prepare entries that the seller records for the (a) sale, (b) cash collection within the discount period,

and (c) cash collection after the discount period.

Exercise 4-10 Preparing adjusting and closing entries for a merchandiser

The following list includes selected permanent accounts and all of the temporary accounts from the December 31 unadjusted trial balance of Emiko Co., a business owned by Kumi Emiko. Use these account balances along with the additional information to journalize (a) adjusting entries and (b) closing entries. Emiko Co. uses a perpetual inventory system.

[continued on next page]

Debit Credit

Merchandise inventory . . . . . . . . . . $30,000 Prepaid selling expenses . . . . . . . . . 5,600 Dividends . . . . . . . . . . . . . . . . . . . . . 33,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . $529,000 Sales returns and allowances . . . . . 17,500 Sales discounts . . . . . . . . . . . . . . . . . 5,000

Debit Credit

Cost of goods sold . . . . . . . . . . $212,000 Sales salaries expense . . . . . . . 48,000 Utilities expense . . . . . . . . . . . . 15,000 Selling expenses . . . . . . . . . . . . 36,000 Administrative expenses . . . . . 105,000

178 Chapter 4 Accounting for Merchandising Operations

Exercise 4-11 Computing net sales for multiple-step income statement

A company reports the following sales-related information. Compute and prepare the net sales portion only of this company’s multiple-step income statement.

Sales, gross . . . . . . . . . . . . . . . . $200,000 Sales returns and allowances . . . . . . . . . . . . $16,000 Sales discounts . . . . . . . . . . . . . 4,000 Sales salaries expense . . . . . . . . . . . . . . . . . 10,000

Additional Information

Accrued and unpaid sales salaries amount to $1,700. Prepaid selling expenses of $3,000 have expired. A physical count of year-end merchandise inventory is taken to determine shrinkage and shows $28,700 of goods still available.

Check Dr. $84,500 to close Income Summary

Exercise 4-12 Impacts of inventory error on key accounts

A retailer completed a physical count of ending merchandise inventory. When counting inventory, employ- ees did not include $3,000 of incoming goods shipped by a supplier on December 31 under FOB shipping point. These goods had been recorded in Merchandise Inventory, but they were not included in the physical count because they were in transit. This means shrinkage was incorrectly overstated by $3,000.

Compute the amount of overstatement or understatement for each of the following amounts for this period. a. Ending inventory b. Total assets c. Net income d. Total equity

Exercise 4-13 Physical count error and profits A2

Refer to the information in Exercise 4-12 and indicate whether the failure to include in-transit inventory as part of the physical count results in an overstatement, understatement, or no effect on the following ratios. a. Gross margin ratio b. Profit margin ratio c. Acid-test ratio d. Current ratio

Exercise 4-14 Computing and analyzing acid-test and current ratios

Compute the current ratio and acid-test ratio for each of the following separate cases. (Round ratios to two decimals.) Which company is in the best position to meet short-term obligations? Explain.

Camaro GTO Torino

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000 $ 110 $1,000 Short-term investments . . . . . . . . . . . . 50 0 580 Current receivables . . . . . . . . . . . . . . . 350 470 700 Inventory . . . . . . . . . . . . . . . . . . . . . . . . 2,600 2,420 4,230 Prepaid expenses . . . . . . . . . . . . . . . . . 200 500 900 Total current assets . . . . . . . . . . . . . . . $5,200 $3,500 $7,410

Current liabilities . . . . . . . . . . . . . . . . . . $2,000 $1,000 $3,800

Exercise 4-15 Preparing a multiple-step income statement

Fit-for-Life Foods reports the following income statement accounts for the year ended December 31. Prepare a multiple-step income statement that includes separate categories for net sales; cost of goods sold; selling expenses; general and administrative expenses; and other revenues, gains, expenses, and losses. Categorize the following accounts as selling expenses: Sales Staff Wages, Rent Expense—Selling Space, TV Advertising Expense, and Sales Commission Expense. Categorize the remaining expenses as general and administrative.

Gain on sale of equipment . . . . . . . . . . . . $ 6,250 Depreciation expense—Office copier . . . . . . . . . . . $ 500 Office supplies expense . . . . . . . . . . . . . . 700 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Insurance expense . . . . . . . . . . . . . . . . . . 1,300 Sales returns and allowances . . . . . . . . . . . . . . . . . 4,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 TV advertising expense . . . . . . . . . . . . . . . . . . . . . . 2,000 Office salaries expense . . . . . . . . . . . . . . 32,500 Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 750 Rent expense—Selling space . . . . . . . . . . 10,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Sales staff wages . . . . . . . . . . . . . . . . . . . 23,000 Sales commission expense . . . . . . . . . . . . . . . . . . . 13,000

Exercise 4-16 Preparing a classified balance sheet for a merchandiser

Adams Co. reports the following balance sheet accounts as of December 31. Prepare a classified balance sheet.

Salaries payable . . . . . . . . . . . . . . . . . . . . $ 6,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 Notes payable (due in 9 years) . . . . . . . . . . . . . . . . 30,000 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . 7,000 Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 Merchandise inventory . . . . . . . . . . . . . . . 14,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Accounts payable . . . . . . . . . . . . . . . . . . . 10,000 Accumulated depreciation—Building . . . . . . . . . . . 5,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . 3,000 Mortgages payable (due in 5 years) . . . . . . . . . . . . 12,000 Accounts receivable . . . . . . . . . . . . . . . . . 4,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 Common stock . . . . . . . . . . . . . . . . . . . . . 10,000

Chapter 4 Accounting for Merchandising Operations 179

Exercise 4-17A Recording purchases, returns, and allowances— periodic P5

Refer to Exercise 4-3 and prepare journal entries to record each of the merchandising transactions assum- ing that the buyer uses the periodic inventory system and the gross method.

Exercise 4-18A Recording sales, purchases, and discounts: buyer and seller—periodic P5

Refer to Exercise 4-6 and prepare journal entries to record each of the merchandising transactions assum- ing that the periodic inventory system and the gross method are used by both the buyer and the seller.

Exercise 4-19A Recording sales, purchases, shipping, and returns: buyer and seller—periodic P5

Refer to Exercise 4-7 and prepare journal entries to record each of the merchandising transactions assum- ing that the periodic inventory system and the gross method are used by both the buyer and the seller.

Exercise 4-20B Recording estimates of future discounts

Med Labs has the following December 31 year-end unadjusted balances: Allowance for Sales Discounts, $0; and Accounts Receivable, $5,000. Of the $5,000 of receivables, $1,000 are within a 2% discount pe- riod, meaning that it expects buyers to take $20 in future-period discounts arising from this period’s sales. a. Prepare the December 31 year-end adjusting journal entry for future sales discounts. b. Assume the same facts above and that there is a $5 year-end unadjusted credit balance in Allowance for

Sales Discounts. Prepare the December 31 year-end adjusting journal entry for future sales discounts. c. Is Allowance for Sales Discounts a contra asset or a contra liability account?

Exercise 4-21B Recording estimates of future returns

Chico Company allows its customers to return merchandise within 30 days of purchase. ∙ At December 31, the end of its first year of operations, Chico estimates future-period merchandise

returns of $60,000 (cost of $22,500) related to its current-year sales. ∙ A few days later, on January 3, a customer returns merchandise with a selling price of $2,000 for a cash

refund; the returned merchandise cost $750 and is returned to inventory as it is not defective. a. Prepare the December 31 year-end adjusting journal entry for estimated future sales returns and allow-

ances (revenue side). b. Prepare the December 31 year-end adjusting journal entry for estimated future inventory returns and

allowances (cost side). c. Prepare the January 3 journal entries to record the merchandise returned.

Exercise 4-22B Recording estimates of future returns

Lopez Company reports unadjusted first-year merchandise sales of $100,000 and cost of merchandise sales of $30,000. a. Compute gross profit (using the unadjusted numbers above). b. The company expects future returns and allowances equal to 5% of sales and 5% of cost of sales. 1. Prepare the year-end adjusting entry to record the sales expected to be refunded. 2. Prepare the year-end adjusting entry to record the cost side of sales returns and allowances. 3. Recompute gross profit using the adjusted numbers from parts 1 and 2. c. Is Sales Refund Payable an asset, liability, or equity account? d. Is Inventory Returns Estimated an asset, liability, or equity account?

Exercise 4-23C Recording sales, purchases, shipping, and returns: buyer and seller—perpetual and net method P7

Refer to Exercise 4-7 and prepare journal entries to record each of the merchandising transactions assum- ing that the perpetual inventory system and the net method are used by both the buyer and the seller.

Exercise 4-24C Recording purchases, sales, returns, and discounts: buyer and seller—perpetual and both net & gross methods

Piere Imports uses the perpetual system in accounting for merchandise inventory and had the following transactions during the month of October. Prepare entries to record these transactions assuming that Piere Imports records invoices (a) at gross amounts and (b) at net amounts.

Oct. 2 Purchased merchandise at a $3,000 price ($2,940 net), invoice dated October 2, terms 2∕10, n∕30. 10 Returned $500 ($490 net) of merchandise purchased on October 2 and debited its account pay-

able for that amount. 17 Purchased merchandise at a $5,400 price ($5,292 net), invoice dated October 17, terms 2∕10, n∕30. 27 Paid for the merchandise purchased on October 17, less the discount. 31 Paid for the merchandise purchased on October 2.

180 Chapter 4 Accounting for Merchandising Operations

Exercise 4-25 Purchasing transactions

Prepare journal entries to record the following transactions of Recycled Fashion retail store. Recycled Fashion uses a perpetual inventory system and the gross method. Mar. 3 Purchased $1,150 of merchandise made from recycled material from GreenWorld Company

with credit terms of 2∕15, n∕60, invoice dated March 3, and FOB shipping point. 4 Paid $75 cash for shipping charges on the March 3 purchase. 5 Returned to GreenWorld unacceptable merchandise that had an invoice price of $150. 18 Paid GreenWorld for the March 3 purchase, net of the discount and the returned merchandise. 19 Purchased $425 of fair trade merchandise from PeopleFirst Corp. with credit terms of 1∕10,

n∕30, invoice dated March 19, and FOB destination. 21 After negotiations, received from PeopleFirst a $25 allowance (for scuffed merchandise) toward

the $425 owed on the March 19 purchase. 29 Sent check to PeopleFirst paying for the March 19 purchase, net of the allowance and the discount.

PROBLEM SET A

Problem 4-1A Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Cabela’s, which uses the perpetual inventory system and the gross method. Hint: It will help to identify each receivable and pay- able; for example, record the purchase on July 1 in Accounts Payable—Boden. July 1 Purchased merchandise from Boden Company for $6,000 under credit terms of 1∕15, n∕30,

FOB shipping point, invoice dated July 1. 2 Sold merchandise to Creek Co. for $900 under credit terms of 2∕10, n∕60, FOB shipping point,

invoice dated July 2. The merchandise had cost $500. 3 Paid $125 cash for freight charges on the purchase of July 1. 8 Sold merchandise that had cost $1,300 for $1,700 cash. 9 Purchased merchandise from Leight Co. for $2,200 under credit terms of 2∕15, n∕60, FOB

destination, invoice dated July 9. 11 Returned $200 of merchandise purchased on July 9 from Leight Co. and debited its account

payable for that amount. 12 Received the balance due from Creek Co. for the invoice dated July 2, net of the discount. 16 Paid the balance due to Boden Company within the discount period. 19 Sold merchandise that cost $800 to Art Co. for $1,200 under credit terms of 2∕15, n∕60, FOB

shipping point, invoice dated July 19. 21 Gave a price reduction (allowance) of $100 to Art Co. for merchandise sold on July 19 and

credited Art’s accounts receivable for that amount. 24 Paid Leight Co. the balance due, net of discount. 30 Received the balance due from Art Co. for the invoice dated July 19, net of discount. 31 Sold merchandise that cost $4,800 to Creek Co. for $7,000 under credit terms of 2∕10, n∕60,

FOB shipping point, invoice dated July 31.

July 24, Cr. Cash, $1,960 July 30, Dr. Cash, $1,078

Check July 12, Dr. Cash, $882 July 16, Cr. Cash, $5,940

Problem 4-2A Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Lowe’s, which uses the per- petual inventory system and the gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on August 1 in Accounts Payable—Aron. Aug. 1 Purchased merchandise from Aron Company for $7,500 under credit terms of 1∕10, n∕30, FOB

destination, invoice dated August 1. 5 Sold merchandise to Baird Corp. for $5,200 under credit terms of 2∕10, n∕60, FOB destination,

invoice dated August 5. The merchandise had cost $4,000. 8 Purchased merchandise from Waters Corporation for $5,400 under credit terms of 1∕10, n∕45,

FOB shipping point, invoice dated August 8. 9 Paid $125 cash for shipping charges related to the August 5 sale to Baird Corp. 10 Baird returned merchandise from the August 5 sale that had cost Lowe’s $400 and was sold for

$600. The merchandise was restored to inventory. 12 After negotiations with Waters Corporation concerning problems with the purchases on

August 8, Lowe’s received a price reduction from Waters of $400 off the $5,400 of goods pur- chased. Lowe’s debited accounts payable for $400.

14 At Aron’s request, Lowe’s paid $200 cash for freight charges on the August 1 purchase, reduc- ing the amount owed (accounts payable) to Aron.

15 Received balance due from Baird Corp. for the August 5 sale less the return on August 10. 18 Paid the amount due Waters Corporation for the August 8 purchase less the price allowance

from August 12.

Check Aug. 9, Dr. Delivery Expense, $125

Aug. 18, Cr. Cash, $4,950

[continued on next page]

Chapter 4 Accounting for Merchandising Operations 181

19 Sold merchandise to Tux Co. for $4,800 under credit terms of n∕10, FOB shipping point, in- voice dated August 19. The merchandise had cost $2,400.

22 Tux requested a price reduction on the August 19 sale because the merchandise did not meet specifications. Lowe’s gave a price reduction (allowance) of $500 to Tux and credited Tux’s accounts receivable for that amount.

29 Received Tux’s cash payment for the amount due from the August 19 sale less the price allow- ance from August 22.

30 Paid Aron Company the amount due from the August 1 purchase.

Aug. 29, Dr. Cash, $4,300

Problem 4-3A Computing merchandising amounts and formatting income statements

C2 P4

Valley Company’s adjusted trial balance on August 31, its fiscal year-end, follows. It categorizes the fol- lowing accounts as selling expenses: Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Debit Credit

Merchandise inventory (ending) . . . . . . . . . . $ 41,000 Other (noninventory) assets . . . . . . . . . . . . . 130,400 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 25,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . 94,550 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,600 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . 2,250 Sales returns and allowances . . . . . . . . . . . . 12,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 74,500 Sales salaries expense . . . . . . . . . . . . . . . . . . 32,000 Rent expense—Selling space . . . . . . . . . . . . . 8,000 Store supplies expense . . . . . . . . . . . . . . . . . 1,500 Advertising expense . . . . . . . . . . . . . . . . . . . . 13,000 Office salaries expense . . . . . . . . . . . . . . . . . 28,500 Rent expense—Office space . . . . . . . . . . . . . 3,600 Office supplies expense . . . . . . . . . . . . . . . . . 400 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $355,150 $355,150

Beginning merchandise inventory was $25,400. Supplementary records of merchandising activities for the year ended August 31 reveal the following itemized costs.

Invoice cost of merchandise purchases . . . . . . . . . $92,000 Purchases returns and allowances . . . . . . . . . . $ 4,500

Purchases discounts received . . . . . . . . . . . . . . . . . 2,000 Costs of transportation-in . . . . . . . . . . . . . . . . . 4,600

Required

1. Compute the company’s net sales for the year. 2. Compute the company’s total cost of merchandise purchased for the year. 3. Prepare a multiple-step income statement that includes separate categories for net sales, cost of goods

sold, selling expenses, and general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold, sell-

ing expenses, and general and administrative expenses.

Check (2) $90,100

(3) Gross profit, $136,850; Net income, $49,850

(4) Total expenses, $161,500

Use the data for Valley Company in Problem 4-3A to complete the following requirement.

Required

Prepare closing entries as of August 31 (the perpetual inventory system is used).

Problem 4-4A Preparing closing entries and interpreting information about discounts and returns C2 P3

The following unadjusted trial balance is prepared at fiscal year-end for Nelson Company. Nelson Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses: Depreciation Expense—Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Problem 4-5A Preparing adjusting entries and income statements; computing gross margin, acid-test, and current ratios

A1 A2 P3 P4

182 Chapter 4 Accounting for Merchandising Operations

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment Accumulated depreciation—Store equipment Accounts payable Common stock Retained earnings

Dividends Sales

1,000 12,500 5,800 2,400

42,900

2,200

2,000 2,200

NELSON COMPANY Unadjusted Trial Balance

January 31 Debit Credit

169,200

15,250 10,000 5,000

27,000

111,950

Cost of goods sold Depreciation expense—Store equipment

Sales salaries expense O�ce salaries expense Insurance expense Rent expense—Selling space

Rent expense—O�ce space Store supplies expense

Advertising expense

Totals

38,400 0

17,500 17,500

0 7,500

7,500 0

9,800

169,200 $

Sales discounts Sales returns and allowances

Required

1. Prepare adjusting journal entries to reflect each of the following: a. Store supplies still available at fiscal year-end amount to $1,750. b. Expired insurance, an administrative expense, is $1,400 for the fiscal year. c. Depreciation expense on store equipment, a selling expense, is $1,525 for the fiscal year. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $10,900

of inventory is still available at fiscal year-end. 2. Prepare a multiple-step income statement for the year ended January 31 that begins with gross sales

and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses.

3. Prepare a single-step income statement for the year ended January 31. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of January 31. (Round ratios to

two decimals.)

Check (2) Gross profit, $67,750

(3) Total expenses, $106,775; Net income, $975

PROBLEM SET B

Problem 4-1B Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of IKEA, which uses the per- petual inventory system and gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on May 2 in Accounts Payable—Havel.

May 2 Purchased merchandise from Havel Co. for $10,000 under credit terms of 1∕15, n∕30, FOB shipping point, invoice dated May 2.

4 Sold merchandise to Rath Co. for $11,000 under credit terms of 2∕10, n∕60, FOB shipping point, invoice dated May 4. The merchandise had cost $5,600.

5 Paid $250 cash for freight charges on the purchase of May 2. 9 Sold merchandise that had cost $2,000 for $2,500 cash. 10 Purchased merchandise from Duke Co. for $3,650 under credit terms of 2∕15, n∕60, FOB des-

tination, invoice dated May 10. 12 Returned $650 of merchandise purchased on May 10 from Duke Co. and debited its account

payable for that amount. 14 Received the balance due from Rath Co. for the invoice dated May 4, net of the discount. 17 Paid the balance due to Havel Co. within the discount period.

Check May 14, Dr. Cash, $10,780 May 17, Cr. Cash, $9,900

[continued on next page]

Chapter 4 Accounting for Merchandising Operations 183

Problem 4-2B Preparing journal entries for merchandising activities—perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Menards, which applies the perpetual inventory system and gross method. Hint: It will help to identify each receivable and payable; for example, record the purchase on July 3 in Accounts Payable—OLB.

July 3 Purchased merchandise from OLB Corp. for $15,000 under credit terms of 1∕10, n∕30, FOB destination, invoice dated July 3.

7 Sold merchandise to Brill Co. for $11,500 under credit terms of 2∕10, n∕60, FOB destination, invoice dated July 7. The merchandise had cost $7,750.

10 Purchased merchandise from Rupert Co. for $14,200 under credit terms of 1∕10, n∕45, FOB shipping point, invoice dated July 10.

11 Paid $300 cash for shipping charges related to the July 7 sale to Brill Co. 12 Brill returned merchandise from the July 7 sale that had cost Menards $1,450 and been sold for

$2,000. The merchandise was restored to inventory. 14 After negotiations with Rupert Co. concerning problems with the merchandise purchased on

July 10, Menards received a price reduction from Rupert of $1,200. Menards debited accounts payable for $1,200.

15 At OLB’s request, Menards paid $200 cash for freight charges on the July 3 purchase, reducing the amount owed (accounts payable) to OLB.

17 Received balance due from Brill Co. for the July 7 sale less the return on July 12. 20 Paid the amount due Rupert Co. for the July 10 purchase less the price reduction granted on July 14. 21 Sold merchandise to Brown for $11,000 under credit terms of 1∕10, n∕30, FOB shipping point,

invoice dated July 21. The merchandise had cost $7,000. 24 Brown requested a price reduction on the July 21 sale because the merchandise did not meet

specifications. Menards gave a price reduction (allowance) of $1,000 to Brown and credited Brown’s accounts receivable for that amount.

30 Received Brown’s cash payment for the amount due from the July 21 sale less the price allow- ance from July 24.

31 Paid OLB Corp. the amount due from the July 3 purchase.

Check July 17, Dr. Cash, $9,310

July 30, Dr. Cash, $9,900

July 31, Cr. Cash, $14,800

May 30, Dr. Cash, $2,450

20 Sold merchandise that cost $1,450 to Tamer Co. for $2,800 under credit terms of 2∕15, n∕60, FOB shipping point, invoice dated May 20.

22 Gave a price reduction (allowance) of $300 to Tamer Co. for merchandise sold on May 20 and credited Tamer’s accounts receivable for that amount.

25 Paid Duke Co. the balance due, net of the discount. 30 Received the balance due from Tamer Co. for the invoice dated May 20, net of discount and

allowance. 31 Sold merchandise that cost $3,600 to Rath Co. for $7,200 under credit terms of 2∕10, n∕60,

FOB shipping point, invoice dated May 31.

Problem 4-3B Computing merchandising amounts and formatting income statements

C1 C2 P4

Barkley Company’s adjusted trial balance on March 31, its fiscal year-end, follows. It categorizes the fol- lowing accounts as selling expenses: Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Debit Credit

Merchandise inventory (ending) . . . . . . . . . . $ 56,500 Other (noninventory) assets . . . . . . . . . . . . . . 202,600 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,500 Common stock . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . 154,425 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,650 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . 5,875 Sales returns and allowances . . . . . . . . . . . . 20,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . 115,600 Sales salaries expense . . . . . . . . . . . . . . . . . . 44,500 Rent expense—Selling space . . . . . . . . . . . . . 16,000 Store supplies expense . . . . . . . . . . . . . . . . . 3,850 Advertising expense . . . . . . . . . . . . . . . . . . . . 26,000 Office salaries expense . . . . . . . . . . . . . . . . . 40,750 Rent expense—Office space . . . . . . . . . . . . . 3,800 Office supplies expense . . . . . . . . . . . . . . . . . 1,100 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $539,575 $539,575

184 Chapter 4 Accounting for Merchandising Operations

Beginning merchandise inventory was $37,500. Supplementary records of merchandising activities for the year ended March 31 reveal the following itemized costs.

Invoice cost of merchandise purchases . . . . . . . . . $138,500 Purchases returns and allowances . . . . . . . . . . . . $6,700

Purchases discounts received . . . . . . . . . . . . . . . . . 2,950 Costs of transportation-in . . . . . . . . . . . . . . . . . . . 5,750

Required

sold, selling expenses, and general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold, sell-

ing expenses, and general and administrative expenses.

Check (2) $134,600

(3) Gross profit, $191,175; Net income, $55,175

(4) Total expenses, $251,600

Problem 4-4B Preparing closing entries and interpreting information about discounts and returns C2 P3

Use the data for Barkley Company in Problem 4-3B to complete the following requirement.

Required

Prepare closing entries as of March 31 (the perpetual inventory system is used).

Problem 4-5B Preparing adjusting entries and income statements; computing gross margin, acid-test, and current ratios

P3 P4 A1 A2

The following unadjusted trial balance is prepared at fiscal year-end for Foster Products Company. Foster Products Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses: Depreciation Expense—Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment Accumulated depreciation—Store equipment Accounts payable Common stock

Dividends Sales

7,400 24,000

9,700 6,600

81,800

2,000

1,000 5,000

FOSTER PRODUCTS COMPANY Unadjusted Trial Balance

October 31 Debit Credit

$320,100

32,000 18,000 3,000

Retained earnings 40,000

227,100

Cost of goods sold Depreciation expense—Store equipment

Sales salaries expense O�ce salaries expense Insurance expense Rent expense—Selling space

Rent expense—O�ce space Store supplies expense Advertising expense

Totals

75,800 0

31,500 31,500

0 13,000

13,000 0

17,800

$320,100

Sales discounts Sales returns and allowances

Required

1. Prepare adjusting journal entries to reflect each of the following: a. Store supplies still available at fiscal year-end amount to $3,700. b. Expired insurance, an administrative expense, is $2,800 for the fiscal year. [continued on next page]

Chapter 4 Accounting for Merchandising Operations 185

Check (2) Gross profit, $142,600

(3) Total expenses, $197,100; Net income, $24,000

SERIAL PROBLEM Business Solutions

P1 P2 P3 P4

This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point.

SP 4 Santana Rey created Business Solutions on October 1, 2019. The company has been successful, and its list of customers has grown. To accommodate the growth, the accounting system is modified to set up separate accounts for each customer. The following chart of accounts includes the account number used for each account and any balance as of December 31, 2019. Santana Rey decided to add a fourth digit with a decimal point to the 106 account number that had been used for the single Accounts Receivable account. This change allows the company to continue using the existing chart of accounts.

c. Depreciation expense on store equipment, a selling expense, is $3,000 for the fiscal year. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $21,300

of inventory is still available at fiscal year-end. 2. Prepare a multiple-step income statement for the year ended October 31 that begins with gross sales

and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses.

3. Prepare a single-step income statement for the year ended October 31. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of October 31. (Round ratios to

two decimals.)

No. Account Title Dr. Cr.

210 Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500

236 Unearned computer services revenue . . . . . . . . . . . . . . 1,500

307 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,000

318 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,360

319 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0

403 Computer services revenue . . . . . . . . . . . . . . . . . . . . . . 0

413 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

414 Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . 0

415 Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

502 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

612 Depreciation expense—Office equipment . . . . . . . . . . . 0

613 Depreciation expense—Computer equipment . . . . . . . . 0

623 Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

637 Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

640 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

652 Computer supplies expense . . . . . . . . . . . . . . . . . . . . . . 0

655 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . 0

684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . . . . 0

No. Account Title Dr. Cr.

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $48,372

106 .1 Alex’s Engineering Co . . . . . . . . . . . . . . . 0

106 .2 Wildcat Services . . . . . . . . . . . . . . . . . . . 0

106 .3 Easy Leasing . . . . . . . . . . . . . . . . . . . . . . 0

106 .4 IFM Co . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

106 .5 Liu Corp . . . . . . . . . . . . . . . . . . . . . . . . . . 0

106 .6 Gomez Co . . . . . . . . . . . . . . . . . . . . . . . . 2,668

106 .7 Delta Co . . . . . . . . . . . . . . . . . . . . . . . . . . 0

106 .8 KC, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

106 .9 Dream, Inc . . . . . . . . . . . . . . . . . . . . . . . . 0

119 Merchandise inventory . . . . . . . . . . . . . . 0

126 Computer supplies . . . . . . . . . . . . . . . . . 580

128 Prepaid insurance . . . . . . . . . . . . . . . . . 1,665

131 Prepaid rent . . . . . . . . . . . . . . . . . . . . . . 825

163 Office equipment . . . . . . . . . . . . . . . . . . 8,000

164 Accumulated depreciation— Office equipment . . . . . . . . . . . . . . . . $ 400

167 Computer equipment . . . . . . . . . . . . . . . 20,000

168 Accumulated depreciation— Computer equipment . . . . . . . . . . . . . 1,250

201 Accounts payable . . . . . . . . . . . . . . . . . . 1,100

In response to requests from customers, S. Rey will begin selling computer software. The company will extend credit terms of 1∕10, n∕30, FOB shipping point, to all customers who purchase this merchandise. However, no cash discount is available on consulting fees. Additional accounts (Nos. 119, 413, 414, 415, and 502) are added to its general ledger to accommodate the company’s new merchandising activities. Its transactions for January through March follow.

Jan. 4 The company paid cash to Lyn Addie for five days’ work at the rate of $125 per day. Four of the five days relate to wages payable that were accrued in the prior year.

5 Santana Rey invested an additional $25,000 cash in the company in exchange for more common stock.

7 The company purchased $5,800 of merchandise from Kansas Corp. with terms of 1∕10, n∕30, FOB shipping point, invoice dated January 7.

9 The company received $2,668 cash from Gomez Co. as full payment on its account. 11 The company completed a five-day project for Alex’s Engineering Co. and billed it $5,500,

which is the total price of $7,000 less the advance payment of $1,500. The company debited Unearned Computer Services Revenue for $1,500.

186 Chapter 4 Accounting for Merchandising Operations

13 The company sold merchandise with a retail value of $5,200 and a cost of $3,560 to Liu Corp., invoice dated January 13.

15 The company paid $600 cash for freight charges on the merchandise purchased on January 7. 16 The company received $4,000 cash from Delta Co. for computer services provided. 17 The company paid Kansas Corp. for the invoice dated January 7, net of the discount. 20 The company gave a price reduction (allowance) of $500 to Liu Corp. and credited Liu’s ac-

counts receivable for that amount. 22 The company received the balance due from Liu Corp., net of the discount and the allowance. 24 The company returned defective merchandise to Kansas Corp. and accepted a credit against

future purchases (debited accounts payable). The defective merchandise invoice cost, net of the discount, was $496.

26 The company purchased $9,000 of merchandise from Kansas Corp. with terms of 1∕10, n∕30, FOB destination, invoice dated January 26.

26 The company sold merchandise with a $4,640 cost for $5,800 on credit to KC, Inc., invoice dated January 26.

31 The company paid cash to Lyn Addie for 10 days’ work at $125 per day. Feb. 1 The company paid $2,475 cash to Hillside Mall for another three months’ rent in advance. 3 The company paid Kansas Corp. for the balance due, net of the cash discount, less the $496

credit from merchandise returned on January 24. 5 The company paid $600 cash to Facebook for an advertisement to appear on February 5 only. 11 The company received the balance due from Alex’s Engineering Co. for fees billed on January 11. 15 The company paid a $4,800 cash dividend. 23 The company sold merchandise with a $2,660 cost for $3,220 on credit to Delta Co., invoice

dated February 23. 26 The company paid cash to Lyn Addie for eight days’ work at $125 per day. 27 The company reimbursed Santana Rey $192 cash for business automobile mileage. The com-

pany recorded the reimbursement as “Mileage Expense.” Mar. 8 The company purchased $2,730 of computer supplies from Harris Office Products on credit

with terms of n∕30, FOB destination, invoice dated March 8. 9 The company received the balance due from Delta Co. for merchandise sold on February 23. 11 The company paid $960 cash for minor repairs to the company’s computer. 16 The company received $5,260 cash from Dream, Inc., for computing services provided. 19 The company paid the full amount due of $3,830 to Harris Office Products, consisting of

amounts created on December 15 (of $1,100) and March 8. 24 The company billed Easy Leasing for $9,047 of computing services provided. 25 The company sold merchandise with a $2,002 cost for $2,800 on credit to Wildcat Services,

invoice dated March 25. 30 The company sold merchandise with a $1,048 cost for $2,220 on credit to IFM Company, in-

voice dated March 30. 31 The company reimbursed Santana Rey $128 cash for business automobile mileage. The com-

pany recorded the reimbursement as “Mileage Expense.”

The following additional facts are available for preparing adjustments on March 31 prior to financial state- ment preparation. a. The March 31 amount of computer supplies still available totals $2,005. b. Prepaid insurance coverage of $555 expired during this three-month period. c. Lyn Addie has not been paid for seven days of work at the rate of $125 per day. d. Prepaid rent of $2,475 expired during this three-month period. e. Depreciation on the computer equipment for January 1 through March 31 is $1,250. f. Depreciation on the office equipment for January 1 through March 31 is $400. g. The March 31 amount of merchandise inventory still available totals $704.

Required

1. Prepare journal entries to record each of the January through March transactions. 2. Post the journal entries in part 1 to the accounts in the company’s general ledger. Note: Begin with the

ledger’s post-closing adjusted balances as of December 31, 2019. 3. Prepare a 6-column work sheet (similar to the one shown in Exhibit 3.13) that includes the unadjusted

trial balance, the March 31 adjustments (a) through (g), and the adjusted trial balance. Do not prepare closing entries and do not journalize the adjustments or post them to the ledger.

Check (2) Ending balances at March 31: Cash, $68,057; Sales, $19,240 (3) Unadj. TB totals, $151,557; Adj. TB totals, $154,082

[continued on next page]

Chapter 4 Accounting for Merchandising Operations 187

GENERAL LEDGER PROBLEM

The General Ledger tool in Connect automates several of the procedural steps in the accounting cycle so that the accounting professional can focus on the impacts of each transaction on the various financial reports. The following General Ledger questions highlight the operating cycle of a merchandising com- pany. In each case, the trial balance is automatically updated from the journal entries recorded.

GL 4-1 Based on Problem 4-1A GL 4-3 Based on Problem 4-5A

GL 4-2 Based on Problem 4-2A

4. Prepare an income statement (from the adjusted trial balance in part 3) for the three months ended March 31, 2020. (a) Use a single-step format. List all expenses without differentiating between selling expenses and general and administrative expenses. (b) Use a multiple-step format that begins with gross sales (service revenues plus gross product sales) and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses. Categorize the follow- ing accounts as selling expenses: Wages Expense, Mileage Expense, and Advertising Expense. Categorize the remaining expenses as general and administrative.

5. Prepare a statement of retained earnings (from the adjusted trial balance in part 3) for the three months ended March 31, 2020.

6. Prepare a classified balance sheet (from the adjusted trial balance) as of March 31, 2020. (6) Total assets, $120,268

COMPANY ANALYSIS A1

Accounting Analysis

AA 4-1 Refer to Apple’s financial statements in Appendix A to answer the following.

Required

1. Assume that the amounts reported for inventories and cost of sales reflect items purchased in a form ready for resale. Compute the net cost of goods purchased for the year ended September 30, 2017.

2. Compute the current ratio and acid-test ratio as of September 30, 2017, and September 24, 2016. 3. Does Apple’s 2017 current ratio outperform or underperform the (assumed) industry average of 1.5? 4. Does Apple’s 2017 acid-test ratio outperform or underperform the (assumed) industry average of 1.0?

APPLE

AA 4-2 Key comparative figures for Apple and Google follow.

Required

1. Compute the amount of gross margin and the gross margin ratio for the two years shown for each of these companies.

2. Which company earns more in gross margin for each dollar of net sales for the current year? 3. Do (a) Apple’s and (b) Google’s current-year gross margins underperform or outperform the industry

(assumed) average of 35.0%? 4. Are (a) Apple’s and (b) Google’s current-year gross margins on a favorable or unfavorable trend?

Apple Google

$ millions Current Year Prior Year Current Year Prior Year

Net sales . . . . . . . . . . . . . . . $229,234 $215,639 $110,855 $90,272

Cost of sales . . . . . . . . . . . . . 141,048 131,376 45,583 35,138

COMPARATIVE ANALYSIS A2

APPLE GOOGLE

AA 4-3 Key comparative figures for Samsung, Apple, and Google follow.

In millions Net Sales Cost of Sales

Samsung . . . . . . . . . . . . . . W239,575,376 W129,290,661

Apple . . . . . . . . . . . . . . . . . $ 229,234 $ 141,048

Google . . . . . . . . . . . . . . . . $ 110,855 $ 45,583

GLOBAL ANALYSIS A2 P4

APPLE GOOGLE Samsung

(4) Net income, $18,833

188 Chapter 4 Accounting for Merchandising Operations

ETHICS CHALLENGE C1 P2

BTN 4-1 Amy Martin is a student who plans to attend approximately four professional events a year at her college. Each event necessitates a financial outlay of $100 to $200 for a new suit and accessories. After incurring a major hit to her savings for the first event, Amy developed a different approach. She buys the suit on credit the week before the event, wears it to the event, and returns it the next week to the store for a full refund on her charge card.

Required

1. Comment on the ethics exhibited by Amy and possible consequences of her actions. 2. How does the merchandising company account for the suits that Amy returns?

Beyond the Numbers

Required

1. Compute the gross margin ratio for each of the three companies. 2. Is Samsung’s gross margin ratio better or worse than (a) Apple’s ratio? (b) Google’s? 3. Do (a) Apple, (b) Google, and (c) Samsung use single-step or multiple-step income statements?

BTN 4-2 You are the financial officer for Music Plus, a retailer that sells goods for home entertainment needs. The business owner, Vic Velakturi, recently reviewed the annual financial statements you prepared and sent you an e-mail stating that he thinks you overstated net income. He explains that although he has invested a great deal in security, he is sure shoplifting and other forms of inventory shrinkage have occurred, but he does not see any deduction for shrinkage on the income statement. The store uses a per- petual inventory system.

Required

Prepare a brief memorandum that responds to the owner’s concerns.

COMMUNICATING IN PRACTICE C2 P3 P5

BTN 4-3 Access the SEC’s EDGAR database (SEC.gov) and obtain the March 21, 2017, filing of its fiscal 2017 10-K report (for year ended January 28, 2017) for J. Crew Group, Inc. (ticker: JCG).

Required

Prepare a table that reports the gross margin ratios for J. Crew using the revenues and cost of goods sold data from J. Crew’s income statement for each of its most recent three years. Analyze and comment on the trend in its gross margin ratio.

TAKING IT TO THE NET C1 A2

BTN 4-4 Official Brands’s general ledger and supplementary records at the end of its current period reveal the following.

TEAMWORK IN ACTION C1 C2

Sales, gross . . . . . . . . . . . . . . . . . . . . $600,000 Merchandise inventory (beginning of period) . . . . . . . $ 98,000

Sales returns & allowances . . . . . . . . 20,000 Invoice cost of merchandise purchases . . . . . . . . . . . . 360,000

Sales discounts . . . . . . . . . . . . . . . . . 13,000 Purchases discounts received . . . . . . . . . . . . . . . . . . . 9,000

Cost of transportation-in . . . . . . . . . . 22,000 Purchases returns and allowances . . . . . . . . . . . . . . . . 11,000

Operating expenses . . . . . . . . . . . . . 50,000 Merchandise inventory (end of period) . . . . . . . . . . . . 84,000

Required

1. Each member of the team is to assume responsibility for computing one of the following items. You are not to duplicate your teammates’ work. Get any necessary amounts to compute your item from the appropriate teammate. Each member is to explain his or her computation to the team in preparation for reporting to the class.

a. Net sales d. Gross profit b. Total cost of merchandise purchases e. Net income c. Cost of goods sold 2. Check your net income with the instructor. If correct, proceed to step 3. 3. Assume that a physical inventory count finds that actual ending inventory is $76,000. Discuss how this

affects previously computed amounts in step 1.

Point: In teams of four, assign the same student a and e. Rotate teams for reporting on a different computation and the analysis in step 3.

Chapter 4 Accounting for Merchandising Operations 189

BTN 4-5 Refer to the opening feature about Build-A-Bear Workshop and its founder Maxine Clark. Assume the business reports current annual sales at approximately $1 million and prepares the following income statement.

ENTREPRENEURIAL DECISION C1 C2 P1

BUILD-A-BEAR WORKSHOP Income Statement

For Year Ended January 31, 2018

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610,000

Expenses (other than cost of sales) . . . . . . . . . . . . . 200,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 190,000

Assume the business sells to individuals and retailers, ranging from small shops to large chains. Assume that they currently offer credit terms of 1∕15, n∕60, and ship FOB destination. To improve their cash flow, they are considering changing credit terms to 3∕10, n∕30. In addition, they propose to change shipping terms to FOB shipping point. They expect that the increase in discount rate will increase net sales by 9%, but the gross margin ratio (and ratio of cost of sales divided by net sales) is expected to remain unchanged. They also expect that delivery expenses will be zero under this proposal; thus, expenses other than cost of sales are expected to increase only 6%.

Required

1. Prepare a forecasted income statement for the year ended January 31, 2019, based on the proposal. 2. Based on the forecasted income statement alone (from your part 1 solution), do you recommend that

the business implement the new sales policies? Explain. 3. What else should the business consider before deciding whether to implement the new policies?

Explain.

BTN 4-6 Arrange an interview (in person or by phone) with the manager of a retail shop in a mall or in the downtown area of your community. Explain to the manager that you are a student studying merchan- dising activities and the accounting for sales returns and sales allowances. Ask the manager what the store policy is regarding returns. Also find out if sales allowances are ever negotiated with customers. Inquire whether management perceives that customers are abusing return policies and what actions management takes to counter potential abuses. Be prepared to discuss your findings in class.

HITTING THE ROAD C1 P2

Point: This activity complements the Ethics Challenge assignment.

Learning Objectives

CONCEPTUAL C1 Identify the items making up

merchandise inventory.

C2 Identify the costs of merchandise inventory.

ANALYTICAL A1 Analyze the effects of inventory

methods for both financial and tax reporting.

P2 Compute the lower of cost or market amount of inventory.

P3 Appendix 5A—Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average.

P4 Appendix 5B—Apply both the retail inventory and gross profit methods to estimate inventory.

A2 Analyze the effects of inventory errors on current and future financial statements.

A3 Assess inventory management using both inventory turnover and days’ sales in inventory.

PROCEDURAL P1 Compute inventory in a perpetual

system using the methods of specific identification, FIFO, LIFO, and weighted average.

Chapter Preview

5 Inventories and Cost of Sales

NTK 5-3, 5-4

INVENTORY VALUATION, ERRORS, AND ANALYSIS

P2 Lower of cost or market A2 Effects of inventory errors A3 Inventory management P3 Appendix: Periodic system P4 Appendix: Inventory

estimation

NTK 5-1

INVENTORY BASICS

C1 Determining inventory items C2 Determining inventory costs

Control of inventory

Physical count

NTK 5-2

INVENTORY COSTING

P1 Cost flow assumptions: Specific identification

First-in, first-out

Last-in, first-out

Weighted average

A1 Effects on financial statements

191

“Show guests you care”—Danny Meyer

Shake It Up

NEW YORK—Danny Meyer opened his first Shake Shack (ShakeShack.com) restaurant in Madison Square Park. The first Shake Shack was a hot dog stand! While much has changed since the first Shack, Danny’s commitment to high-quality ingre- dients has not.

“We call it fine-casual,” explains Danny. “Shake Shack . . . is proving that people don’t want to go backwards in terms of how their food was sourced, how it was cooked.”

Managing this “modern-day roadside burger stand” was not easy. Danny’s Shack grew from “$5,000 worth of hamburgers” to “$30,000-plus” of hamburgers per day. Danny needed an accounting system to track everything.

“The thinking back then was, to have a successful restaurant, the owner had to be there 24/7,” says Danny. To expand Shake Shack, that had to change. Danny put in an inventory system for each of his Shacks. “Great companies,” insists Danny, “figured [inventory] out.”

To ensure fresh sourced ingredients were available at the Shacks, Danny set up an inventory tracking system. He pre- pared and read inventory reports and applied inventory man- agement tools. His inventory system tracks all transactions, and he regularly reviews accounting data in making key decisions.

“You need to get your ducks in a line,” asserts Danny. This means that Shake Shack must successfully manage its inven- tory, even as growth continues.

To be successful, Danny insists that “the numbers add up.” Once your financial house is in order, explains Danny, “you need to take more risk.” He adds, “The best start-ups are businesses that find a unique way to solve problems for people—sometimes problems that people didn’t even know they had.”

Sources: Shake Shack website, January 2019; Fool.com, December 2016; Eater.com, September 2016; Inc.com, May 2015

Determining Inventory Items Merchandise inventory includes all goods that a company owns and holds for sale. This is true regardless of where the goods are located when inventory is counted. Special atten- tion is directed at goods in transit, goods on consignment, and goods that are damaged or obsolete.

Goods in Transit Does a buyer’s inventory include goods in transit from a supplier? If ownership has passed to the buyer, the goods are included in the buyer’s inventory. We deter- mine this by reviewing shipping terms. FOB shipping point—goods are included in buyer’s inventory once they are shipped. FOB destination—goods are included in buyer’s inventory after arrival at their destination.

Goods on Consignment Goods on consignment are goods shipped by the owner, called the consignor, to another party, the consignee. A consignee sells goods for the owner. The consignor owns the consigned goods and reports them in its inventory. For example, Upper Deck pays sports celebrities such as Russell Wilson of the Seattle Seahawks to sign memorabilia, which are offered to card shops on consignment. Upper Deck, the consignor, reports these items in its inventory until sold. The consignee never reports consigned goods in inventory.

Goods Damaged or Obsolete Damaged, obsolete (out-of-date), and deteriorated goods are not reported in inventory if they cannot be sold. If these goods can be sold at a

INVENTORY BASICS

C1 Identify the items making up merchandise inventory.