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BUS550-FinancialandManagerialAccounting5thedition.pdf

Financial & managerial Accounting

John J. Wild

Ken W. Shaw

Barbara Chiappetta

5th edition

information for decisions

5th edition

fin a n c ia l &

m a n a g er ia l

a c c o u n t in g

Wild Shaw

chiappetta

9 7 8 0 0 7 8 0 2 5 6 0 0

9 0 0 0 0

www.mhhe.com

ISBN 978-0-07-802560-0 MHID 0-07-802560-5

E A N

Get Connected.

Studying anytime, anywhere has never been easier... With Connect Plus Accounting for Financial and Managerial Accounting, 5e, you receive the most advanced study tools as well as a fully integrated, media-rich E-book.

What kind of study tools?

LearnSmart™—no two students are alike. LearnSmart™ uses a series of adaptive questions to pinpoint exactly what you know and what you don’t know. The result is your own learning path that helps you retain more knowledge, learn faster, and study more efficiently.

Guided Examples give you a narrated, animated, step-by-step walkthrough of an exercise similar to the one you’ve been assigned by your instructor, allowing you to identify, review, and reinforce the concepts and activities covered in class.

Interactive Presentations provide important chapter material through an engaging, hands-on presentation, bringing the text content to life.

The Media-Rich E-book allows your instructor to share notes with you and your classmates. You can also insert and review your own notes, highlight the text, search for specific information, and interact with media resources.

Connect Plus Accounting gives you a complete digital solution that allows you to access your course materials from any computer, anytime.

If Connect Plus Accounting sounds good to you, start a three-week FREE TRIAL today!

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It’s that simple to begin using Connect Plus Accounting today.

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The integrated solutions for Wild’s Financial and Managerial Accounting 5e have been proven to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. Known for its engaging style, the Wild solution employs the use of current companies, LearnSmart, and instant feedback on practice problems to help students engage with course materials, comprehend the content, and achieve higher outcomes in the course.

McGraw-Hill’s adaptive learning component, LearnSmart, provides assignable modules that help students master core concepts and come to class more prepared.

In addition, Interactive Presentations deliver learning objectives in an interactive environment, giving students access to course-critical content anytime, anywhere.

Finally, our new Intelligent Response Technology-based content offers students an intelligent homework experience that helps them stay focused on learning instead of navigating the technology.

McGraw-Hill LearnSmart™ is an adaptive learning program that identifies what an individual student knows and doesn’t know. LearnSmart’s adaptive learning path helps students learn faster, study more efficiently, and retain more knowledge.

Intelligent Response Technology (IRT) is Connect Accounting’s new student

interface for end-of-chapter assessment content. Intelligent Response Technology

provides a general journal application that looks and feels more like what you would find in a general ledger software

package, improves answer acceptance to reduce student frustration with formatting

issues (such as rounding), and, for select questions, provides an expanded

table that guides students through the process of solving the problem.

Connect Accounting’s Interactive Presentations teach each chapter’s core learning objectives and concepts through an engaging, hands-on presentation, bringing the text content to life. Interactive Presentations harness the full power of technology to truly engage and appeal to all learning styles. Interactive Presentations are ideal in all class formats—online, face-to-face, or hybrid.

Get Connected.

FEATURES

PROVEN EFFECTIVE

LearnSmart™

Intelligent Response Technology

Interactive Presentations

accounting

®

The integrated solutions for Wild’s Financial and Managerial Accounting 5e have been proven to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. Known for its engaging style, the Wild solution employs the use of current companies, LearnSmart, and instant feedback on practice problems to help students engage with course materials, comprehend the content, and achieve higher outcomes in the course.

McGraw-Hill’s adaptive learning component, LearnSmart, provides assignable modules that help students master core concepts and come to class more prepared.

In addition, Interactive Presentations deliver learning objectives in an interactive environment, giving students access to course-critical content anytime, anywhere.

Finally, our new Intelligent Response Technology-based content offers students an intelligent homework experience that helps them stay focused on learning instead of navigating the technology.

McGraw-Hill LearnSmart™ is an adaptive learning program that identifies what an individual student knows and doesn’t know. LearnSmart’s adaptive learning path helps students learn faster, study more efficiently, and retain more knowledge.

Intelligent Response Technology (IRT) is Connect Accounting’s new student

interface for end-of-chapter assessment content. Intelligent Response Technology

provides a general journal application that looks and feels more like what you would find in a general ledger software

package, improves answer acceptance to reduce student frustration with formatting

issues (such as rounding), and, for select questions, provides an expanded

table that guides students through the process of solving the problem.

Connect Accounting’s Interactive Presentations teach each chapter’s core learning objectives and concepts through an engaging, hands-on presentation, bringing the text content to life. Interactive Presentations harness the full power of technology to truly engage and appeal to all learning styles. Interactive Presentations are ideal in all class formats—online, face-to-face, or hybrid.

Get Connected.

FEATURES

PROVEN EFFECTIVE

LearnSmart™

Intelligent Response Technology

Interactive Presentations

accounting

®

Get Engaged.

Lecture Capture

eBooks

Connect Plus includes a media-rich eBook that allows you to share your notes with

your students. Your students can insert and review their own notes,

highlight the text, search for specific information, and interact

with media resources. Using an eBook with Connect Plus gives your students a complete digital solution

that allows them to access their materials from any computer.

Make your classes available anytime, anywhere. With simple, one-click recording, students can search for a word or phrase and be taken to the exact place in your lecture that they need to review.

Get Engaged.

Lecture Capture

eBooks

Connect Plus includes a media-rich eBook that allows you to share your notes with

your students. Your students can insert and review their own notes,

highlight the text, search for specific information, and interact

with media resources. Using an eBook with Connect Plus gives your students a complete digital solution

that allows them to access their materials from any computer.

Make your classes available anytime, anywhere. With simple, one-click recording, students can search for a word or phrase and be taken to the exact place in your lecture that they need to review.

Financial and Managerial Accounting

John J. Wild University of Wisconsin at Madison

Ken W. Shaw University of Missouri at Columbia

Barbara Chiappetta Nassau Community College

INFORMATION FOR DECISIONS

5thedition

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FINANCIAL AND MANAGERIAL ACCOUNTING: INFORMATION FOR DECISIONS, FIFTH EDITION Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Previous editions © 2011, 2009, and 2007. 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 The McGraw-Hill Companies, Inc., 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 978-0-07-802560-0 MHID 0-07-802560-5

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Library of Congress Cataloging-in-Publication Data Wild, John J. Financial and managerial accounting: information for decisions / John J. Wild, University of

Wisconsin at Madison, Ken W. Shaw, University of Missouri at Columbia, Barbara Chiappetta, Nassau Community College.—5th edition.

pages cm Includes index. ISBN 978-0-07-802560-0 (alk. paper)—ISBN 0-07-802560-5 (alk. paper) 1. Accounting. 2. Managerial accounting. I. Shaw, Ken W. II. Chiappetta, Barbara. III. Title. HF5636.W674 2013 658.15911—dc23

2012037525

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

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, and McGraw-Hill does not guarantee the accuracy of the information presented at these sites.

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Adapting to the Needs of Today's Students

Enhancements in technology have changed the spectrum of

how we live and learn in the world today. Being able to

download and work with learning tools on smart phones,

tablets, or laptop computers empowers students to drive their

own learning by putting increasingly intelligent technology

into their hands.

No two students are alike, and whether the goal is to

become an accountant or a businessperson or simply to be

an informed consumer of accounting information, Financial

and Managerial Accounting (FinMan) has helped generations

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With FinMan on your side, you’ll be provided with engaging

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Its chapter-opening vignettes showcase dynamic, successful

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FinMan also delivers innovative technology to help student

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restrictive format that adapts to the needs of today’s students.

Our new content features:

• a general journal interface that looks and feels more like

that found in practice.

• an auto-calculation feature that allows students to focus on

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• a smart (auto-fill) drop-down design.

The end result is content that better prepares students for

the real world. Connect Accounting also includes digitally

based, interactive adaptive learning tools that provide an

opportunity to engage students more effectively by offering

varied instructional methods and more personalized learning

paths that build on different learning styles, interests, and

abilities, allowing students to work at their own pace.

McGraw-Hill LearnSmart™ is an intelligent learning system

that uses a series of adaptive questions to pinpoint each

student’s knowledge gaps. LearnSmart then provides an

optimal learning path for each student, so that they spend less

time in areas they already know and more time in areas they

don’t. The result is LearnSmart’s adaptive learning path that

helps students retain more knowledge, learn faster, and study

more efficiently.

Our Interactive Presentations teach each chapter’s core

learning objectives in a rich multimedia format, bringing the

content to life. Your students will come to class prepared

when you assign Interactive Presentations. Students can also

review the Interactive Presentations as they study.

Guided Examples provide students with narrated, animated,

step-by-step walkthroughs of algorithmic versions of assigned

exercises. Students appreciate the Guided Examples because

they can help students learn accounting and complete

assignments when outside of class.

Connect Plus Accounting integrates a media-rich online

version of the textbook with Connect Accounting.

"This is an excellent book that is well-written and contains excellent illustrations. It has the

best online supplements of any of the texts that I have reviewed. . . . This is an excellent

book that I would recommend to all of my colleagues." — KAREN CRISONINO, County College of Morris

Financial and Managerial Accounting, 5e

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JOHN J. WILD is a distinguished profes- sor 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.

Professor Wild teaches accounting courses at both the undergraduate and graduate levels. He has received numerous teaching honors, includ-

ing the Mabel W. Chipman Excellence-in-Teaching Award, the depart- mental Excellence-in-Teaching Award, and the Teaching Excellence Award from the 2003 and 2005 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. Professor Wild has received several research honors and 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.

Professor Wild 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. Professor Wild is author of Fundamental Accounting Principles, Financial Accounting, Managerial Accounting, and College Accounting, each published by McGraw-Hill/Irwin. His 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, and other journals. He is past associate editor of Contemporary Accounting Research and has served on several editorial boards including The Accounting Review.

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

KEN W. SHAW is an associate professor of accounting and the Deloitte Professor of Accounting at the University of Missouri. He previously was on the faculty at the University of Maryland at College Park. 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.

Professor Shaw teaches financial accounting at the undergraduate and graduate levels. He received the Williams-Keepers LLC Teaching Excellence award in 2007, was voted the “Most Influential Professor” by three 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.

Professor Shaw 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 national and regional meetings. Professor Shaw’s research appears in the Journal of Accounting Research; 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 and the Journal of Business Research. Professor Shaw is co-author of Fundamental Accounting Principles, Managerial Accounting, and College Accounting, published by McGraw-Hill.

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

About the Authors

BARBARA CHIAPPETTA received her BBA in Accountancy and MS in Education from Hofstra University and is a tenured full professor at Nassau Community College. For the past two decades, she has been an active executive board member of the Teachers of Accounting at Two-Year Colleges (TACTYC), serving 10 years as vice president and as president from 1993 through 1999. As an active member of the American Accounting

Association, she has served on the Northeast Regional Steering Committee, chaired the Curriculum Revision Committee of the Two- Year Section, and participated in numerous national committees. Professor Chiappetta has been inducted into the American Accounting Association Hall of Fame for the Northeast Region. She had also

received the Nassau Community College dean of instruction’s Faculty Distinguished Achievement Award. Professor Chiappetta was honored with the State University of New York Chancellor’s Award for Teaching Excellence in 1997. As a confirmed believer in the benefits of the active learning pedagogy, Professor Chiappetta has authored Student Learning Tools, an active learning workbook for a first-year accounting course, published by McGraw-Hill/Irwin.

In her leisure time, Professor Chiappetta enjoys tennis and partici- pates on a U.S.T.A. team. She also enjoys the challenge of bridge. Her husband, Robert, is an entrepreneur in the leisure sport industry. She has two sons—Michael, a lawyer, specializing in intellectual property law in New York, and David, a composer, pursuing a career in music for film in Los Angeles.

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Dear Colleagues/Friends,

As we roll out the new edition of Financial and Managerial Accounting, we thank

each of you who provided suggestions to improve our textbook. As teachers, we

know how important it is to select the right book for our course. This new edition

reflects the advice and wisdom of many dedicated reviewers, symposium and

workshop participants, students, and instructors. Our book consistently rates

number one in customer loyalty because of you. Together, we have created

the most readable, concise, current, accurate, and innovative accounting book

available today.

Throughout the writing process, we steered this book in the manner you direct-

ed. Reviewers, instructors, and students say this book’s enhanced presentation,

graphics, and technology cater to different learning styles and helps students

better understand accounting. Connect Plus Accounting offers new features to

improve student learning and to assist instructor teaching and grading. You and

your students will find all these tools easy to apply.

We owe the success of this book to you and other instructors who graciously

took time to help us focus on the changing demands of today’s students and

their learning needs. We feel fortunate to have witnessed our profession’s

extraordinary devotion to teaching. Your feedback and suggestions are reflected

in everything we write. Please accept our heartfelt thanks for your dedication in

helping today’s students learn, understand, and appreciate accounting.

With kindest regards,

John J. Wild Ken W. Shaw Barbara Chiappetta

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Adapting to the Needs of McGraw-Hill Connect Plus Accounting is a complete online assignment, learning, and textbook assessment solution that connects your students with the tools and resources needed to achieve success through faster learning, more efficient studying, and higher retention of knowledge. Key features found in Connect Plus Accounting include:

Intelligent Response Technology Intelligent Response Technology is Connect Accounting's new student interface for end-of-chapter assessment content. Intelligent Response Technology provides a general journal application that looks and feels more like what you would find in a general ledger software package, improves answer acceptance to reduce student frustra- tion with formatting issues (such as rounding), and, for select questions, provides an expanded table that guides students through the process of solving the problem.

"I love how the general journal was set up. It felt like what I would be filling out if I had an accounting job."

—Student, Chabot Community College

"I like that this system was formatted like real-world accounting is." —Student, Rose State College

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Today's Students!

Connect Accounting helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. Connect grades homework automatically and gives imme- diate feedback on any questions students may have missed.

"This system has improved the journal entry and T-account set-up processes to more accurately resemble the way it is done in class."

—Student, Tallahassee Community College

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Interactive Presentations Connect Accounting's Interactive Presentations teach each chapter's core learning objec- tives and concepts through an engaging, hands-on presenta- tion, bringing the text content to life. Interactive Presentations harness the full power of tech- nology to truly engage and appeal to all learning styles. Interactive Presentations are ideal in all class formats—online, face-to-face, or hybrid.

Adapting to the Needs of

Integrated eBooks Connect Plus includes a media-rich eBook. With it, you can share your notes with your students, and they can insert their own notes, highlight the text, search for specific infor- mation, and review their materials. Using an eBook with Connect gives your students a complete digital solution that allows them to access their materials from any computer. And over time, as more and more students use mobile devices, our eBooks will even enable them to learn on the go.

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Guided Examples Guided Examples provide narrated, animated, and step- by-step walkthroughs of algorithmic ver- sions of assigned exercises in Connect Accounting, allowing the student to iden- tify, review, or reinforce the concepts and activities covered in class. Guided Examples provide immediate feedback and focus on the areas where students need the most guidance.

LearnSmart No two students are alike. McGraw-Hill LearnSmart™ is an intelligent learning system that uses a series of adaptive questions to pinpoint each student's knowl- edge gaps. LearnSmart then provides an opti- mal learning path for each student, so that they spend less time in areas they already know and more time in areas they don't. The result is that LearnSmart's adaptive learning path helps students retain more knowledge, learn faster, and study more efficiently.

Student Resource Library The Connect Accounting Student Study Center gives access to addi- tional resources such as recorded lec- tures, online practice materials, an eBook, and more.

Today's Students!

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Simple Assignment Management and Smart Grading With Connect Plus Accounting, creating assignments is easier than ever, so you can spend more time teaching and less time managing. Connect Accounting enables you to:

• Create and deliver assignments easily with select end-of-chapter questions and test bank items. • Go paperless with the eBook and online submission and grading of student assignments. • Have assignments scored automatically, giving students immediate feedback on their work and side-by-

side comparisons with correct answers. • Reinforce classroom concepts with practice tests and instant quizzes.

McGraw-Hill’s solutions are proven to improve student performance. With Connect Accounting, students can access a wealth of engaging resources to help them study more effectively and perform at a higher level on homework and exams. Connect Accounting also allows instructors to assign McGraw-Hill’s world class content and assess student performance.

The integrated solutions for Financial and Managerial Accounting have been specifically designed to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. McGraw-Hill’s adaptive learning component, LearnSmart, pro- vides assignable modules that help students master chapter core content and come to class more prepared. In addition, Interactive Presentations deliver learning objectives in an interactive environment, giving stu- dents access to course-critical content anytime, anywhere. Known for its engaging style, the FinMan solution employs the use of current companies, LearnSmart, and our instant feedback on practice problems to help students engage with our materials, comprehend the content, and achieve higher outcomes in the course.

Alternate Chapter Options This edition of Financial and Managerial Accounting features five alternate chapters that can be substituted for the traditional chapters through McGraw-Hill Learning Solutions or Create. These chapters provide alternate methods of teaching and learning chapter material and are fully supported in Connect. Alternate chapters available include:

• Chapter 5 - "Inventories and Cost of Sales" featuring the periodic inventory method • Chapter 10 - "Long-Term Liabilities" featuring the effective interest method • Chapter 12 - "Reporting on the Statement of Cash Flows" featuring the direct method • Chapter 16 - "Process Cost Accounting" featuring the First-In, First-Out method • Chapter 20 - "Master Budgets and Planning" featuring manufacturing budgets Contact your publisher's representative or learning solutions specialist for more information.

Adapting to the Needs of

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Today's Instructors

Instructor Library The Connect Accounting Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. The Connect Accounting Instructor Library includes: access to the eBook version of the text, PowerPoint files, Solutions Manual, Instructor Resource Manual, and Test Bank.

Student Reporting Connect Accounting keeps instructors informed about how each stu- dent, section, and class is performing, allowing for more productive use of lecture and office hours. The reporting function enables you to:

• View scored work immediately and track individual or group per- formance with assignment and grade reports.

• Access an instant view of student or class performance relative to learning objectives.

• Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA.

• Identify low-performance students with the "At Risk" student report.

Tegrity: Lectures 24/7

Make your classes available anytime, anywhere. With simple one-click recording, instructors can record lectures, presentations, and step-by-step problem solutions with Tegrity. Using Tegrity with Connect Accounting, instructors can post recordings directly to Connect for student viewing. Students can also search for a word or phrase and be taken to the exact place in your lecture that they need to review.

To learn more about Tegrity watch a two-minute Flash demo at http://tegritycampus.mhhe.com.

McGraw-Hill Customer Experience Group Contact Information

At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why

our services don’t stop after you purchase our products. You can e-mail our Product Specialists 24 hours a day

to get product training online. Or you can search our knowledge bank of Frequently Asked Questions on

our support Website. For Customer Support, call 800-331-5094 or visit www.mhhe.com/support. One of our

Technical Support Analysts will be able to assist you in a timely fashion.

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We offer an Online Learning Center (OLC) that follows Financial and Managerial Accounting chapter by chapter. It doesn’t require any building or maintenance on your part. It’s ready to go the moment you and your students type in the URL: www.mhhe.com/wildFINMAN5e As students study and learn from Financial and Managerial Accounting, they can visit the Student Edition of the OLC Website to work with a multitude of helpful tools:

A secured Instructor Edition stores essential course materials to save you prep time before class. Everything you need to run a lively classroom and an efficient course is included. All resources available to students, plus . . .

• Instructor’s Resource Manual • Solutions Manual • Solutions to Excel Template Assignments • Test Bank • Solutions to Sage 50 Complete Accounting and QuickBooks templates

The OLC Website also serves as a doorway to other technology solutions, like course management systems.

• Generic Template Working Papers • Chapter Learning Objectives • Interactive Chapter Quizzes

• PowerPoint® Presentations • Excel Template Assignments

How Can Text-Related Web Resources Enrich My Course? Online Learning Center (OLC)

McGraw-Hill CampusTM

McGraw-Hill Campus™ is a new one-stop teaching and learning experience available to users of any learning management system. This complimentary integration allows faculty and students to enjoy single sign-on (SSO) access to all McGraw-Hill Higher Education materials and synchronized grade-book with our award-winning McGraw-Hill Connect platform. McGraw-Hill Campus provides faculty with instant access to all McGraw-Hill Higher Education teaching materials (eTextbooks, test banks, PowerPoint slides, animations and learning objects, and so on), allowing them to browse, search, and use any instructor ancillary content in our vast library at no additional cost to instructor or students. Students enjoy SSO access to a variety of free (quizzes, flash cards, narrated presentations, and so on) and subscription-based products (McGraw-Hill Connect). With this integration enabled, faculty and students will never need to create another account to access McGraw-Hill products and services. For more information on McGraw-Hill Campus please visit our website at www.mhcampus.com.

McGraw-Hill Higher Education and Blackboard have teamed up. What does this mean for you?

1. Single sign-on. Now you and your students can access McGraw-Hill's Connect™ and Create™ right from within your Blackboard course —all with one single sign-on.

2. Deep integration of content and tools. You get single sign-on with Connect and Create, you also get integration of McGraw-Hill content and content engines right in Blackboard. Whether you're choosing a book for your course or building Connect assignments, all the tools you need are right where you want them—inside Blackboard.

3. One grade book. Keeping several grade books and manually synchronizing grades in Blackboard is no longer necessary. When a student completes an integrated Connect assignment, the grade for that assignment automatically (and instantly) feeds your Blackboard grade center.

4. A solution for everyone. Whether your institution is already using Blackboard or you just want to try Blackboard on your own, we have a solution for you. McGraw-Hill and Blackboard can now offer you easy access to industry-leading technology and content, whether your campus hosts it, or we do. Be sure to ask your local McGraw-Hill representative for details.

Online Course Management

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xiii

ALEKS: A Superior, Student-Friendly Accounting Experience:

• Artificial Intelligence Fills Individual Student Knowledge Gaps

• Cycle of Learning & Assessment Increases Learning Momentum & Engages Students

• Adaptive, Open-Response Environment Avoids Multiple-Choice Questions

• Customizable Curriculum Aligns with Your Course Syllabi and Textbooks

• Dynamic, Automated Reports Monitor Detailed Student & Class Progress

To learn more, visit: www.aleks.com/highered/business

ALEKS is a registered trademark of ALEKS Corporation.

How Can Adaptive Online Learning Improve Student Performance?

CourseSmart CourseSmart is a new way to find and buy eTextbooks. CourseSmart has the largest selection of eTextbooks available anywhere, offering thousands of the most commonly adopted textbooks from a wide variety of higher educa- tion publishers. CourseSmart eTextbooks are available in one standard online reader with full text search, notes, highlighting, and email tools for sharing between classmates. Visit www.CourseSmart.com for more information on ordering.

"After I adopted ALEKS for my Principles of Accounting course, I got fewer and shorter lines for my office hours, and the class average jumped 10-15 percent overall. It’s a win-win situation." —Professor Fatma Cebenoyan, Hunter College, NY

Significantly Increase Student Success and Retention

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Using Accounting for Decisions Whether we prepare, analyze, or apply accounting informa- tion,  one skill remains essential: decision-making. To help develop good decision-making habits and to illustrate the relevance of accounting, our book uses a unique pedagogical framework we call the Decision Center. This framework is comprised of a variety of approaches and subject areas, giving students insight into every aspect of business decision-making; see three examples to the right and one below. Answers to Decision Maker and Ethics boxes are at the end of each chapter.

CAP Model The Conceptual/Analytical/Procedural (CAP) Model allows courses to be specially designed to meet your teaching needs or those of a diverse faculty. This model identifies learning ob- jectives, textual materials, assignments, and test items by C, A, or P, allowing different instructors to teach from the same ma- terials, yet easily customize their courses toward a conceptual, analytical, or procedural approach (or a combination thereof) based on personal preferences.

Innovative Textbook Features

"We are very impressed with the text itself. The updated look, colors, illustrations, . . . the inclusion of IFRS information will help the transition in the future— which is a good thing. We have the flexibility to pick and choose for now with the way you have laid out the information."

—Bob Urell, Irvine Valley College

Global View This section explains international accounting practices relating to the material covered in that chapter. This section is purposefully located at the end of each chapter so that each instructor can decide what emphasis, if at all, is to be assigned to it. The aim of this Global View section is to describe accounting practices and to identify the similarities and differences in international accounting practices versus that in the United States. As we move toward global convergence in accounting practices, and as we witness the likely conversion of U.S. GAAP to IFRS, the importance of student familiarity with international accounting grows. This innovative section helps us begin down that path of learning and teaching global accounting practices.

Learning Objectives

CONCEPTUAL

C1 Explain the steps in processing transactions and the role of source documents. (p. 50)

C2 Describe an account and its use in recording transactions. (p. 51) C3 Describe a ledger and a chart of accounts. (p. 54) C4 Define debits and credits and explain double-entry accounting. (p. 55)

ANALYTICAL

A1 Analyze the impact of transactions on accounts and financial statements. (p. 59) A2 Compute the debt ratio and describe its use in analyzing financial condition. (p. 69)

PROCEDURAL

P1 Record transactions in a journal and post entries to a ledger. (p. 56) P2 Prepare and explain the use of a trial balance. (p. 65)

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We explained that accounting under U.S. GAAP is similar, but n tion discusses differences in adjusting accounts, preparing finan liabilities on a balance sheet.

Adjusting Accounts Both U.S. GAAP and IFRS includ ing accounts. Although some variations exist in revenue and ex all of the adjustments in this chapter are accounted for identica ters we describe how certain assets and liabilities can result i value measurements.

Preparing Financial Statements Both U.S. GAAP an cial statements following the same process discussed in this cha GAAP and IFRS require current items to be separated from noncu a classified balance sheet). U.S. GAAP balance sheets report curr liquid to least liquid, where liquid refers to the ease of converting nearest to maturity to furthest from maturity, maturity refers to the balance sheets normally present noncurrent items first (and equity ment. Other differences with financial statements exist, which we i the following example of IFRS reporting for its assets, liabilities,

GLOBAL VIEW

PIAGGIO Balance Sheet (in thousands of

December 31, 2011

Assets Noncurrent assets Total equity . . . . .

PIAGGIO

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xiv

Women Entrepreneurs The Center for Women’s Business Research reports that women-owned businesses, such as Nom Nom Truck, are growing and that they:

• Total approximately 11 million and employ nearly 20 million workers. • Generate $2.5 trillion in annual sales and tend to embrace technology. • Are philanthropic—70% of owners volunteer at least once per month. • Are more likely funded by individual investors (73%) than venture firms (15%). ■

Decision Insight

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Payables Manager As a new accounts payable manager, you are being trained by the outgoing man- ager. 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 also 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. When a supplier complains, we blame the computer system and the mailroom.” Do you continue this payment policy? ■ [Answer—p. 208]

Decision Ethics

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Entrepreneur You purchase a batch of products on terms of 3y10, ny90, but your company has limited cash and you must borrow funds at an 11% annual rate if you are to pay within the discount period. Is it to your advantage to take the purchase discount? Explain. ■ [Answer—p. 208]

Decision Maker

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Total Asset Turnover Decision Analysis

A1 Compute total asset turnover and apply it to analyze a company’s use of assets.

A company’s assets are important in determining its ability to generate sales and earn income. Managers devote much attention to deciding what assets a company acquires, how much it invests in assets, and how to use assets most efficiently and effectively. One important measure of a company’s ability to use its as- sets is total asset turnover, defined in Exhibit 8.18.

EXHIBIT 8.18 Total Asset TurnoverTotal asset turnover 5

Net sales Average total assets

The numerator reflects the net amounts earned from the sale of products and services. The denominator reflects the average total resources devoted to operating the company and generating sales.

ill l ’ l k l i hibi 8 19 f i i M l

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“I like the layout of the text and the readability. The illustrations and comics in the book make the text seem less intimidating and boring for students. The PowerPoint slides are easy to understand and use, the pictorials are great, and the text has great coverage of accounting material. The addition of IFRS information and the updates to the opening stories are great. I like that the decision insights are about businesses the students can relate to (i.e., Facebook, women start-up businesses, etc)."

—Jeannie Liu, Chaffey College

Bring Accounting To Life

xv

Chapter Preview With Flowchart This feature provides a handy textual/ visual guide at the start of every chapter. Students can now begin their reading with a clear understanding of what they will learn and when, allowing them to stay more focused and organized along the way.

Long-Term Liabilities

Bond Issuances

• Issuance at par • Issuance at a discount • Issuance at a premium • Bond pricing

Bond Basics

• Bond financing • Bond trading • Issuance procedures

Bond Retirement

• At maturity • Before maturity • By conversion

Long-Term Notes

• Installment notes • Mortgage terms

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Quick Check These short question/answer features reinforce the material immediately preceding them. They allow the reader to pause and refl ect on the topics described, then receive immediate feedback before going on to new topics. Answers are pro- vided at the end of each chapter.

12. Give an example of a natural resource and of an intangible asset. 13. A company pays $650,000 for an ore deposit. The deposit is estimated to have 325,000 tons

of ore that will be mined over the next 10 years. During the first year, it mined, processed, and sold 91,000 tons. What is that year’s depletion expense?

14. On January 6, 2013, a company pays $120,000 for a patent with a remaining 17-year legal life to produce a toy expected to be marketable for three years. Prepare entries to record its acquisition and the December 31, 2013, amortization entry.

Quick Check Answers — p. 421

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Marginal Student Annotations These annotations provide students with additional hints, tips, and examples to help them more fully understand the concepts and retain what they have learned. The annotations also include notes on global implications of accounting and further examples.

when an insurance fee, called a premium, is pai account Prepaid Insurance. Over time, the exp this asset account and reported in expenses on in Prepaid Insurance and is reported on the bala accounts that will expire or be used before the statements are prepared. In this case, the prepa

Point: Prepaid accounts that apply to current and future periods are assets. These assets are adjusted at the end of each period to reflect only those amounts that have not yet expired, and to record as expenses those amounts that have expired.

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xvi

Demonstration Problems present both a problem and a complete solution, allowing students to review the entire problem-solving process and achieve success.

Chapter Summaries provide students with a review organized by learning objectives. Chapter Summaries are a component of the CAP model (see page xiv), which recaps each conceptual, analytical, and procedural objective.

Key Terms are bolded in the text and repeated at the end of the chapter with page numbers indi- cating their location. The book also includes a com- plete Glossary of Key Terms.

Quick Study assignments are short exercises that often focus on one learning objective. Most are included in Connect Account- ing. There are usually 8-10 Quick Study assignments per chapter.

Problem Sets A & B are proven problems that can be assigned as homework or for in-class projects. All problems are coded according to the CAP model (see page xiv), and Set A is included in Connect Accounting.

Exercises are one of this book’s many strengths and a competitive advantage. There are about 10-15 per chapter and most are included in Connect Accounting.

Multiple Choice Quiz questions quickly test chapter knowledge before a student moves on to complete Quick Studies, Exercises, and Problems.

Once a student has finished reading the chapter, how well he or she retains the material can depend greatly on the questions, exer- cises, and problems that reinforce it. This book leads the way in comprehensive, accurate assignments.

Outstanding Assignment Material

Use the following adjusted trial balance and additional information to complete the requirements.

DEMONSTRATION PROBLEM 1

KC ANTIQUES

Adjusted Trial Balance

December 31, 2013

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Store supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,600

Accumulated depreciation—Equipment $ 16 600

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dditional information to complete the requirements.

KCC AAAAAANNNNTIQUES

usttteeeeddddd TTTrial Balance

ceeemmmmmmmbbber 31, 2013

Debit Credit

. . . . . . . . . . . . . . . . . $ 7,000

. . . . . . . . . . . . . . . . . 13,000

. . . . . . . . . . . . . . . . . 60,000

. . . . . . . . . . . . . . . . . 1,500

. . . . . . . . . . . . . . . . . 45,600

ipment $ 16 600

PLANNING THE SOLUTION ● Compute the total cost of merchandise purchases for 2013. ● 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

lli l d d i i i

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SOLUTION TO DEMONSTRATION PROBLEM 1 1.

Invoice cost of merchandise purchases . . . . . . . . $150,000 Less: Purchases discounts received . . . . . . . . . . . . 2,500 Purchase returns and allowances . . . . . . . . . 2,700 Add: Cost of transportation-in . . . . . . . . . . . . . . . 5,000 Total cost of merchandise purchases . . . . . . . . . . $149,800

2. Multiple-step income statement

KC ANTIQUES

Income Statement

For Year Ended December 31, 2013

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

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KK a c p

Appropriated retained earnings (p. 482)

Authorized stock (p. 469)

Basic earnings per share (p. 485)

Book value per common share (p. 486)

Book value per preferred share (p. 486)

Call price (p. 479)

Callable preferred stock (p. 479)

Discount on stock (p. 471)

Dividend in arrears (p. 477)

Dividend yield (p. 486)

Earnings per share (EPS) (p. 485)

Financial leverage (p. 479)

Large stock dividend (p. 474)

Liquidating cash dividend (p. 474)

Preemptive right (p. 468)

Preferred stock (p. 476)

Premium on stock (p. 471)

Price-earnings (PE) ratio (p. 485)

Prior period adjustments (p. 483)

Proxy (p. 467)

Restricted retained earnings (p. 482)

Key Terms

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ue per prefe ed s a e (p. 486)

e

pr

a c a eve age (p. 479) o pe od adjust e ts (p. 83)

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 507 mhhe.com/wildFINMAN5e

2. A company reports net income of $75,000. Its weighted- average common shares outstanding is 19,000. It has no other stock outstanding. Its earnings per share is:

a. $4.69 b. $3.95 c. $3.75 d. $2.08 e. $4.41

1. A corporation issues 6,000 shares of $5 par value common stock for $8 cash per share. The entry to record this transaction includes:

a. A debit to Paid-In Capital in Excess of Par Value for $18,000.

b. A credit to Common Stock for $48,000. c. A credit to Paid-In Capital in Excess of Par Value for

$30,000. d. A credit to Cash for $48,000.

A di C S k f $30 000

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d. $2.08 e. $4.41

o Paid In Capital in Excess of Par Value for

Cash for $48,000. $

Units Unit Cost

Beginning inventory on January 1 . . . . . . . . . 320 $3.00

Purchase on January 9 . . . . . . . . . . . . . . . . . 80 3.20

Purchase on January 25 . . . . . . . . . . . . . . . . 100 3.34

Information: A company reports the following beginning inventory and purchase January. On January 26, the company sells 350 units. 150 units remain in ending inven

QUICK STUDY

QS 5-1 Perpetual: Inventory costing with FIFO

P1

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Exercise 5-2 Inventory costs

C2

ers, purchased the contents of an estate for $75,000. Terms of the purchase he cost of transporting the goods to Walberg Associates’ warehouse was ed the shipment at a cost of $300. Prior to putting the goods up for sale, they cost of $980. Determine the cost of the inventory acquired from the estate.

d $20,000 of goods to Harlow Co., and Harlow Co. has arranged to sell y the consignor and the consignee. Which company should include any ventory? shipped $12,500 of merchandise FOB destination to Harlow Co. Which $12,500 of merchandise in transit as part of its year-end inventory?

EXERCISES

Exercise 5-1 Inventory ownership C1

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PROBLEM SET A

Problem 5-1A Perpetual: Alternative cost flows

P1

Information: W purchases and s 80 units from be of 40 units from

Date

Mar. 1

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a S

D tDateDate

Mar. 1 into the following purchases

ale consisted of 8 units from le consisted of 12 units from pril 25 purchase.)

PROBLEM SET B

Problem 5-1B Perpetual: Alternative cost flows

P1 Units Sold at Retail

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xvii

The End of the Chapter Is Only the Beginning Our valuable and proven assignments aren’t just confi ned to the book. From problems that require technological solutions to materials found exclusively online, this book’s end-of-chapter material is fully integrated with its technology package.

• Quick Studies, Exercises, and Problems available in Connect are marked with an icon.

• Problems supported by the Sage 50 Complete Accounting or Quickbooks are marked with an icon.

• Problems supported with Microsoft Excel template assignments are marked with an icon.

• Assignments that focus on global accounting practices and companies are often identified with an icon.

accounting

Helps Students Master Key Concepts

"The serial problems are excellent…. I like the continuation of the same problem to the next chapters if applicable. I use the Quick Studies as practice problems. . . . Students have commented that this really works for them if they work (these questions) before attempting the assigned exercises and problems. I also like the discussion (questions) and make this an assignment. You have done an outstanding job presenting accounting to our students."

—Jerri Tittle, Rose State College

mhhe.com/wildFINMAN5e

Beyond the Numbers exercises ask students to use accounting fi gures and understand their meaning. Students also learn how accounting applies to a variety of business situations. These creative and fun exercises are all new or updated, and are divided into sections:

• Reporting in Action • Comparative Analysis • Ethics Challenge • Communicating in Practice

• Taking It To The Net • Teamwork in Action • Hitting the Road • Entrepreneurial Decision • Global Decision

BTN 12-1 Refer to Polaris’ financial statements in Appendix A to answer the following. 1. Is Polaris’ statement of cash flows prepared under the direct method or the indirect method? How

do you know? 2. For each year 2011, 2010, and 2009, is the amount of cash provided by operating activities more or

less than the cash paid for dividends? 3. What is the largest amount in reconciling the difference between net income and cash flow from

operating activities in 2011? In 2010? In 2009? 4. Identify the largest cash inflow and outflow for investing and for financing activities in 2012 and in 2010.

Fast Forward

5. Obtain Polaris’ financial statements for a year ending after December 31, 2011, from either its Website (Polaris.com) or the SEC’s database (www .sec.gov). Since December 31, 2011, what are Polaris’

Beyond the Numbers

REPORTING IN ACTION A1

Polaris

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Serial Problem uses a continuous running case study to illustrate chapter concepts in a familiar context. The Se- rial Problem can be followed continuously from the fi rst chapter or picked up at any later point in the book; enough information is provided to ensure students can get right to work.

SERIAL PROBLEM Success Systems

A1 P1 P2

(This serial problem started in Chapter 1 and continues through most of the chapters. If the Chapter 1 segment was not completed, the problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany this book.)

SP 2 On October 1, 2013, Adria Lopez launched a computer services company called Success Systems, which provides consulting services, computer system installations, and custom program development. Adria adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2013. The company’s initial chart of accounts follows.

Account No. Account No.

Cash . . . . . . . . . . . . . . . . . . . . . . 101 A. Lopez, Capital . . . . . . . . . . . . . . . . . . . 301

Accounts Receivable . . . . . . . . . 106 A. Lopez, Withdrawals . . . . . . . . . . . . . . 302

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

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Enhancements in This Edition

Chapter 1 Twitter NEW opener with new entrepreneurial assignment Streamlined and reorganized discussion of the users of accounting information Updated salary information and new margin notes on the value of education New presentation on the ‘fraud triangle’ and its relevance to accounting and internal control New discussion on the joint role of the FASB and IASB in standard setting Revised layout for accounting principles and assumptions New information on the Dodd-Frank act and its relevance to accounting New survey data from executives on the impact of fraud in the economic downturn New world map on the adoption of IFRS or a variant of IFRS across countries New company (Dell) for the return on assets section of Decision Analysis

Chapter 2 Nom Nom Truck NEW opener with new entrepreneurial assignment Reorganized discussion and presentation of assets, liabilities, and equity accounts Revised description of journalizing and posting of transactions New headings on each general journal for this chapter’s major illustration introducing our unique four-step transaction analysis Revised global view and new Piaggio’s (abbreviated) balance sheet Updated debt ratio discussion using recent Skechers’s information

Chapter 3 ash&dans NEW opener with new entrepreneurial assignment New layout for the types of adjustments New example of unearned revenues using USA Today Enhanced and emphasized the innovative three-step process for adjusting accounts Updated IFRS and FASB revenue recognition convergence

Added six new Quick Studies to directly apply the three-step adjustment process Expanded explanation of temporary and permanent accounts Revised visual display of four-step closing process Enhanced display of general ledger for ease in learning

Chapter 4 Faithful Fish NEW opener with new entrepreneurial assignment Enhanced exhibit on transportation costs and FOB terms, with inclusion of entries New discussion of online ordering, tracking numbers, RFID, and FOB Revised the two-step explanation of recording merchandise sales New discussion on the importance and risks of accounting for sales returns Revised visual display of a sales invoice Revised discussion of merchandising purchases and sales New Volkswagen example of IFRS income statement

Chapter 5 Feverish Ice Cream NEW opener with new entrepreneurial assignment Enhanced exhibit that visually shows cost flows from inventory to financial statements, with superior info-graphics Added new discussion on inventory controls New explanatory boxes added to selected exhibits as learning aids Expanded assignments covering perpetual and periodic inventory measurement New material on IFRS and inventory methods

Chapter 6 CHEESEBOY NEW opener with new entrepreneurial assignment New discussion of payroll controls Expanded presentation of ‘Hacker’s Guide’ New discussion of the lock box and its purpose New data on sources of fraud complaints

New evidence on methods to override controls New visual on document to bond (insure) an employee New example of MLB controls, or lack thereof

Chapter 7 Under Armour NEW opener with new entrepreneurial assignment Added explanation of credit card sales New discussion of mobile payment systems using mini-card-readers and iPads New illustration comparing bad debts recognition under the allowance method versus the direct write-off method Revised exhibit on aging of accounts receivable, including all detailed accounts New illustration on why the banker’s rule is commonly applied

Chapter 8 BizChair.com NEW opener with new entrepreneurial assignment New learning boxes added to selected exhibits identifying salvage value New explanation on how asset purchases occurring on different days of the month are commonly processed New example of extraordinary repairs applied to the stealth bomber New notes added to emphasize that depreciation is cost allocation, and not valuation New explanation on how drugmakers fight patent expirations New information on the Mickey Mouse Protection Act for intangibles New goodwill example using Google’s purchase of YouTube

Chapter 9 SmartIT Staffing NEW opener with new entrepreneurial assignment Revised unearned revenues example based on Rihanna ticket sales Added explanation on the role of sellers as tax collection ‘agents’ for the government New information on franchise costs and how they are accounted for Added select formulas to enhance the exhibit on payroll deductions

Updated payroll rates to 2012 with discussion on likely adjustments for 2013 and 2014 Added discussion on maximum withholding allowances claimed New discussion on IRS actions against companies that fail to pay employment taxes New evidence on payroll fraud, its median loss, and time taken to uncover such frauds

Chapter 10 barley & birch NEW opener with new entrepreneurial assignment New explanation on why debt (credit) financing is less costly than equity financing New margin graphics (four) illustrating how a debt’s carrying value is periodically adjusted until it equals maturity value at the end of its life New margin boxes on calculator functions to compute the price of bonds New explanation of what is investment grade debt New discussion on the role of unreported liabilities and the 2008-2009 financial crisis Reference to changes in lease accounting New discussion of collateral and its role in debt financing New separate appendix learning objectives on amortizing a discount or a premium using effective interest

Chapter 11 Groupon NEW opener with new entrepreneurial assignment New discussion of Facebook’s IPO and the role of accounting information New reference to corporate governance New reference to state laws and where companies incorporate New examples using Target for stock quotes and Google for stock splits New discussion of fraudulent information dissemination and stock prices Updated the global view on equity accounting

This edition’s revisions are driven by instructors and students. General revisions to the entire book follow (including chapter-by-chapter revisions):

• Revised and updated assignments throughout

• Updated ratio/tool analysis and data for each chapter

• New material on International Financial Reporting Standards (IFRS) in most chapters, including global examples

• New and revised entrepreneurial examples and elements

• Revised serial problem through nearly all chapters

• New art program, visual info-graphics, and text layout

• New Polaris (maker of ATVs, snowmobiles, motorcycles, and electric vehicles) annual report with comparisons to competitors, including Arctic Cat, KTM (IFRS), and Piaggio (IFRS) with new assignments

• Updated graphics added to each chapter’s analysis section

• New technology content integrated and referenced in the book

• Updated Global View section in each chapter

• New innovative assignments sprinkled throughout the book

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For Better Learning

Chapter 12 TOMS NEW opener with new entrepreneurial assignment Revised graphics to better illustrate cash inflows and outflows for operating, investing, and financing activities Revised graphic to better reflect cash and cash equivalents Added discussion on the use of T-accounts for reconstructing transactions impacting cash New margin clarification for computing free cash flow New discussion on the potential for IASB and FASB to issue guidance for the statement of cash flow that would require the direct method… stay tuned

Chapter 13 Motley Fool REVISED opener with new entrepreneurial assignment New companies—Polaris, Arctic Cat, KTM and Piaggio—data throughout the chapter, exhibits, and illustrations New boxed discussion on the role of financial statement analysis to fight and prevent fraud Enhanced horizontal, vertical, ratio analysis using new companies and industry data Streamlined global view section

Chapter 14 Back to the Roots NEW opener with new entrepreneurial assignment New analytical learning objective Updated ACFE statistics on fraud costs New exhibit and discussion on fraud occurrence and average fraud loss by industry Revised discussion of direct and indirect costs and related exhibit for added clarity New summary of cost classifications and associated managerial decisions New Decision Analysis to focus on raw materials inventory turnover and days’ sales in raw materials inventory Moved discussion of types of manufacturing costs to appear before presentation of manufacturer’s financial statements Expanded discussion of financial statements for service companies New end of chapter assignments on raw materials inventory management and cost classification for service companies Moved cycle time discussion to Chapter 23

Chapter 15 Astor and Black NEW opener with new entrepreneurial assignment Reorganized discussion of job order costing for service companies New discussion of accounting for nonmanufacturing costs and their role in pricing decisions Added new journal entries for indirect materials and indirect labor for improved learning

Chapter 16 Three Twins Ice Cream NEW opener with new entrepreneurial assignment Revised comparison of job order and process costing systems New comparison of reports produced from job order and process costing systems Added details for accounts used in the entry to record sales in process costing Added new process costing assignments Revisions to two learning objectives

Chapter 17 Belgium Brewing Company NEW opener with new entrepreneurial assignment New section on activity-based costing for service providers Enhanced discussions and exhibits on overhead allocation methods New Decision Insight on the use of activity-based costing for business decisions New section on the costs of quality Added several new assignments for better learning

Chapter 18 Leather Head Sports NEW opener with new entrepreneurial assignment New graphics on relations between per-unit fixed and variable costs and volume Revised discussion of per-unit fixed and variable costs Moved discussion of margin of safety to section on break-even Revised discussion of assumptions in CVP analysis Enhanced the formatting and layout of several key exhibits New discussion and examples of using the contribution margin income statement to perform sensitivity analyses and compute sales needed for target income Revised data for estimating cost behavior New discussion on the use of RFID tags to control inventory costs and for error-reduction

Chapter 19 Samanta Shoes REVISED opener with entrepreneurial assignment New Global View with reference to McDonald’s international operations Revised section on limitations of variable costing New discussion of absorption costing and IFRS Revised several exhibits for better learning Enhanced examples of absorption and variable costing and their differences Added new assignments for better learning

Chapter 20 Freshii NEW opener with new entrepreneurial assignment New discussion on incentive compensation and budgeting Expanded global view on foreign currency exchange rates and budgeting Updated discussion on Apple’s cash cushion Added new end of chapter assignments

Chapter 21 Folsom Custom Skis NEW opener with new entrepreneurial assignment New discussion on budgeting for service providers Revised several exhibits for learning clarity Revised discussion of predicting activity levels New enhanced exhibit on framework for understanding total overhead variance, including formulas Revised discussion of controllable and volume variances

Chapter 22 United By Blue NEW opener with new entrepreneurial assignment Revised discussion linking direct and indirect expenses to controllable and uncontrollable costs Highlighted four-step process to prepare departmental income statements Moved discussion and illustration of profit margin and investment turnover to main body of chapter Added discussion on cycle time and cycle efficiency New exhibit on how to prepare departmental performance reports Edited discussion of example on preparing departmental performance reports New discussion on issues in computing return on (assets) investment and residual income New discussion on the link between executive compensation and company performance

Updated global view on division reporting and its explanation for added clarity

Chapter 23 Charlie’s Brownies NEW opener with new entrepreneurial assignment New discussion on outsourcing of information and technology services Simplified discussions and exhibits for several examples of managerial decisions Streamlining of selected explanations

Chapter 24 Gamer Grub REVISED opener with new entrepreneurial assignment Updated graphic on industry cost of capital estimates New presentation on payback periods for health care providers New discussion on link between CEO compensation and IRR Simplified computation of the accounting rate of return New example showing calculation of net present value with salvage value New exhibit showing formula for computing average investment Enhanced graphics on NPV and IRR decision rules

Appendix C myYearbook (MeetMe Inc.) NEW opener with new entrepreneurial assignment New discussion of the two optional presentations for comprehensive income per FASB guidance in 2012 Revised discussion of accounting for securities New reference to Greek debt in the context of international operations

Appendix D New examples of LLPs and their prevalence among professional services New discussion of the potential for multiple drawing accounts in practice Revised and streamlined three-step process to liquidate a partnership

Appendix E Expanded discussion and examples of hackers and internal controls New pneumonic tool for system principles Enhanced exhibit on system components New discussion on voice recognition controls New discussion on cloud computing, its implications to accounting, and its risks New references to XBRL, Great Plains, and QuickBooks in accounting Updated discussion and examples for ERP

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Instructor’s Resource CD-ROM ISBN13: 9780077598624 ISBN10: 0077598628

This is your all-in-one resource. It allows you to create custom presentations from your own materials or from the follow- ing text-specific materials provided in the CD’s asset library:

• Instructor’s Resource Manual Written by April Mohr, Jefferson Community and Technical College, SW.

This manual contains (for each chap- ter) a Lecture Outline, a chart linking all assignment materials to Learning Objectives, and additional visuals with transparency masters.

• Solutions Manual

Written by John J. Wild, Ken W. Shaw, and Anita Kroll, University of Wisconsin–Madison.

• Test Bank

Revised by Laurie Hays, Western Michigan University.

• PowerPoint® Presentations Prepared by Anna Boulware, St. Charles Community College.

Presentations allow for revision of lecture slides, and includes a viewer, allowing screens to be shown with or without the software.

Working Papers Vol. 1, Chapters 1-13 ISBN13: 9780077598709 ISBN10: 0077598709

Vol. 2, Chapters 12-24 ISBN13: 9780077598723 ISBN10: 0077598725

Written by John J. Wild.

Connect Accounting with LearnSmart Two Semester Access Code Card ISBN13: 9780077598594 ISBN10: 0077598598

Connect Plus Accounting with LearnSmart Two Semester Access Code Card ISBN13: 9780077598617 ISBN10: 007759861x

Carol Yacht's Sage 50 Complete Accounting 2013 Student Guide and Templates ISBN13: 9780077796860 ISBN10: 0077796861

Prepared by Carol Yacht.

To better prepare students for account- ing in the real world, selected end-of- chapter material in the text is tied to Sage 50 Complete Accounting 2013 soft- ware (formerly Peachtree). The accompa- nying student guide provides a step-by- step walkthrough for students on how to complete the problem in the software.

QuickBooks Pro 2013 Student Guide and Templates ISBN13: 9780077598686 ISBN10: 0077598687

Prepared by Carol Yacht.

To better prepare students for account- ing in the real world, selected end-of- chapter material in the text is tied to QuickBooks software. The accompanying student guide provides a step-by-step walkthrough for students on how to complete the problem in the software.

Instructor Supplements

Student Supplements

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Assurance of Learning Ready

Many educational institutions today are focused on the notion of assur- ance of learning, an important element of some accreditation standards. Financial and Managerial Accounting is designed specifi cally to support your

assurance of learning initiatives with a simple, yet powerful solution. Each test bank question for Financial and Managerial Accounting maps to a specifi c chapter learning objective listed in the text. You can use our test bank software, EZ Test Online or Connect Accounting to easily query for learn- ing objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test to aggregate student results in similar fashion, making the collection and presentation of assurance of learning data simple and easy.

AACSB Statement

The McGraw-Hill Companies is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Financial and Managerial Accounting recognizes the curricula guidelines detailed in the AACSB stan-

dards for business accreditation by connecting selected questions in the test bank to the six general knowledge and skill guidelines in the AACSB standards. The statements contained in Financial and Managerial Accounting are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Financial and Managerial Accounting and the teaching package make no claim of any specifi c AACSB qualifi cation or evaluation, we have within Financial and Managerial Accounting labeled select questions according to the six general knowledge and skills areas.

"Connect certainly offers so much for the students and at the same time helps the professors. The professors can offer more learning opportunities to the students without intensive time investment."

—Constance Hylton, George Mason University

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Khaled Abdou, Penn State University - Berks

Anne Marie Anderson, Raritan Valley Community College

Elaine Anes, Heald College -Fresno

Jerome Apple, University of Akron

Thomas Arcuri, Florida State University

Jack Aschkenazi, American Intercontinental University

Sidney Askew, Borough of Manhattan Community College

Lawrence Awopetu, University of Arkansas -Pine Bluff

Jon Backman, Spartanburg Community College

Charles Baird, University of Wisconsin-Stout

Richard Barnhart, Grand Rapids Community College

Judy Benish, Fox Valley Tech College

Patricia Bentley, Keiser University

Jaswinder Bhangal, Chabot College

Sandra Bitenc, University of Texas at Arlington

Susan Blizzard, San Antonio College

Marvin Blye, Wor-Wic Community College

Patrick Borja, Citrus College

Anna Boulware, St. Charles Community College

Gary Bower, Community College of Rhode Island-Flanagan

Billy Brewster, University of Texas at Arlington

Leslee Brock, Southwest Mississippi Community College

Gregory Brookins, Santa Monica College

Regina Brown, Eastfield College

Marci Butterfield, University of Utah

Roy Carson, Anne Arundel Community College

Deborah Carter, Coahoma Community College

Roberto Castaneda, DeVry University Online

Amy Chataginer, Mississippi Gulf Coast Community College

Gerald Childs, Waukesha County Technical College

Colleen Chung, Miami Dade College- Kendall

Shifei Chung, Rowan University

Robert Churchman, Harding University

Marilyn Ciolino, Delgado Community College

Thomas Clement, University of North Dakota

Oyinka Coakley, Broward College

Susan Cockrell, Birmingham-Southern College

Lisa Cole, Johnson County Community College

Robbie R. Coleman, Northeast Mississippi Community College

Jackie Conrecode, Florida Gulf Coast University

Debora Constable, Georgia Perimeter College

Cheryl Corke, Genesse Community College

James Cosby, John Tyler Community College

Ken Couvillion, Delta College

Karen Crisonino, County College of Morris

Loretta Darche, Southwest Florida College

Judy Daulton, Piedmont Technical College

Dorothy Davis, University of Louisiana-Monroe

Stan Davis, University of Tennessee at Chattanooga

Walter DeAguero, Saddleback College

Mike Deschamps, MiraCosta College

Pamela Donahue, Northern Essex Community College

Steve Doster, Shawnee State University

Larry Dragosavac, Edison Community College

Samuel Duah, Bowie State University

Robert Dunlevy, Montgomery County Community College

Ron Dustin, Fresno City College

Jerrilyn Eisenhauer, Tulsa Community College-Southeast

Ronald Elders, Virginia College

Terry Elliott, Morehead State University

Albert Fisher, College of Southern Nevada

Annette Fisher, Glendale Community College

Acknowledgments John J. Wild, Ken W. Shaw, Barbara Chiappetta, and McGraw-Hill/Irwin would like to recog- nize the following instructors for their valuable feedback and involvement in the development of Financial and Managerial Accounting, 5e. We are thankful for their suggestions, counsel, and encouragement.

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David Flannery, Bryant and Stratton College

Hollie Floberg, Tennessee Wesleyan College

Linda Flowers, Houston Community College

Jeannie Folk, College of DuPage

Rebecca Foote, Middle Tennessee State University

Paul Franklin, Kaplan University

Tim Garvey, Westwood College

Barbara Gershman, Northern Virginia Community College- Woodbridge

Mike Glasscock, Amarillo College

Diane Glowacki, Tarrant County College

Ernesto Gonzalez, Florida National College

Gloria Grayless, Sam Houston State University

Ann Gregory, South Plains College

Rameshwar Gupta, Jackson State University

Pat Halliday, Santa Monica College

Keith Hallmark, Calhoun Community College

Rebecca Hancock, El Paso Community College-Valley Verde

Mechelle Harris, Bossier Parish Community College

Tracey Hawkins, University of Cincinnati-Clermont College

Thomas Hayes, University of Arkansas-Ft. Smith

Laurie Hays, Western Michigan University

Rita Hays, Southwestern Oklahoma State University

Roger Hehman, University of Cincinnati-Clermont College

Cheri Hernandez, Des Moines Area Community College

Margaret Hicks, Howard University

Melanie Hicks, Liberty University

James Higgins, Holy Family University

Patricia Holmes, Des Moines Area Community College

Barbara Hopkins, Northern Virginia Community College-Manassas

Wade Hopkins, Heald College

Les Hubbard, Solano College

Deborah Hudson, Gaston College

James Hurst, National College

Constance Hylton, George Mason University

Christine Irujo, Westfield State University

Todd Jensen, Sierra College

Fred Jex, Macomb Community College

Gina M. Jones, Aims Community College

Jeff Jones, College of Southern Nevada

Rita Jones, Columbus State University

Sandra Jordan, Florida State College at Jacksonville

Dmitriy Kalyagin, Chabot College

Thomas Kam, Hawaii Pacific University

Naomi Karolinski, Monroe Community College

Shirly A. Kleiner, Johnson County Community College

Tamara Kowalczyk, Appalachian State University

Anita Kroll, University of Wisconsin-Madison

David Krug, Johnson County Community College

Christopher Kwak, DeAnza College

Jeanette Landin, Empire College

Beth Lasky, Delgado Community College

David Laurel, South Texas College

Charles Lewis, Houston Community College

Danny Litt, University of California Los Angeles

Jeannie Liu, Chaffey College

James L. Lock, Northern Virginia Community College

Debra Luna, El Paso Community College

Amado Mabul, Heald College

Lori Major, Luzerne County Community College

Jennifer Malfitano, Delaware County Community College

Maria Mari, Miami Dade College-Kendall

Thomas S. Marsh, Northern Virginia Community College- Annandale

Karen Martinson, University of Wisconsin-Stout

Brenda Mattison, Tri-County Technical College

Stacie Mayes, Rose State College

Donald McWilliams, Jackson State University

Jeanine Metzler, Northampton Community College

Theresa Michalow, Moraine Valley Community College

Kathleen Michele Francois, WECA – Madison

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Julie Miller, Chippewa Valley Tech College

Tim Miller, El Camino College

John Minchin, California Southern University

Edna C. Mitchell, Polk State College

Jill Mitchell, Northern Virginia Community College

Angela Mott, Northeast Mississippi Community College

Timothy Murphy, Diablo Valley College

Kathleen O’Donnell, Onondaga Community College

Ahmed Omar, Burlington County College

Margaret Parilo, Cosumnes River College

Paige Paulsen, Salt Lake Community College

Yvonne Phang, Borough of Manhattan Community College

Gary Pieroni, Diablo Valley College

James Racic, Lakeland Community College

David Ravetch, University of California Los Angeles

Ruthie Reynolds, Howard University

Cecile Roberti, Community College of Rhode Island

Patrick Rogan, Cosumnes River College

Paul Rogers, Community College of Beaver County

Helen Roybark, Radford University

Alphonse Ruggiero, Suffolk County Community College

Arjan Sadhwani, South University

Kin Kin Sandhu, Heald College

Marcia Sandvold, Des Moines Area Community College

Richard Sarkisian, Camden County College

Gary Schader, Kean University

Tracy Schmeltzer, Wayne Community College

Debbie Schmidt, Cerritos College

Darlene Schnuck, Waukesha County Technical College

Elizabeth Serapin, Columbia Southern University

Geeta Shankhar, University of Dayton

Regina Shea, Community College of Baltimore County—Essex

James Shelton, Liberty University

Jay Siegel, Union County College

Jaye Simpson, Tarrant County College

Gerald Singh, New York City College of Technology

Erik Slayter, California Polytechnic State University San Luis Obispo

Lois Slutsky, Broward College-South

Gerald Smith, University of Northern Iowa

Kathleen Sobieralski, University of Maryland University College

Charles Spector, State University of New York at Oswego

Diane Stark, Phoenix College

Thomas Starks, Heald College

Carolyn L. Strauch, Crowder College

Latazia Stuart, Fortis University Online

David Sulzen, Ferrum College

Dominique Svarc, William Rainey Harper College

Linda Sweeney, Sam Houston State University

Margaret Tanner, University of Arkansas—Ft. Smith

Ulysses Taylor, Fayetteville State University

Anthony Teng, Saddleback College

Paula Thomas, Middle Tennessee State University

Teresa Thompson, Chaffey Community College

Leslie Thysell, John Tyler Community College

Jerri Tittle, Rose State College

Melanie Torborg, Globe University

Shafi Ullah, Broward College

Bob Urell, Irvine Valley College

Adam Vitalis, University of Wisconsin-Madison

Patricia Walczak, Lansing Community College

Terri Walsh, Seminole State College-Oviedo

Shunda Ware, Atlanta Technical College

Dave Welch, Franklin University

Jean Wells-Jessup, Howard University

Christopher Widmer, Tidewater Community College

Andrew Williams, Edmonds Community College

Gayle Williams, Sacramento City College

Kenneth L. Wild, University of London

Jonathan M. Wild, University of Wisconsin

John Woodward, Polk State College

Wanda Wong, Chabot College

Patricia Worsham, Norco College, Riverside Community College

Lynnette Yerbury, Salt Lake Community College

Judy Zander, Grossmont College

Mary Zenner, College of Lake County

Jane Zlojutro, Northwestern Michigan College

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In addition to the helpful and generous colleagues listed above, we thank the entire McGraw-Hill/Irwin Financial and Managerial Accounting, 5e team, including Tim Vertovec, Steve Schuetz, Christina Sanders, Aaron Downey of Matrix Productions, Lori Koetters, Matthew Baldwin, Carol Bielski, Patricia Plumb, Jeremy Cheshareck, Ron Nelms, Xin Lin, Julie Hankins, and Brian Nacik. We also thank the great marketing and sales support staff, including Michelle Heaster and Kathleen Klehr. Many talented educa- tors and professionals worked hard to create the supplements for this book, and for their efforts we’re grateful. Finally, many more people we either did not meet or whose efforts we did not personally witness nevertheless helped to make this book everything that it is, and we thank them all.

John J. Wild Ken W. Shaw Barbara Chiappetta

"This textbook does address many learning styles and at the same time allows for many teaching styles ... our faculty have been very pleased with the continued revisions and supplements. From paper working papers ... to continually improved homework sites and e-books. I’m a ‘Wild’ fan!" —Rita Hays, Southwestern Oklahoma State University

The authors extend a special thank you to our contributing and technology supplement authors: Contributing Authors: Anita Kroll, University of Wisconsin; Kathleen O'Donnell, Onondaga Community College Accuracy Checkers: Dave Krug, Johnson County Community College; Albert Fisher, College of Southern Nevada; Judy Zander,

Grossmont College; Ann McCarthy, Eastern Carolina University; Mark McCarthy, East Carolina University; and Helen Roybark, Radford University

LearnSmart Authors: April Mohr, Jefferson Community and Technical College, SW; Anna Boulware, St. Charles Community College; Brenda Mattison, Tri County Technical College; and Dominique Svarc, William Rainey Harper College

Online Quizzes: Constance Hylton, George Mason University Interactive Presentations: Jeannie Folk, College of DuPage PowerPoint: Anna Boulware, St. Charles Community College Instructor Resource Manual: April Mohr, Jefferson Community and Technical College, SW Test Bank: Laurie Hays, Western Michigan University QuickBooks and Sage 50 Complete Accounting: Carol Yacht Excel Templates: Jack Terry

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Brief Contents

1 Introducing Accounting in Business 2 2 Analyzing and Recording

Transactions 50

3 Adjusting Accounts and Preparing Financial Statements 96

4 Accounting for Merchandising Operations 160

5 Inventories and Cost of Sales 208 6 Cash and Internal Controls 256 7 Accounts and Notes Receivable 300 8 Long-Term Assets 334 9 Current Liabilities 376 10 Long-Term Liabilities 420 11 Corporate Reporting and Analysis 464 12 Reporting Cash Flows 508 13 Analysis of Financial Statements 562 14 Managerial Accounting Concepts and

Principles 608

15 Job Order Costing and Analysis 652 16 Process Costing and Analysis 690

17 Activity Based Costing and Analysis 736 18 Cost Behavior and Cost-Volume-Profit

Analysis 776

19 Variable Costing and Performance Reporting 814

20 Master Budgets and Performance Planning 846

21 Flexible Budgets and Standard Costs 894 22 Performance Measurement and

Responsibility Accounting 940

23 Relevant Costing for Managerial Decisions 984

24 Capital Budgeting and Investment Analysis 1014

Appendix A Financial Statement Information A-1

Appendix B Time Value of Money B Appendix C Investments and International

Operations C

*Appendix D Accounting for Partnerships *Appendix E Accounting with Special Journals

xxvi

* Appendices D&E are available on the book’s Website, mhhe.com/wildFINMAN5e, and as print copy from a McGraw-Hill representative.

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Preface iii

1 Introducing Accounting in Business 2

Importance of Accounting 4 Users of Accounting Information 5 Opportunities in Accounting 6

Fundamentals of Accounting 7 Ethics—A Key Concept 7 Fraud Triangle 8 Generally Accepted Accounting Principles 9 International Standards 9 Conceptual Framework and Convergence 10 Sarbanes–Oxley (SOX) 13 Dodd-Frank 14

Transaction Analysis and the Accounting Equation 15

Accounting Equation 15 Transaction Analysis 16 Summary of Transactions 19

Financial Statements 20 Income Statement 20 Statement of Retained Earnings 20 Balance Sheet 20 Statement of Cash Flows 22

Global View 22 Decision Analysis—Return on Assets 23 Appendix 1A Return and Risk Analysis 27 Appendix 1B Business Activities and the Accounting

Equation 27

2 Analyzing and Recording Transactions 50

Analyzing and Recording Process 52 Source Documents 52 The Account and Its Analysis 53

Analyzing and Processing Transactions 56 Ledger and Chart of Accounts 56 Debits and Credits 57 Double-Entry Accounting 57

Journalizing and Posting Transactions 58 Analyzing Transactions—An Illustration 61 Accounting Equation Analysis 65

Trial Balance 67 Preparing a Trial Balance 67 Using a Trial Balance to Prepare Financial Statements 68

Global View 70 Decision Analysis—Debt Ratio 71

3 Adjusting Accounts and Preparing Financial Statements 96

Timing and Reporting 98 The Accounting Period 98 Accrual Basis versus Cash Basis 99 Recognizing Revenues and Expenses 100

Adjusting Accounts 100 Frameworks for Adjustments 100 Prepaid (Deferred) Expenses 101 Unearned (Deferred) Revenues 104 Accrued Expenses 105 Accrued Revenues 107 Links to Financial Statements 109 Adjusted Trial Balance 110

Preparing Financial Statements 110 Closing Process 112

Temporary and Permanent Accounts 112 Recording Closing Entries 112 Post-Closing Trial Balance 114 Accounting Cycle 116

Classified Balance Sheet 117 Classification Structure 117 Classification Categories 118

Global View 120 Decision Analysis—Profit Margin and Current

Ratio 121 Appendix 3A Alternative Accounting for

Prepayments 125 Appendix 3B Work Sheet as a Tool 127 Appendix 3C Reversing Entries 129

Contents

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xxviii Contents

4 Accounting for Merchandising Operations 160

Merchandising Activities 162 Reporting Income for a Merchandiser 162 Reporting Inventory for a Merchandiser 163 Operating Cycle for a Merchandiser 163 Inventory Systems 163

Accounting for Merchandise Purchases 164 Purchase Discounts 165 Purchase Returns and Allowances 166 Transportation Costs and Ownership Transfer 167

Accounting for Merchandise Sales 169 Sales of Merchandise 169 Sales Discounts 170 Sales Returns and Allowances 170

Completing the Accounting Cycle 172 Adjusting Entries for Merchandisers 172 Preparing Financial Statements 173 Closing Entries for Merchandisers 173 Summary of Merchandising Entries 173

Financial Statement Formats 174 Multiple-Step Income Statement 175 Single-Step Income Statement 176 Classified Balance Sheet 176

Global View 177 Decision Analysis—Acid-Test and Gross Margin

Ratios 178 Appendix 4A Periodic Inventory System 183 Appendix 4B Work Sheet—Perpetual System 187

5 Inventories and Cost of Sales 208

Inventory Basics 210 Determining Inventory Items 210 Determining Inventory Costs 211 Internal Controls and Taking a Physical Count 211

Inventory Costing under a Perpetual System 211 Inventory Cost Flow Assumptions 212 Inventory Costing Illustration 213 Specific Identification 213 First-In, First-Out 215 Last-In, First-Out 215 Weighted Average 216 Financial Statement Effects of Costing Methods 218 Consistency in Using Costing Methods 219

Valuing Inventory at LCM and the Effects of Inventory Errors 219

Lower of Cost or Market 219 Financial Statement Effects of Inventory Errors 220

Global View 222 Decision Analysis—Inventory Turnover and Days’

Sales in Inventory 223 Appendix 5A Inventory Costing under a Periodic

System 229 Appendix 5B Inventory Estimation Methods 234

6 Cash and Internal Controls 256

Internal Control 258 Purpose of Internal Control 258 Principles of Internal Control 259 Technology and Internal Control 261 Limitations of Internal Control 262

Control of Cash 263 Cash, Cash Equivalents, and Liquidity 263 Cash Management 264 Control of Cash Receipts 264 Control of Cash Disbursements 266

Banking Activities as Controls 270 Basic Bank Services 270 Bank Statement 272 Bank Reconciliation 273

Global View 276 Decision Analysis—Days’ Sales Uncollected 277 Appendix 6A Documentation and Verification 280 Appendix 6B Control of Purchase

Discounts 283

7 Accounts and Notes Receivable 300

Accounts Receivable 302 Recognizing Accounts Receivable 302 Valuing Accounts Receivable—Direct Write-Off Method 306 Valuing Accounts Receivable—Allowance Method 307 Estimating Bad Debts—Percent of Sales Method 308 Estimating Bad Debts—Percent of Receivables Method 309 Estimating Bad Debts—Aging of Receivables Method 310

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Notes Receivable 312 Computing Maturity and Interest 312 Recognizing Notes Receivable 313 Valuing and Settling Notes 314

Disposal of Receivables 315 Selling Receivables 315 Pledging Receivables 315

Global View 316 Decision Analysis—Accounts Receivable Turnover 317

8 Long-Term Assets 334 SECTION 1—PLANT ASSETS 336 Cost Determination 337

Land 337 Land Improvements 338 Buildings 338 Machinery and Equipment 338 Lump-Sum Purchase 338

Depreciation 339 Factors in Computing Depreciation 339 Depreciation Methods 340 Partial-Year Depreciation 344 Change in Estimates for Depreciation 345 Reporting Depreciation 345

Additional Expenditures 346 Ordinary Repairs 347 Betterments and Extraordinary Repairs 347

Disposals of Plant Assets 348 Discarding Plant Assets 348 Selling Plant Assets 348

SECTION 2—NATURAL RESOURCES 350 Cost Determination and Depletion 350 Plant Assets Used in Extracting 351

SECTION 3—INTANGIBLE ASSETS 351 Cost Determination and Amortization 351 Types of Intangibles 352

Global View 354 Decision Analysis—Total Asset Turnover 355 Appendix 8A Exchanging Plant Assets 358

9 Current Liabilities 376 Characteristics of Liabilities 378

Defining Liabilities 378 Classifying Liabilities 378 Uncertainty in Liabilities 379

Known Liabilities 380 Accounts Payable 380 Sales Taxes Payable 380 Unearned Revenues 381 Short-Term Notes Payable 381 Payroll Liabilities 383 Multi-Period Known Liabilities 386

Estimated Liabilities 387 Health and Pension Benefits 387 Vacation Benefits 388 Bonus Plans 388 Warranty Liabilities 388 Multi-Period Estimated Liabilities 389

Contingent Liabilities 390 Accounting for Contingent Liabilities 390 Reasonably Possible Contingent Liabilities 390 Uncertainties that Are Not Contingencies 391

Global View 391 Decision Analysis—Times Interest Earned Ratio 392 Appendix 9A Payroll Reports, Records,

and Procedures 395 Appendix 9B Corporate Income Taxes 401

10 Long-Term Liabilities 420 Basics of Bonds 422

Bond Financing 422 Bond Trading 423 Bond-Issuing Procedures 424

Bond Issuances 424 Issuing Bonds at Par 424 Bond Discount or Premium 425 Issuing Bonds at a Discount 425 Issuing Bonds at a Premium 428 Bond Pricing 430

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Bond Retirement 431 Bond Retirement at Maturity 431 Bond Retirement before Maturity 431 Bond Retirement by Conversion 432

Long-Term Notes Payable 432 Installment Notes 433 Mortgage Notes and Bonds 434

Global View 435 Decision Analysis—Debt Features and the Debt-to-

Equity Ratio 436 Appendix 10A Present Values of Bonds and Notes 440 Appendix 10B Effective Interest Amortization 442 Appendix 10C Issuing Bonds between Interest

Dates 444 Appendix 10D Leases and Pensions 446

11 Corporate Reporting and Analysis 464

Corporate Form of Organization 466 Characteristics of Corporations 466 Corporate Organization and Management 467 Stockholders of Corporations 468 Basics of Capital Stock 469

Common Stock 470 Issuing Par Value Stock 470 Issuing No-Par Value Stock 471 Issuing Stated Value Stock 472 Issuing Stock for Noncash Assets 472

Dividends 473 Cash Dividends 473 Stock Dividends 474 Stock Splits 476

Preferred Stock 476 Issuance of Preferred Stock 477 Dividend Preference of Preferred Stock 477 Convertible Preferred Stock 478 Callable Preferred Stock 479 Reasons for Issuing Preferred Stock 479

Treasury Stock 480 Purchasing Treasury Stock 480 Reissuing Treasury Stock 481 Retiring Stock 482

Reporting of Equity 482 Statement of Retained Earnings 482 Statement of Stockholders’ Equity 483 Reporting Stock Options 483

Global View 484 Decision Analysis—Earnings per Share, Price-

Earnings Ratio, Dividend Yield, and Book Value per Share 485

12 Reporting Cash Flows 508

Basics of Cash Flow Reporting 510 Purpose of the Statement of Cash Flows 510 Importance of Cash Flows 510 Measurement of Cash Flows 511 Classification of Cash Flows 511 Noncash Investing and Financing 513 Format of the Statement of Cash Flows 513 Preparing the Statement of Cash Flows 514

Cash Flows from Operating 516 Indirect and Direct Methods of Reporting 516 Application of the Indirect Method of Reporting 517 Summary of Adjustments for Indirect Method 522

Cash Flows from Investing 523 Three-Stage Process of Analysis 523 Analysis of Noncurrent Assets 523 Analysis of Other Assets 524

Cash Flows from Financing 525 Three-Stage Process of Analysis 525 Analysis of Noncurrent Liabilities 525 Analysis of Equity 526 Proving Cash Balances 527

Global View 527 Decision Analysis—Cash Flow Analysis 528 Appendix 12A Spreadsheet Preparation of the Statement

of Cash Flows 532 Appendix 12B Direct Method of Reporting Operating

Cash Flows 535

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13 Analysis of Financial Statements 562

Basics of Analysis 564 Purpose of Analysis 564 Building Blocks of Analysis 564 Information for Analysis 565 Standards for Comparisons 565 Tools of Analysis 566

Horizontal Analysis 566 Comparative Statements 566 Trend Analysis 569

Vertical Analysis 571 Common-Size Statements 571 Common-Size Graphics 573

Ratio Analysis 574 Liquidity and Efficiency 575 Solvency 579 Profitability 580 Market Prospects 581 Summary of Ratios 582

Global View 584 Decision Analysis—Analysis Reporting 584 Appendix 13A Sustainable Income 588

14 Managerial Accounting Concepts and Principles 608

Managerial Accounting Basics 610 Purpose of Managerial Accounting 610 Nature of Managerial Accounting 611 Managerial Decision Making 613 Fraud and Ethics in Managerial Accounting 613

Managerial Cost Concepts 614 Types of Cost Classifications 614 Identification of Cost Classifications 617 Cost Concepts for Service Companies 617

Reporting Manufacturing Activities 618 Manufacturer’s Costs 618 Manufacturer’s Balance Sheet 619 Manufacturer’s Income Statement 620 Flow of Manufacturing Activities 622 Manufacturing Statement 623 Trends in Managerial Accounting 625

Global View 627 Decision Analysis—Raw Materials Inventory Turnover

and Days’ Sales of Raw Materials Inventory 628

15 Job Order Costing and Analysis 652

Job Order Cost Accounting 654 Cost Accounting System 654 Job Order Production 654 Job Order Costing of Services 655 Events in Job Order Costing 655 Job Cost Sheet 656

Job Order Cost Flows and Reports 658 Materials Cost Flows and Documents 658 Labor Cost Flows and Documents 660 Overhead Cost Flows and Documents 661 Summary of Cost Flows 663

Adjusting Factory Overhead 665 Factory Overhead T-Account 665 Underapplied or Overapplied Overhead 666

Global View 666 Decision Analysis—Pricing for Services 667

16 Costing and Analysis 692

Process Operations 692 Comparing Job Order and Process Operations 693 Organization of Process Operations 693 GenX Company—An Illustration 693

Process Cost Accounting 695 Comparing Job Order and Process Cost Accounting Systems 695 Direct and Indirect Costs 695 Accounting for Materials Costs 696 Accounting for Labor Costs 697 Accounting for Factory Overhead 697

Equivalent Units of Production 699 Accounting for Goods in Process 699 Differences in Equivalent Units for Materials, Labor, and Overhead 699

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Process Costing Illustration 700 Step 1: Determine the Physical Flow of Units 701 Step 2: Compute Equivalent Units of Production 701 Step 3: Compute the Cost per Equivalent Unit 702 Step 4: Assign and Reconcile Costs 702 Transfers to Finished Goods Inventory and Cost of Goods Sold 705 Trends in Process Operations 707

Global View 707 Decision Analysis—Hybrid Costing System 707 Appendix 16A FIFO Method of Process Costing 709

17 Activity-Based Costing and Analysis 736

Assigning Overhead Costs 738 Plantwide Overhead Rate Method 739 Departmental Overhead Rate Method 740 Activity-Based Costing Rates and Method 743

Applying Activity-Based Costing 744 Step 1: Identify Activities and the Costs They Cause 744 Step 2: Trace Overhead Costs to Cost Pools 745 Step 3: Determine Activity Rates 746 Step 4: Assign Overhead Costs to Cost Objects 746

Assessing Activity-Based Costing 748 Advantages of Activity-Based Costing 748 Disadvantages of Activity-Based Costing 750 ABC for Service Providers 750 Types of Activities 750

Global View 752 Decision Analysis—Customer Profitability 752

18 Cost Behavior and Cost-Volume- Profit Analysis 776

Identifying Cost Behavior 778 Fixed Costs 778 Variable Costs 780 Mixed Costs 780 Step-Wise Costs 780 Curvilinear Costs 781

Measuring Cost Behavior 781 Scatter Diagrams 782 High-Low Method 782 Least-Squares Regression 783 Comparison of Cost Estimation Methods 784

Using Break-Even Analysis 784 Contribution Margin and Its Measures 784 Computing the Break-Even Point 785 Computing the Margin of Safety 786 Preparing a Cost-Volume-Profit Chart 787 Making Assumptions in Cost-Volume-Profit Analysis 788

Applying Cost-Volume-Profit Analysis 789 Computing Income from Sales and Costs 789 Computing Sales for a Target Income 790 Using Sensitivity Analysis 792 Computing a Multiproduct Break-Even Point 793

Global View 795 Decision Analysis—Degree of Operating Leverage 795 Appendix 18A Using Excel to Estimate Least-Squares

Regression 797

19 Variable Costing and Performance Reporting 814

Introducing Variable Costing and Absorption Costing 816

Computing Unit Cost 817

Performance Reporting (Income) Implications 818 Units Produced Equal Units Sold 818 Units Produced Exceed Units Sold 820 Units Produced Are Less Than Units Sold 821 Summarizing Income Reporting 822 Converting Income under Variable Costing to Absorption Costing 823

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Contents xxxiii

Comparing Variable Costing and Absorption Costing 823

Planning Production 823 Setting Prices 825 Controlling Costs 826 Limitations of Reports Using Variable Costing 826 Variable Costing for Service Firms 827

Global View 827 Decision Analysis—Break-Even Analysis 827

20 Master Budgets and Performance Planning 846

Budget Process 848 Strategic Budgeting 848 Benchmarking Budgets 848 Budgeting and Human Behavior 849 Budgeting as a Management Tool 849 Budgeting Communication 849

Budget Administration 850 Budget Committee 850 Budget Reporting 850 Budget Timing 851

Master Budget 852 Master Budget Components 852 Operating Budgets 854 Capital Expenditures Budget 858 Financial Budgets 858

Global View 862 Decision Analysis—Activity-Based Budgeting 862 Appendix 20A Production and Manufacturing

Budgets 868

21 Flexible Budgets and Standard Costs 894

SECTION 1—FLEXIBLE BUDGETS 896 Budgetary Process 896

Budgetary Control and Reporting 896 Fixed Budget Performance Report 897 Budget Reports for Evaluation 898

Flexible Budget Reports 898 Purpose of Flexible Budgets 898 Preparation of Flexible Budgets 898 Flexible Budget Performance Report 900

SECTION 2—STANDARD COSTS 901 Materials and Labor Standards 902

Identifying Standard Costs 902 Setting Standard Costs 902

Cost Variances 903 Cost Variance Analysis 903 Cost Variance Computation 903 Computing Materials and Labor Variances 904

Overhead Standards and Variances 907 Setting Overhead Standards 907 Predicting Activity Levels 908 Computing Overhead Cost Variances 908

Global View 910 Decision Analysis—Sales Variances 911 Appendix 21A: Expanded Overhead Variances and

Standard Cost Accounting System 916

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22 Performance Measurement and Responsibility Accounting 940

Responsibility Accounting 942 Motivation for Departmentalization 942 Departmental Evaluation 942 Controllable versus Uncontrollable Costs 943

Cost Centers 944 Responsibility Accounting System 944 Evaluating Cost Center Performance 944

Profit Center 945 Direct and Indirect Expenses 945 Allocation of Indirect Expenses 946 Departmental Income Statements 947 Departmental Contribution to Overhead 951

Evaluating Investment Center Performance 953 Financial Performance Evaluation Measures 953 Nonfinancial Performance Evaluation Measures 955

Global View 957 Decision Analysis—Cycle Time and Cycle

Efficiency 957 Appendix 22A Transfer Pricing 961 Appendix 22B Joint Costs and Their Allocation 962

23 Relevant Costing for Managerial Decisions 984

Decisions and Information 986 Decision Making 986 Relevant Costs 986

Managerial Decision Scenarios 987 Additional Business 987 Make or Buy 989 Scrap or Rework 990 Sell or Process 990 Sales Mix Selection 991 Segment Elimination 993 Keep or Replace Equipment 993 Qualitative Decision Factors 994

Decision Analysis—Setting Product Price 994

24 Capital Budgeting and Investment Analysis 1014

Introduction to Capital Budgeting 1016

Methods Not Using Time Value of Money 1016 Payback Period 1016 Accounting Rate of Return 1019

Methods Using Time Value of Money 1020 Net Present Value 1020 Internal Rate of Return 1023 Comparison of Capital Budgeting Methods 1025

Global View 1026 Decision Analysis—Break-Even Time 1026 Appendix 24A Using Excel to Compute Net Present

Value and Internal Rate of Return 1029

Appendix A Financial Statement Information A-1 Polaris A-2 Arctic Cat A-10 KTM A-14 Piaggio A-18 Appendix B Time Value of Money B Appendix C Investments and International Operations C *Appendix D Accounting for Partnerships *Appendix E Accounting with Special Journals Glossary G

Credits CR

Index IND

Chart of Accounts CA

* Appendices D&E are available on the book’s Website, mhhe.com/wildFINMAN5e, and as print copy from a McGraw-Hill representative.

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Financial and Managerial Accounting INFORMATION FOR DECISIONS

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Learning Objectives

CONCEPTUAL

C1 Explain the purpose and importance of accounting. (p. 4) C2 Identify users and uses of, and opportunities in, accounting. (p. 5) C3 Explain why ethics are crucial to accounting. (p. 7) C4 Explain generally accepted accounting principles and define and apply several

accounting principles. (p. 9)

C5 Appendix 1B—Identify and describe the three major activities of organizations. (p. 27)

ANALYTICAL

A1 Define and interpret the accounting equation and each of its components. (p. 15)

A2 Compute and interpret return on assets. (p. 23) A3 Appendix 1A—Explain the relation between return and risk. (p. 27)

PROCEDURAL

P1 Analyze business transactions using the accounting equation. (p. 16) P2 Identify and prepare basic financial statements and explain how they

interrelate. (p. 20)

Introducing Accounting in Business 1

A Look at This Chapter

Accounting is crucial in our information age. In this chapter, we discuss the importance of accounting to different types of organizations and describe its many users and uses. We explain that ethics are essential to accounting. We also explain business transactions and how they are reflected in financial statements.

A Look Ahead

Chapter 2 describes and analyzes business transactions. We explain the analysis and recording of transactions, the ledger and trial balance, and the double- entry system. More generally, Chapters 2 and 3 use the accounting cycle to show how financial statements reflect business activities.

Learning Objectives are classified as conceptual, analytical, or procedural.

2

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Accounting for Twitter SAN FRANCISCO—“We came across the word ‘twitter,’ and it was just perfect,” recalls Jack Dorsey (right of photo). “The defini- tion was ‘a short burst of inconsequential information,’ and ‘chirps from birds,’ and that’s exactly what the product was.” Today, Twitter boasts over 200 million users. Founded by Jack, along with Biz Stone and Evan Williams (left), Twitter (Twitter.com) is “facilitating connections between businesses and individuals in meaningful and relevant ways,” says Jack. Along the way, the young entrepreneurs had to learn accounting and the details of preparing and interpreting financial statements. “There is so much going on here,” explains Biz when describ- ing Twitter’s business model. However, admits Evan, “We did a poor job of communicating.” Important questions involving busi- ness formation, transaction analysis, and financial reporting arose. The entrepreneurs eventually met those challenges and, in the process, set Twitter apart. “If you stand pat,” says Evan, “you risk being stagnant.” Information is the focus within Twitter’s accounting records and systems. Jack recalls that when they launched Twitter, there were all these reasons why they would not succeed. He applied their similar “can-do” approach to accounting information. “My whole philosophy is making tech [and accounting] more acces- sible and human,” says Jack. This includes using accounting in- formation to make key business decisions. Twitter is the language of micro-blogging, and accounting is the language of business. “Twitter is so many things: a messaging

service, a customer-service tool, a real-time search,” explains Biz, and the accounting system had to capture those things. Biz adds that Twitter is exploring additional “interesting ways to generate rev- enue.” That revenue-stream is reflected in its financial statements, which are based on transaction analysis and accounting concepts. Twitter’s revenues exhibit growth and reflect what experts call the monetizing of its business. A recent study by the mar- keting firm SocialTwist found that the click-through rate was 19 for Twitter, which is the number of clicks on an embedded link. This compares with 3 clicks for Facebook links. Twitter’s reve- nues in the recent year were estimated at $45 million, which are projected to exceed $100 million next year. Twitter also tracks its expenses and asset purchases. Twitter owners have an esti- mated valuation of between $5 and $10 billion! The three entrepreneurs emphasize that accounting records must be in order for Twitter to realize its full potential. Many ex- perts predict a public offering of its stock within the next two years, which could generate untold wealth. Still, Evan recog- nizes that “so many people here [at Twitter] contribute to that success.” He also emphasizes that learning is a key to their busi- ness success. “I realized,” insists Evan, “I could buy accounting books and learn something that people spent years learning.”

[Sources: Twitter Website, January 2013; Entrepreneur, December 2010; USA Today, May 2009; Smedio.com, June 2011; San Francisco Chronicle, March 2011; SocialTwist.com, October 2010; The Wall Street Journal, February 2011]

“There is so much going on here . . .” —BIZ STONE (CENTER)

Decision Insight A Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur. An Entrepreneurial Decision problem at the end of the assignments returns to this feature with a mini-case.

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Chapter Preview

Today’s world is one of information — its preparation, commu- nication, analysis, and use. Accounting is at the core of this information age. Knowledge of accounting gives us career opportunities and the insight to take advantage of them. This book introduces concepts, procedures, and analyses that help us

make better decisions, including career choices. In this chapter we describe accounting, the users and uses of accounting infor- mation, the forms and activities of organizations, and several ac- counting principles. We also introduce transaction analysis and financial statements.

Fundamentals of Accounting

• Ethics—key concept • Generally accepted

accounting principles • International standards

Importance of Accounting

• Accounting information users

• Opportunities in accounting

Transaction Analysis

• Accounting equation • Transaction

analysis—illustrated

Financial Statements

• Income statement • Statement of retained

earnings • Balance sheet • Statement of cash flows

EXHIBIT 1.1 Accounting Activities

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

Identifying Recording Communicating

A Preview opens each chapter with a summary of topics covered.

Real company names are printed in bold magenta.

Why is accounting so popular on campus? Why are there so many openings for accounting jobs? Why is accounting so important to companies? Why do politicians and business leaders focus on accounting regulations? The answer is that we live in an information age, where that information, and its reliability, impacts us all. Accounting is an information and measurement system that identifies, records, and communi- cates relevant, reliable, and comparable information about an organization’s business activities. Identifying business activities requires that we select relevant transactions and events. Examples are the sale of iPhones by Apple and the receipt of ticket money by TicketMaster. Recording business activities requires that we keep a chronological log of transactions and events measured in dollars. Communicating business activities requires that we prepare accounting reports such as financial statements, which we analyze and interpret. (The financial statements and notes of Polaris are shown in Appendix A near the end of this book. This appendix also shows the financial statements of Arctic Cat, KTM, and Piaggio.) Exhibit 1.1 summarizes accounting activities. Accounting is part of our everyday lives. Our most common contact with accounting is through credit approvals, checking accounts, tax forms, and payroll. These experiences tend to focus on the recordkeeping parts of accounting. Recordkeeping, or bookkeeping, is the record- ing of transactions and events, either manually or electronically. This is just one part of account- ing. Accounting also identifies and communicates information on transactions and events, and it includes the crucial processes of analysis and interpretation. Technology is a key part of modern business and plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving clerical accuracy. Some small organizations continue to perform various accounting tasks manually, but even they are impacted

IMPORTANCE OF ACCOUNTING

C1 Explain the purpose and importance of accounting.

4

Introducing Accounting in Business

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Chapter 1 Introducing Accounting in Business 5

by technology. As technology makes more information available, the demand for accounting in- creases and so too the skills for applying that information. Consulting, planning, and other finan- cial services are now closely linked to accounting. These services require sorting through data, interpreting their meaning, identifying key factors, and analyzing their implications.

Users of Accounting Information Accounting is called the language of business because all organizations set up an accounting information system to communicate data to help people make better decisions. Exhibit 1.2 shows that accounting serves many users (this is a partial listing) who can be divided into two groups: external users and internal users.

Margin notes further enhance the textual material.

Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting. The best software and recordkeeping cannot make up for lack of accounting knowledge.

Internal usersExternal users

A A 000039

EXHIBIT 1.2 Users of Accounting Information

Infographics reinforce key concepts through visual learning.

External Information Users External users of accounting information are not directly involved in running the organization. They include shareholders (investors), lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. External users have limited access to an organization’s information. Yet their business decisions depend on information that is reliable, relevant, and comparable. Financial accounting is the area of accounting aimed at serving external users by providing them with general-purpose financial statements. The term general-purpose refers to the broad range of purposes for which external users rely on these statements. Following is a partial list of external users and some decisions they make with ac- counting information.

● Lenders (creditors) loan money or other resources to an organization. Banks, savings and loans, co-ops, and mortgage and finance companies are lenders. Lenders look for informa- tion to help them assess whether an organization is likely to repay its loans with interest.

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

● Directors are typically elected to a board of directors to oversee their interests in an organiza- tion. Since directors are responsible to shareholders, their information needs are similar.

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

● Nonexecutive employees and labor unions use financial statements to judge the fairness of wages, assess job prospects, and bargain for better wages.

● Regulators often have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) and other tax authorities require organizations to file accounting reports in computing taxes. Other regulators include utility boards that use ac- counting information to set utility rates and securities regulators that require reports for com- panies that sell their stock to the public.

● Voters, legislators, and government officials use accounting information to monitor and eval- uate government receipts and expenses.

● Contributors to nonprofit organizations use accounting information to evaluate the use and impact of their donations.

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

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6 Chapter 1 Introducing Accounting in Business

● Suppliers use accounting information to judge the soundness of a customer before making sales on credit.

● Customers use financial reports to assess the staying power of potential suppliers.

Internal Information Users Internal users of accounting information are those di- rectly involved in managing and operating an organization. They use the information to help improve the efficiency and effectiveness of an organization. Managerial accounting is the area of accounting that serves the decision-making needs of internal users. Internal reports are not subject to the same rules as external reports and instead are designed with the special needs of internal users in mind. Following is a partial list of internal users and some decisions they make with accounting information.

● Research and development managers need information about projected costs and revenues of any proposed changes in products and services.

● Purchasing managers need to know what, when, and how much to purchase. ● Human resource managers need information about em ployees’ payroll, benefits, perfor-

mance, and compensation. ● Production managers depend on information to monitor costs and ensure quality. ● Distribution managers need reports for timely, accurate, and efficient delivery of products

and services. ● Marketing managers use reports about sales and costs to target consumers, set prices, and

monitor consumer needs, tastes, and price concerns. ● Service managers require information on the costs and benefits of looking after products and

services.

Opportunities in Accounting Accounting information is in all aspects of our lives. When we earn money, pay taxes, in- vest savings, budget earnings, and plan for the future, we use accounting. Accounting has four broad areas of opportunities: financial, managerial, taxation, and accounting-related. Exhibit 1.3 lists selected opportunities in each area.

• Preparation • Analysis • 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 1.3 Accounting Opportunities

Exhibit 1.4 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting offers the next largest number of op-

portunities, which involve services such as audit- ing and tax advice. Still other opportunities exist in government and not-for-profit agencies, includ- ing business regulation and investigation of law violations.

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,

EXHIBIT 1.4 Accounting Jobs by Area

Private accounting

58% Public

accounting 23%

Government, not-for-profit and

education 19%

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Chapter 1 Introducing Accounting in Business 7

pass an examination, and exhibit ethical character. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), personal financial specialist (PFS), certified fraud examiner (CFE), and certified forensic accountant (CrFA). Demand for accounting specialists is strong. Exhibit 1.5 reports average annual salaries for several accounting positions. Salary variation depends on location, company size, professional designation, experience, and other factors. For example, salaries for chief financial officers (CFO) range from under $100,000 to more than $1 million per year. Likewise, salaries for book- keepers range from under $30,000 to more than $80,000.

Point: Census Bureau (2011) reports that for workers 25 and over, higher education yields higher average pay: Advanced degree . . . . . . . . . . $81,568 Bachelor’s degree . . . . . . . . . . 57,326 High school degree . . . . . . . . 36,876 No high school degree. . . . . . 26,124

Point: The largest accounting firms are Deloitte, Ernst & Young, KPMG, and Price- waterhouseCoopers.

Point: For updated salary information: Abbott-Langer.com www.AICPA.org Kforce.com

EXHIBIT 1.5 Accounting Salaries for Selected Fields

Field Title (experience) 2011 Salary 2016 Estimate*

Public Accounting Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . $202,000 $223,000

Manager (6 – 8 years) . . . . . . . . . . . . . . . . 97,500 107,500

Senior (3 – 5 years) . . . . . . . . . . . . . . . . . . 75,000 83,000

Junior (0 – 2 years) . . . . . . . . . . . . . . . . . . 57,500 63,500

Private Accounting CFO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242,000 267,000

Controller/Treasurer . . . . . . . . . . . . . . . 157,500 174,000

Manager (6 – 8 years) . . . . . . . . . . . . . . . . 91,500 101,000

Senior (3 – 5 years) . . . . . . . . . . . . . . . . . . 74,500 82,000

Junior (0 – 2 years) . . . . . . . . . . . . . . . . . . 53,000 58,500

Recordkeeping Full-charge bookkeeper . . . . . . . . . . . . . 59,500 65,500

Accounts manager . . . . . . . . . . . . . . . . . . 52,000 57,500

Payroll manager . . . . . . . . . . . . . . . . . . . . 55,500 61,000

Accounting clerk (0 – 2 years) . . . . . . . . . 38,500 42,500

* Estimates assume a 2% compounded annual increase over current levels (rounded to nearest $500).

Quick Check is a chance to stop and reflect on key points.

1. What is the purpose of accounting? 2. What is the relation between accounting and recordkeeping? 3. Identify some advantages of technology for accounting. 4. Who are the internal and external users of accounting information? 5. Identify at least five types of managers who are internal users of accounting information.

Quick Check Answers — p. 29

Point: U.S. Bureau of Labor (June 2011) reports higher education is associated with a lower unemployment rate: Bachelor’s degree or more . . . . 4.4% High school degree . . . . . . . . . . 10.0% No high school degree. . . . . . . . 14.3%

Accounting is guided by principles, standards, concepts, and assumptions. This section de- scribes several of these key fundamentals of accounting.

Ethics—A Key Concept The goal of accounting is to provide useful information for decisions. For information to be use- ful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions. For example, accounting users are less likely to trust an auditor’s report if the auditor’s pay depends on the client’s success . To avoid such con- cerns, ethics rules are often set. For example, auditors are banned from direct investment in their

FUNDAMENTALS OF ACCOUNTING

Point: Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior officers and the contents of that code.

C3 Explain why ethics are crucial to accounting.

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8 Chapter 1 Introducing Accounting in Business

client and cannot accept pay that depends on figures in the client’s reports. Exhibit 1.6 gives guidelines for making ethical decisions. Accountants face many ethical choices as they prepare financial reports. These choices can affect the price a buyer pays and the wages paid to workers. They can even affect the success of products and services. Misleading information can lead to a wrongful closing of a division that harms workers, customers, and suppliers. There is an old saying: Good ethics are good business. Some people extend ethics to social responsibility, which refers to a concern for the impact of actions on society. An organization’s social responsibility can include donations to hospitals, colleges, community programs, and law enforcement. It also can include programs to reduce pollution, increase product safety, improve worker conditions, and support continuing education. These programs are not limited to large companies. For example, many small businesses offer discounts to students and senior citizens. Still others help sponsor events such as the Special Olympics and summer reading programs.

Point: The American Institute of Certified Public Accountants’ Code of Professional Conduct is available at www.AICPA.org.

EXHIBIT 1.6 Guidelines for Ethical Decision Making

Use personal ethics to recognize an ethical concern.

Consider all good and bad consequences.

Choose best option after weighing all consequences.

Identify ethical concerns Analyze options Make ethical decision

Decision Insight boxes highlight relevant items from practice.

Virtuous Returns Virtue is not always its own reward. Compare the S&P 500 with the Domini Social Index (DSI), which covers 400 companies that have especially good records of social responsibility. We see that returns for companies with socially responsible behavior are roughly on par with those of the S&P 500 for the past 10-year period (Domini.com, 2011 Annual Report). Copyright © 2005 by KLD Research & Analytics, Inc. The “Domini 400 Social Index” is a service mark of

KLD Research & Analytics. ■ 6

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DSEFX S&P 500

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$12,932 S&P 500

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Decision Insight

Fraud Triangle The fraud triangle is a model created by a criminologist that asserts the following three factors must exist for a person to commit fraud: opportunity, pressure, and rationalization. Opportunity is one side of the fraud triangle. A person must envision a way to commit fraud with a low perceived risk of getting caught. Employers can directly reduce this risk. An example of some control on opportunity is a pre-employment background check. Pressure, or incentive, is another side of the fraud triangle. A person must have some pressure to commit fraud. Ex- amples are unpaid bills and addictions. Rationalization, or attitude, is the third side of the fraud triangle. A person who rationalizes fails to see the criminal nature of the fraud or justifies the action. It is important to recognize that all three factors of the fraud triangle must usually exist for fraud to occur. The absence of one or more factors suggests fraud is unlikely. The key to dealing with fraud is to focus on prevention. It is less expensive and more effec- tive to prevent fraud from happening than it is to try to detect the crime. By the time the fraud is

O pp

or tu

ni ty

Rationalization

Financial Pressure

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Chapter 1 Introducing Accounting in Business 9

Generally Accepted Accounting Principles Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). We must understand these principles to best use accounting data. GAAP aims to make information relevant, reliable, and comparable. Relevant information affects deci- sions of users. Reliable information is trusted by users. Comparable information is helpful in contrasting organizations. In the United States, the Securities and Exchange Commission (SEC), a government agency, has the legal authority to set GAAP. The SEC also oversees proper use of GAAP by companies that raise money from the public through issuances of their stock and debt. Those companies that issue their stock on U.S. exchanges include both U.S. SEC registrants (companies incorporated in the United States) and non-U.S. SEC registrants (companies incorporated under non-U.S. laws). The SEC has largely delegated the task of setting U.S. GAAP to the Financial Accounting Stan- dards Board (FASB), which is a private-sector group that sets both broad and specific principles.

International Standards In today’s global economy, there is increased demand by external users for comparability in ac- counting reports. This demand often arises when companies wish to raise money from lenders and investors in different countries. To that end, the International Accounting Standards Board (IASB), an independent group (consisting of individuals from many countries), issues Interna- tional Financial Reporting Standards (IFRS) that identify preferred accounting practices. If standards are harmonized, one company can potentially use a single set of financial state- ments in all financial markets. Differences between U.S. GAAP and IFRS are decreasing as the FASB and IASB pursue a convergence process aimed to achieve a single set of accounting stan- dards for global use. More than 115 countries now require or permit companies to prepare fi- nancial reports following IFRS. Further, non-U.S. SEC registrants can use IFRS in financial reports filed with the SEC (with no reconciliation to U.S. GAAP). This means there are two sets of accepted accounting principles in the United States: (1) U.S. GAAP for U.S. SEC registrants and (2) either IFRS or U.S. GAAP for non-U.S. SEC registrants. The SEC is encouraging the FASB to change U.S. GAAP over a period of several years by endorsing, and thereby incorporating, individual IFRS standards into U.S. GAAP. This endorse- ment process would still allow the FASB to modify IFRS when necessary. The SEC would:

● Maintain its statutory oversight of the FASB, including authority to prescribe accounting principles and standards for U.S. issuers.

● Contribute to oversight and governance of the IASB through its involvement on the IFRS Foundation Monitoring Board.

Point: State ethics codes require CPAs who audit financial statements to disclose areas where those statements fail to comply with GAAP. If CPAs fail to report noncompliance, they can lose their licenses and be subject to criminal and civil actions and fines.

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

They Fought the Law Our economic and social welfare depends on reliable accounting. Some individuals forgot that and are now paying their dues. They include Raj Rajaratnam (in photo), an investor, convicted of trading stocks using inside information; Bernard Madoff of Madoff Investment Securities, convicted of falsifying securities records; Bernard Ebbers of WorldCom, convicted of an $11 billion accounting scandal; Andrew Fastow of Enron, guilty of hiding debt and inflating income; and Ramalinga Raju of Satyam Computers, accused of over- stating assets by $1.5 billion. ■

Decision Insight

discovered, the money is gone and chances are slim that it will be recovered. Additionally, it is costly and time-consuming to investigate a fraud.

Both internal and external users rely on internal controls to reduce the likelihood of fraud. Inter- nal controls are procedures set up to protect company property and equipment, ensure reliable ac- counting reports, promote efficiency, and encourage adherence to company policies. Examples are good records, physical controls (locks, passwords, guards), and independent reviews.

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10 Chapter 1 Introducing Accounting in Business

Principles and Assumptions of Ac counting Accounting principles (and assump- tions) are of two types. General principles are the basic assumptions, concepts, and guidelines for preparing financial statements. Specific principles are detailed rules used in reporting busi- ness transactions and events. General principles stem from long-used accounting practices. Spe- cific principles arise more often from the rulings of authoritative groups.

IFRS Like the FASB, the IASB uses a conceptual framework to aid in revising or drafting new standards. However, unlike the FASB, the IASB’s conceptual framework is used as a reference when specific guidance is lack- ing. The IASB also requires that transactions be accounted for according to their substance (not only their legal form), and that financial statements give a fair presentation, whereas the FASB narrows that scope to fair presentation in accordance with U.S. GAAP. ■

Conceptual Framework and Convergence The FASB and IASB are attempting to converge and enhance the conceptual framework that guides standard setting. The FASB framework consists broadly of the following:

● Objectives—to provide information useful to investors, creditors, and others.

● Qualitative Characteristics—to require information that is relevant, reliable, and comparable.

● Elements—to define items that financial statements can contain.

● Recognition and Measurement—to set criteria that an item must meet for it to be recognized as an element; and how to mea- sure that element.

For updates on this joint FASB and IASB conceptual framework convergence we can check with FASB.org or ifrs.org Websites. We must remember that U.S. GAAP and IFRS are two similar, but not identical, systems. However, their similarities greatly outweigh any differ- ences. The remainder of this section describes key principles and assumptions of accounting.

Objectives of financial accounting

Recognition and measurement

Qualitative characteristics Elements

Principles and Scruples Auditors, directors, and lawyers are using principles to improve accounting reports. Examples include accounting restatements at Navistar, financial restatements at Nortel, accounting reviews at Echostar, and expense adjustments at Electronic Data Sys- tems. Principles-based accounting has led accounting firms to drop cli- ents deemed too risky. Examples include Grant Thornton’s resignation as auditor of Fremont General due to alleged failures in providing infor- mation when promised, and Ernst and Young’s resignation as auditor of Catalina Marketing due to alleged accounting errors. ■

Decision Insight

The FASB would continue, but its role would be to provide input and support to the IASB in crafting high-quality, global standards. The FASB is to develop a transition plan to effect these changes over the next five years or so. For updates on this roadmap, we can check with the AICPA (IFRS.com), FASB (FASB.org), and IASB (ifrs.org).

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Chapter 1 Introducing Accounting in Business 11

We need to under- stand both general and specific principles to effectively use ac- counting information. Several general prin- ciples are des cribed in this section that are relied on in later chap- ters. General princi- ples (in purple font with white shading) and assumptions (in red font with white shading) are portrayed as building blocks of GAAP in Exhibit 1.7. The specific principles are described as we encoun- ter them in the book.

Accounting Principles General principles consist of at least four basic principles, four assump- tions, and two constraints.

● Measurement The measurement principle, also called the cost principle, usually prescribes that accounting information is based on actual cost (with a potential for subsequent adjustments to market). Cost is mea sured on a cash or equal-to-cash basis. This means if cash is given for a ser vice, its cost is meas ured as the amount of 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 re- ceived. The cost principle emphasizes reliability and verifiability, and information based on cost is considered objective. Objectivity means that information is supported by independent, unbi- ased evidence; it demands more than a person’s opinion. To illustrate, suppose a company pays $5,000 for equipment. The cost principle requires that this purchase be recorded at $5,000. It makes no difference if the owner thinks this equipment is worth $7,000. Later in the book we introduce fair value measures.

● Revenue recognition Revenue (sales) is the amount received from selling products and ser- vices. The revenue recognition principle provides guidance on when a company must rec- ognize revenue. To recognize means to record it. If revenue is recognized too early, a company would look more profitable than it is. If revenue is recognized too late, a company would look less profitable than it is. Three concepts are important to revenue recognition. (1) Revenue is recognized when earned. The earnings process is normally complete when services are per- formed or a seller transfers ownership of products to the buyer. (2) Proceeds from selling products and services need not be in cash. A common noncash proceed received by a seller is a customer’s promise to pay at a future date, called credit sales. (3) Revenue is measured by the cash received plus the cash value of any other items received.

● Expense recognition The expense recognition principle, also called the matching principle, prescribes that a company record the expenses it incurred to generate the revenue reported. The principles of matching and revenue recognition are key to modern accounting.

● Full disclosure The full disclosure principle prescribes that a company report the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Example: When a bookstore sells a textbook on credit is its earnings process complete? Answer: A bookstore can record sales for these books minus an amount expected for returns.

GAAPGAAP

Measurement

Full disclosure

Revenue recognition

Expense recognition

Business entity

Time period

Monetary unit

Going concern

Materiality Benefits > Cost

Principles

Assumptions

Constraints

EXHIBIT 1.7 Building Blocks for GAAP

Point: The cost principle is also called the historical cost principle.

Revenues for the Green Bay Packers, New England Patriots, New York Giants, and other professional football teams include ticket sales, television and cable broadcasts, radio rights, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they represent 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

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12 Chapter 1 Introducing Accounting in Business

Point: Abuse of the entity assumption was a main culprit in Enron’s collapse.

Point: For currency conversion: xe.com

Accounting Assumptions There are four accounting assumptions: the going-concern assump- tion, the monetary unit assumption, the time period assumption, and the business entity assumption.

● Going concern The going-concern assumption means that accounting information reflects a pre- sumption that the business will continue operating instead of being closed or sold. This implies, for example, that property is reported at cost instead of, say, liquidation values that assume closure.

● Monetary unit The monetary unit assumption means that we can express transactions and events in monetary, or money, units. Money is the common denominator in business. Exam- ples of monetary units are the dollar in the United States, Canada, Australia, and Singapore; and the peso in Mexico, the Philippines, and Chile. The monetary unit a company uses in its accounting reports usually depends on the country where it operates, but many companies today are expressing reports in more than one monetary unit.

● Time period The time period assumption presumes that the life of a company can be di- vided into time periods, such as months and years, and that useful reports can be prepared for those periods.

● Business entity The business entity assumption means that a business is accounted for sep- arately from other business entities, including its owner. The reason for this assumption is that separate information about each business is necessary for good decisions. A business entity can take one of three legal forms: proprietorship, partnership, or corporation.

1. A sole proprietorship, or simply proprietorship, is a business owned by one person in which that person and the company are viewed as one entity for tax and liability purposes. No special legal requirements must be met to start a proprietorship. It is a separate entity for accounting purposes, but it is not a separate legal entity from its owner. This means, for example, that a court can order an owner to sell personal belongings to pay a propri- etorship’s debt. This unlimited liability of a proprietorship is a disadvantage. However, an advantage is that a proprietorship’s income is not subject to a business income tax but is instead reported and taxed on the owner’s personal income tax return. Pro prietorship at- tributes are summarized in Exhibit 1.8, including those for partnerships and corporations.

EXHIBIT 1.8 Attributes of Businesses

Attribute Present Proprietorship Partnership Corporation

One owner allowed . . . . . . . . . . . . yes no yes

Business taxed . . . . . . . . . . . . . . . . no no yes

Limited liability . . . . . . . . . . . . . . . . no* no* yes

Business entity . . . . . . . . . . . . . . . . yes yes yes

Legal entity . . . . . . . . . . . . . . . . . . . no no yes

Unlimited life . . . . . . . . . . . . . . . . . no no yes

* Proprietorships and partnerships that are set up as LLCs provide limited liability.

2. A partnership is a business owned by two or more people, called partners, which are jointly liable for tax and other obligations. Like a proprietorship, no special legal require- ments must be met in starting a partnership. The only requirement is an agreement bet- ween partners to run a business to gether. The agreement can be either oral or written and usually indicates how income and losses are to be shared. A partnership, like a proprietor- ship, is not legally separate from its owners. This means that each partner’s share of profits is reported and taxed on that partner’s tax return. It also means unlimited liability for its partners. However, at least three types of partnerships limit liability. A limited partnership (LP) includes a general partner(s) with unlimited liability and a limited partner(s) with lia- bility restricted to the amount invested. A limited liability partnership (LLP) restricts part- ners’ liabilities to their own acts and the acts of individuals under their control. This protects an innocent partner from the negligence of another partner, yet all partners remain respon- sible for partnership debts. A limited liability company (LLC) offers the limited liability of a corporation and the tax treatment of a partnership (and proprietorship). Most proprietor- ships and partnerships are now organized as LLCs.

3. A corporation, also called C corporation, is a business legally separate from its owner or owners, meaning it is responsible for its own acts and its own debts. Separate legal status

Point: Proprietorships and partnerships are usually managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who appoint managers to run the business.

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Chapter 1 Introducing Accounting in Business 13

means that a corporation can conduct business with the rights, duties, and responsibilities of a person. A corporation acts through its managers, who are its legal agents. Separate legal status also means that its owners, who are called shareholders (or stockholders), are not personally liable for corporate acts and debts. This limited liability is its main ad- vantage. A main disadvantage is what’s called double taxation—meaning that (1) the cor- poration income is taxed and (2) any distribution of income to its owners through dividends is taxed as part of the owners’ personal income, usually at the 15% rate. (For lower in- come taxpayers, the dividend tax is less than 15%, and in some cases zero.) An S corpora- tion, a corporation with special attributes, does not owe corporate income tax. Owners of S corporations report their share of corporate income with their personal income. Owner- ship of all corporations is divided into units called shares or stock. When a corporation issues only one class of stock, we call it common stock (or capital stock). Decision Ethics boxes are role-

playing exercises that stress ethics in accounting and business.

Entrepreneur You and a friend develop a new design for in-line skates that improves speed by 25% to 30%. You plan to form a business to manufacture and market those skates. You and your friend want to minimize taxes, but your prime concern is potential lawsuits from individuals who might be injured on these skates. What form of organization do you set up? ■ [Answer—p. 28]

Decision Ethics

Company Alleged Accounting Abuses

Enron . . . . . . . . . . . . . . . . . . . . . . . . . Inflated income, hid debt, and bribed officials

WorldCom . . . . . . . . . . . . . . . . . . . . . Understated expenses to inflate income and hid debt

Fannie Mae . . . . . . . . . . . . . . . . . . . . . Inflated income

Adelphia Communications . . . . . . . . . Understated expenses to inflate income and hid debt

AOL Time Warner . . . . . . . . . . . . . . . . Inflated revenues and income

Xerox. . . . . . . . . . . . . . . . . . . . . . . . . . Inflated income

Bristol-Myers Squibb . . . . . . . . . . . . . . Inflated revenues and income

Nortel Networks . . . . . . . . . . . . . . . . Understated expenses to inflate income

Global Crossing . . . . . . . . . . . . . . . . . . Inflated revenues and income

Tyco . . . . . . . . . . . . . . . . . . . . . . . . . . Hid debt, and CEO evaded taxes

Halliburton . . . . . . . . . . . . . . . . . . . . . Inflated revenues and income

Qwest Communications . . . . . . . . . . . Inflated revenues and income

Point: An audit examines whether financial statements are prepared using GAAP. It does not attest to absolute accuracy of the statements.

Accounting Constraints There are two basic constraints on financial reporting.

● Materiality The materiality constraint prescribes that only information that would influ- ence the decisions of a reasonable person need be disclosed. This constraint looks at both the importance and relative size of an amount.

● Benefit exceeds cost The cost-benefit constraint prescribes that only information with ben- efits of disclosure greater than the costs of providing it need be disclosed.

Conservatism and industry practices are also sometimes referred to as accounting constraints.

Sarbanes–Oxley (SOX) Congress passed the Sarbanes–Oxley Act, also called SOX, to help curb financial abuses at companies that issue their stock to the public. SOX requires that these public companies apply both accounting oversight and stringent internal controls. The desired results include more transparency, accountability, and truthfulness in reporting transactions. Compliance with SOX requires documentation and verification of internal controls and in- creased emphasis on internal control effectiveness. Failure to comply can yield financial penal- ties, stock market delisting, and criminal prosecution of executives. Management must issue a report stating that internal controls are effective. CEOs and CFOs who knowingly sign off on bogus accounting reports risk millions of dollars in fines and years in prison. Auditors also must verify the effectiveness of internal controls. A listing of some of the more publicized accounting scandals in recent years follows.

Point: BusinessWeek reports that ex- ternal audit costs run about $35,000 for start-ups, up from $15,000 pre-SOX.

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14 Chapter 1 Introducing Accounting in Business

To reduce the risk of accounting fraud, companies set up governance systems. A company’s governance system includes its owners, managers, employees, board of directors, and other important stakeholders, who work together to reduce the risk of accounting fraud and increase confidence in accounting reports.

The impact of SOX regulations for accounting and business is discussed throughout this book. Ethics and investor confidence are key to company success. Lack of confidence in ac- counting numbers impacts company value as evidenced by huge stock price declines for Enron, WorldCom, Tyco, and ImClone after accounting misconduct was uncovered.

Dodd-Frank Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd- Frank, in a desire to (1) promote accountability and transparency in the financial system, (2) put an end to the notion of “too big to fail,” (3) protect the taxpayer by ending bailouts, and (4) protect consumers from abusive financial services. It includes provisions whose impacts are unknown until regulators set detailed rules. However, a few proposals are notable and include the following:

● Exemption from Section 404(b) of SOX for smaller public entities (whose public value is less than $75 million) from the requirement to obtain an external audit on the effectiveness of internal control over financial reporting.

● Independence for all members of the compensation committee (including additional disclo- sures); in the event of an accounting restatement, an entity must set policies mandating re- covery (“clawback”) of excess incentive compensation.

● Requires the SEC, when sanctions exceed $1 million, to pay whistle-blowers between 10% and 30% of the sanction.

0% 10% 30%20% 40%

Increased fraud awareness 39%

Greater fraud assessment 22%

Expanded internal auditing 20%

Economic Downturn, Fraud Upturn? Executives polled show that 80% believe that the economic downturn has or will have a significant impact on fraud control in their companies (Deloitte 2010). The top three responses to the question “What activity would best counter this increased fraud risk?” are tallied in the graphic to the right. ■

Decision Insight

6. What are internal controls and why are they important? 7. What three-step guidelines can help people make ethical decisions? 8. Why are ethics and social responsibility valuable to organizations? 9. Why are ethics crucial in accounting? 10. Who sets U.S. accounting rules? 11. How are U.S. companies affected by international accounting standards? 12. How are the objectivity concept and cost principle related? 13. Why is the business entity assumption important? 14. Why is the revenue recognition principle important? 15. What are the three basic forms of business organization? 16. Identify the owners of corporations and the terminology for ownership units.

Quick Check Answers — p. 29

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Chapter 1 Introducing Accounting in Business 15

Key terms are printed in bold and defined again in the end- of-book glossary.

Point: The phrases “on credit” and “on account” imply that cash payment will occur at a future date.

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B il l

In v o

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B il l

Lones

Bes t Bu

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To understand accounting information, we need to know how an accounting system captures relevant data about transactions, and then classifies, records, and reports data.

Accounting Equation The accounting system reflects two basic aspects of a company: what it owns and what it owes. As- sets are resources a company owns or controls. Examples are cash, supplies, equipment, and land, where each carries expected benefits. The claims on a company’s assets—what it owes—are sepa- rated into owner and nonowner claims. Liabilities are what a company owes its nonowners (credi- tors) in future payments, products, or services. Equity (also called owner’s equity or capital) refers to the claims of its owner(s). Together, liabilities and equity are the source of funds to acquire assets. The relation of assets, liabilities, and equity is reflected in the following accounting equation:

Assets 5 Liabilities 1 Equity

Liabilities are usually shown before equity in this equation because creditors’ claims must be paid before the claims of owners. (The terms in this equation can be rearranged; for example, Assets 2 Liabilities 5 Equity.) The accounting equation applies to all transactions and events, to all companies and forms of organization, and to all points in time. For example, Apple’s assets equal $116,371, its liabilities equal $39,756, and its equity equals $76,615 ($ in millions). Let’s now look at the accounting equation in more detail.

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. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or prod- uct on credit is said to have an account receivable from that customer.

Liabilities Liabilities are creditors’ claims on assets. These claims reflect company obliga- tions to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts pay- able to suppliers, notes payable to banks, and taxes payable to the government.

Equity Equity is the owner’s claim on assets, and is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. A corporation’s equity—often called stockholders’ or shareholders’ equity—has two parts: contributed capital and retained earnings. Contributed capital refers to the amount that stockholders invest in the company—included under the title common stock. Retained earnings refer to income (revenues less expenses) that has not been distributed to its stockholders. The distribution of assets to stockholders is called dividends, which reduce retained earnings. Revenues increase retained earnings (via net income) and are resources generated from a company’s earnings ac- tivities. Examples are consulting services provided, sales of products, facilities rented to others, and commissions from services. Expenses decrease retained earnings and are the cost of assets or services used to earn revenues. Examples are costs of employee time, use of supplies, and ad- vertising, utilities, and insurance services from others. In sum, retained earnings is the accumu- lated revenues less the accumulated expenses and dividends since the company began. This breakdown of equity yields the following expanded accounting equation:

TRANSACTION ANALYSIS AND THE ACCOUNTING EQUATION

A1 Define and interpret the accounting equation and each of its components.

Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.

Equity

Assets 5 Liabilities 1 Contributed Capital 1 Retained Earnings

5 Liabilities 1 Common Stock 2 Dividends 1 Revenues 2 Expenses

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16 Chapter 1 Introducing Accounting in Business

Transaction Analysis Business activities can be described in terms of transactions and events. External transactions are exchanges of value between two entities, which yield changes in the accounting equation. An example is the sale of ad space by Twitter. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An example is Twitter’s use of its supplies, which are reported as expenses when used. Events refer to happenings 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 floods and fires that destroy assets and create losses. They do not include, for example, the signing of service or product contracts, which by themselves do not impact the accounting equation. This section uses the accounting equation to analyze 11 selected transactions and events of FastForward, a start-up consulting (service) business, in its first month of operations. Remem- ber that each transaction and event leaves the equation in balance and that assets always equal the sum of liabilities and equity.

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consult- ing business, named FastForward and set up as a corporation, that focuses on assessing the perfor- mance of footwear and accessories. Taylor owns and manages the business. The marketing plan for the business is to focus primarily on publishing online reviews and consulting with clubs, ath- letes, and others who place orders for footwear and accessories with manufacturers. Taylor person- ally invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, the cash (an asset) and the stockholders’ equity each equal $30,000. The source of increase in equity is the owner’s investment (stock issu- ance), which is included in the column titled Common Stock. The effect of this transaction on FastForward is reflected in the accounting equation as follows (we label the equity entries):

P1 Analyze business transactions using the accounting equation.

Point: There are 3 basic types of company operations: (1) Services — providing customer services for profit, (2) Merchandisers — buying products and re-selling them for profit, and (3) Manufacturers — creating products and selling them for profit.

Assets 5 Liabilities 1 Equity

Cash 5 Common Stock

(1) 1$30,000 5 1$30,000 owner investment

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

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 5 Common Stock

Old Bal. $30,000 5 $30,000

(2) 22,500 1 $2,500 _______ _______ _______ New Bal. $27,500 1 $ 2,500 5 $30,000

$30,000 $30,000

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

Web Info Most organizations maintain Websites that include accounting data—see Polaris Industries (Polaris.com) as an example. Polaris makes off-road vehicles such as all-terrain vehicles (ATV) and snowmobiles; it also makes on-road vehicles such as motorcy- cles and small electric vehicles. The SEC keeps an online database called EDGAR (www. SEC.gov/edgar.shtml), which has accounting information for thousands of companies that issue stock to the public. 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 services such as Finance.Google.com and Finance.Yahoo.com offer online data and analysis. ■

Decision Insight

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Chapter 1 Introducing Accounting in Business 17

Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to ac- quire 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 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Common Stock

Old Bal. $27,500 1 $2,500 5 $30,000

(3) 226,000 1 $26,000 ________ ______ _________ _______ New Bal. $ 1,500 1 $2,500 1 $ 26,000 5 $30,000

$30,000 $30,000

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

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Accounts 1 Common Stock Payable

Old Bal. $1,500 1 $2,500 1 $26,000 5 $30,000

(4) 1 7,100 1$7,100 ______ ______ _______ ________ _______ New Bal. $1,500 1 $9,600 1 $26,000 5 $ 7,100 1 $30,000

$37,100 $37,100

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

Transaction 5: Provide Services for Cash FastForward earns revenues by selling online ad space to manufacturers and by consulting with clients about test results on footwear and accessories. It earns net income only if its revenues are greater than its expenses incurred in earning them. In one of its first jobs, FastForward provides consulting services to a power- walking club and immediately collects $4,200 cash. The accounting equation reflects this in- crease in cash of $4,200 and in equity of $4,200. This increase in equity is identified in the far right column under Revenues because the cash received is earned by providing consulting services.

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues Payable Stock

Old Bal. $1,500 1 $9,600 1 $26,000 5 $7,100 1 $30,000

(5) 14,200 1 $4,200 consulting _______ ______ ________ ______ ________ _______ New Bal. $5,700 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $ 4,200

$41,300 $41,300

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

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 rent to the landlord of the building where its facilities are located. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is reflected in the following accounting equation as transaction 6. FastForward also pays the biweekly $700 salary of the company’s only employee. This is reflected in the accounting equation as transac- tion 7. Both transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, as opposed to assets, because their benefits are used in December (they

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of foot- wear and accessories are needed. These additional supplies total $7,100, but as we see from the accounting equation in transaction 3, FastForward has only $1,500 in cash. Taylor 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 sup- plies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount. The effects of this purchase follow:

Example: If FastForward pays $500 cash in transaction 4, how does this partial payment affect the liability to CalTech? What would be FastForward’s cash balance? Answers: The liability to CalTech would be reduced to $6,600 and the cash balance would be reduced to $1,000.

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18 Chapter 1 Introducing Accounting in Business

have no future benefits after December). These transactions also use up an asset (cash) in carry- ing out FastForward’s operations. The accounting equation shows that both transactions reduce cash and equity. The far right column identifies these decreases as Expenses.

Transaction 8: Provide Services and Facilities for Credit FastForward provides consulting services of $1,600 and rents its test facilities for $300 to a podiatric services center. The rental involves allowing members to try recommended footwear and accessories at FastForward’s testing area. The center is billed for the $1,900 total. This transaction results in a new asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue components reflected in the Revenues column of the accounting equation:

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $4,000 1 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $4,200 2 $1,700

(8) 1 $1,900 1 1,600 consulting

1 300 rental ______ _______ ______ _______ ______ _______ ______ ________ New Bal. $4,000 1 $ 1,900 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

$41,500 $41,500

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

Transaction 9: Receipt of Cash from Accounts Receivable The client in trans- action 8 (the podiatric center) pays $1,900 to FastForward 10 days after it is billed for consult- ing services. This transaction 9 does not change the total amount of assets and does not affect liabilities or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward rendered the services in transaction 8, not when the cash is now collected. This emphasis on the earnings process instead of cash flows is a goal of the revenue recognition principle and yields useful information to users. The new balances follow:

By definition, increases in expenses yield decreases in equity.

Point: Receipt of cash is not always a revenue.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $4,000 1 $1,900 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

(9) 11,900 2 1,900 _______ _______ ______ _______ ______ _______ ______ ______ New Bal. $5,900 1 $ 0 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

$41,500 $41,500

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

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Sup- ply $900 cash as partial payment for its earlier $7,100 purchase of supplies (transaction 4), leav- ing $6,200 unpaid. The accounting equation shows that this transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an expense even though cash flows out of FastForward (instead the expense is recorded when FastForward derives the benefits from these supplies).

Assets 5 Liabilities 1 Equity

Cash 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Payable Stock

Old Bal. $5,700 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $4,200

(6) 21,000 2 $1,000 rent _______ ______ _______ ______ _______ _______ ________ Bal. 4,700 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200 2 1,000

(7) 2 700 2 700 salaries _______ ______ _______ ______ _______ _______ ________ New Bal. $4,000 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $4,200 2 $ 1,700

$39,600 $39,600

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

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

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Chapter 1 Introducing Accounting in Business 19

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 re- ported as expenses because they are not part of the company’s earnings process. Since dividends are not company expenses, they are not used in computing net income.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $5,900 1 $ 0 1 $9,600 1 $26,000 5 $7,100 1 $30,000 1 $6,100 2 $1,700

(10) 2 900 2 900 ______ ________ ______ _______ ______ _______ ______ ______ New Bal. $5,000 1 $ 0 1 $9,600 1 $26,000 5 $6,200 1 $30,000 1 $6,100 2 $1,700

$40,600 $40,600

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

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 2 Dividends 1 Revenues 2 Expenses Receivable Payable Stock

Old Bal. $5,000 1 $ 0 1 $9,600 1 $26,000 5 $6,200 1 $30,000 1 $6,100 2 $1,700

(11) 2 200 2 $200 dividend ______ ______ ______ _______ ______ _______ _____ ______ ______ New Bal. $4,800 1 $ 0 1 $9,600 1 $26,000 5 $6,200 1 $30,000 2 $200 1 $6,100 2 $1,700

$40,400 $40,400

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

By definition, increases in dividends yield decreases in equity.

Summary of Transactions We summarize in Exhibit 1.9 the effects of these 11 transactions of FastForward using the accounting equation. First, we see that the accounting equation remains in balance after each transaction. Second, transactions can be analyzed by their effects on components of the

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Supplies 1 Equipment 5 Accounts 1 Common 2 Dividends 1 Revenues 2 Expenses Receivable Payable Stock

(1) $30,000 5 $30,000

(2) 2 2,500 1 $2,500 ________ _______ ________ Bal. 27,500 1 2,500 5 30,000

(3) 226,000 1 $26,000 ________ _______ __________ ________ Bal. 1,500 1 2,500 1 26,000 5 30,000

(4) 1 7,100 1$7,100 ________ _______ __________ _________ ________ Bal. 1,500 1 9,600 1 26,000 5 7,100 1 30,000

(5) 1 4,200 1 $4,200 ________ _______ __________ _________ ________ _______ Bal. 5,700 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200

(6) 2 1,000 2 $1,000 ________ _______ __________ _________ ________ _______ _______ Bal. 4,700 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200 2 1,000

(7) 2 700 2 700 ________ _______ __________ _________ ________ _______ _______ Bal. 4,000 1 9,600 1 26,000 5 7,100 1 30,000 1 4,200 2 1,700

(8) 1 $1,900 1 1,600

1 300 ________ _______ _______ __________ _________ ________ _______ _______ Bal. 4,000 1 1,900 1 9,600 1 26,000 5 7,100 1 30,000 1 6,100 2 1,700

(9) 1 1,900 2 1,900 ________ _______ _______ __________ _________ ________ _______ _______ Bal. 5,900 1 0 1 9,600 1 26,000 5 7,100 1 30,000 1 6,100 2 1,700

(10) 2 900 2 900 ________ _______ _______ __________ _________ ________ _______ _______ Bal. 5,000 1 0 1 9,600 1 26,000 5 6,200 1 30,000 1 6,100 2 1,700

(11) 2 200 2 $200 ________ _______ _______ __________ _________ ________ _____ _______ _______ Bal. $ 4,800 1 $ 0 1 $ 9,600 1 $ 26,000 5 $ 6,200 1 $ 30,000 2 $ 200 1 $6,100 2 $ 1,700

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20 Chapter 1 Introducing Accounting in Business

accounting equation. For example, in transactions 2, 3, and 9, one asset increased while an- other asset decreased by equal amounts.

Point: Knowing how financial statements are prepared improves our analysis of them. We develop the skills for analysis of financial statements throughout the book. Chapter 13 focuses on financial statement analysis.

17. When is the accounting equation in balance, and what does that mean? 18. How can a transaction not affect any liability and equity accounts? 19. Describe a transaction increasing equity and one decreasing it. 20. Identify a transaction that decreases both assets and liabilities.

Quick Check Answers — p. 29

This section introduces us to how financial statements are prepared from the analysis of busi- ness transactions. The four financial statements and their purposes are:

1. Income statement — describes a company’s revenues and expenses along with the result- ing net income or loss over a period of time due to earnings activities.

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

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

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

We prepare these financial statements, in this order, using the 11 selected transactions of Fast- Forward. (These statements are technically called unadjusted — we explain this in Chapters 2 and 3.)

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is conveniently taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from transactions 5 and 8 and rental revenue of $300 from transaction 8. Expenses are reported after revenues. (For convenience in this chapter, we list larger amounts first, but we can sort expenses in different ways.) Rent and salary expenses are from transactions 6 and 7. Expenses reflect the costs to generate the revenues reported. Net income (or loss) is reported at the bottom of the statement and is the amount earned in December. Stockholders’ investments and dividends are not part of income.

Statement of Retained Earnings The statement of retained earnings reports information about how retained earnings changes over the reporting period. This statement shows beginning retained earnings, events that in- crease 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 the beginning balance equal to that as of the end of the prior reporting period (such as from November 30). Fast- Forward’s statement shows the $4,400 of net income earned during the period. This links the income statement to the statement of retained earnings (see line 1 ). The statement also re- ports 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 refers to Fast- Forward’s financial condition at the close of business on December 31. The left side of the balance

FINANCIAL STATEMENTS

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

Point: Net income is sometimes called earnings or profit.

Point: The statement of retained earnings is also called the statement of changes in retained earnings. Note: Beg. Retained Earnings 1 Net Income 2 Dividends 5 End. Retained Earnings

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Chapter 1 Introducing Accounting in Business 21

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2013

Retained earnings, December 1, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400 _______

4,400

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 _______

Retained earnings, December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,200 _______ _______

FASTFORWARD Statement of Cash Flows

For Month Ended December 31, 2013

Cash flows from operating activities

Cash received from clients ($4,200 1 $1,900). . . . . . . . . . $ 6,100

Cash paid for supplies ($2,500 1 $900) . . . . . . . . . . . . . . . (3,400)

Cash paid for rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,000)

Cash paid to employee . . . . . . . . . . . . . . . . . . . . . . . . . . . . (700) ________ Net cash provided by operating activities . . . . . . . . . . . . . $ 1,000

Cash flows from investing activities

Purchase of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26,000) ________ Net cash used by investing activities . . . . . . . . . . . . . . . . . (26,000)

Cash flows from financing activities

Investments by stockholder. . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Dividends to stockholder . . . . . . . . . . . . . . . . . . . . . . . . . . (200) ________ Net cash provided by financing activities . . . . . . . . . . . . . . 29,800 _________ Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800

Cash balance, December 1, 2013 . . . . . . . . . . . . . . . . . . . . . . 0 _________ Cash balance, December 31, 2013 . . . . . . . . . . . . . . . . . . . . . $ 4,800 _________ _________

FASTFORWARD Income Statement

For Month Ended December 31, 2013

Revenues

Consulting revenue ($4,200 1 $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 ____________ ____________

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 Balance Sheet

December 31, 2013

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: A single ruled line denotes an addition or subtraction. Final totals are double underlined. Negative amounts are often in parentheses.

EXHIBIT 1.10 Financial Statements and Their Links

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

1

3

Point: Arrow lines show how the statements are linked. 1 Net income is used to compute equity. 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.

2

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22 Chapter 1 Introducing Accounting in Business

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 lia- bilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Either presentation is acceptable.) As always, we see the accounting equation applies: Assets of $40,400 5 Liabilities of $6,200 1 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 parentheses to denote subtrac- tion. Net cash provided by operating activities for December is $1,000. If cash paid exceeded the $5,100 cash received, we would call it “cash used by operating activities.” The second section re- ports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include the long-term borrowing and repaying of cash from lenders and the cash investments from, and dividends to, stockholders. FastForward reports $30,000 from the owner’s initial investment and the $200 cash dividend. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows FastForward increased its cash balance by $4,800 in December. Since it started with no cash, the ending balance is also $4,800 — see line 3 . We see that cash flow numbers are different from income statement (accrual) numbers, which is common.

Point: Statement of cash flows has three main sections: operating, investing, and financing.

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

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

21. Explain the link between the income statement and the statement of retained earnings. 22. Describe the link between the balance sheet and the statement of retained earnings. 23. Discuss the three major sections of the statement of cash flows.

Quick Check Answers — p. 29

Accounting according to U.S. GAAP is similar, but not identical, to IFRS. Throughout the book we use this last section to identify major similarities and differences between IFRS and U.S. GAAP for the mate- rials in each chapter.

Basic Principles Both U.S. GAAP and IFRS include broad and similar guidance for accounting. However, neither system specifies particular account names nor the detail required. (A typical chart of accounts is shown near the end of this book.) IFRS does require certain minimum line items be reported in the balance sheet along with other minimum disclosures that U.S. GAAP does not. On the other hand, U.S. GAAP requires disclosures for the current and prior two years for the income statement, statement of cash flows, and statement of retained earnings (equity), while IFRS requires disclosures for the current and prior year. Still, the basic principles behind these two systems are similar.

Transaction Analysis Both U.S. GAAP and IFRS apply transaction analysis identically as shown in this chapter. Although some variations exist in revenue and expense recognition and other principles, all of the transactions in this chapter are accounted for identically under these two systems. It is often said that U.S. GAAP is more rules-based whereas IFRS is more principles-based. The main difference on the rules versus principles focus is with the approach in deciding how to account for certain transactions. Under U.S. GAAP, the approach is more focused on strictly following the accounting rules; under IFRS, the approach is more focused on a review of the situation and how accounting can best reflect it. This dif- ference typically impacts advanced topics beyond the introductory course.

Financial Statements Both U.S. GAAP and IFRS prepare the same four basic financial statements. To illustrate, a condensed version of Piaggio’s income statement follows (numbers are in Euros thousands).

GLOBAL VIEW

PIAGGIO

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Chapter 1 Introducing Accounting in Business 23

Piaggio manufactures two-, three- and four-wheel vehicles, and is Europe’s leading manufacturer of motorcy- cles and scooters. Similar condensed versions can be prepared for the other three statements (see Appendix A).

PIAGGIO Income Statement (in € thousands) For Year Ended December 31, 2011

Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,516,463

Cost for materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 904,060

Cost for services, leases, employees, depreciation, and other expenses . . . . . . . . . 533,045

Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,305

Net income (profit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,053

Gold shading marks jurisdictions that permit or require IFRS for some or all domestic companies; light tan marks jurisdictions that have either modified or delayed implementation of IFRS.

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COSTA RICA

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CUBA

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DOMINICAN REPUBLIC

TRINIDAD AND TOBAGO

AFGHANISTAN

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KYRGYZSTAN

INDIA

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PAKISTAN

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PORTUGAL SPAIN

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London Kiev

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San Francisco

Chicago

Montreal

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Los Angeles

Havana

Dallas

Miami

Atlanta

Seattle

Anchorage

Lima

Rio De Janeiro

São Paulo

Honolulu

Cape Town

Kinshasa

Lagos

Baghdad

Tehran

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Bangkok

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Status of IFRS Accounting impacts companies across the world, which requires us to take a global view. IFRS is now adopted or accepted in over 115 countries, including over 30 member-states of the EU (see gold and light tan shading in the map below). Teal shading in the map reflects a system other than IFRS. The FASB and IASB continue to work on the convergence of IFRS and U.S. GAAP. Further, the SEC has a “roadmap” for ultimate use of IFRS by U.S. companies. Currently, the roadmap extends out over the next several years.

Return on Assets Decision Analysis

A Decision Analysis section at the end of each chapter is devoted to financial statement analysis. We or- ganize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profit- ability, and (4) market prospects — Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we need benchmarks to identify good, bad, or average levels. Common bench- marks include the company’s prior levels and those of its competitors.

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

A2 Compute and interpret return on assets.

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24 Chapter 1 Introducing Accounting in Business

This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Dell has its marketing department compute return on assets for every order. Return on assets (ROA), also called return on investment (ROI ), is defined in Exhibit 1.11.

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. To illustrate, Dell reports net income of $3,492 million for fiscal year 2012. At the beginning of fiscal 2012, its total assets are $38,599 million and at the end of fiscal 2012, they total $44,533 million. Dell’s return on assets for fiscal 2012 is:

Return on assets 5 $3,492 million

($38,599 million 1 $44,533 million) y2 5 8.4%

Is an 8.4% return on assets good or bad for Dell? To help answer this question, we compare (benchmark) Dell’s return with its prior performance, the returns of competitors (such as Hewlett-Packard, IBM, and Lenovo), and the returns from alternative investments. Dell’s return for each of the prior five years is in the second column of Exhibit 1.12, which ranges from 4.8% to 11.1%.

EXHIBIT 1.11 Return on Assets Return on assets 5

Net income Average total assets

Dell shows a fairly stable pattern of good returns that reflect its productive use of assets. There is a de- cline in its 2009–2010 returns reflecting the recessionary period. We compare Dell’s return to the normal return for similar manufacturers of computers (third column). Industry averages are available from services such as Dun & Bradstreet’s Industry Norms and Key Ratios and The Risk Management Association An- nual Statement Studies. When compared to the industry, Dell performs slightly above average.

Return on Assets

Fiscal Year Dell Industry

2012 . . . . . . . . . . . . . . . 8.4% 6.9%

2011 . . . . . . . . . . . . . . . 7.3 6.5

2010 . . . . . . . . . . . . . . . 4.8 4.7

2009 . . . . . . . . . . . . . . . 9.2 7.2

2008 . . . . . . . . . . . . . . . 11.1 8.1 2012 2011 2009 2008

0%

2%

4%

6%

8%

10%

12%

Return on Assets: Industry Dell

2010

EXHIBIT 1.12 Dell and Industry Returns

Business Owner You own a small winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 19% return on its assets. The industry return for this manufacturer is 14%. Do you purchase this manufacturer? ■ [Answer—p. 29]

Decision Maker

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

The Demonstration Problem is a review of key chapter content. The Planning the Solution offers strategies in solving the problem.

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

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

b. On August 2, Expressions paid $600 cash for furniture for the shop. c. On August 3, Expressions paid $500 cash to rent space in a strip mall for August. d. On August 4, it purchased $1,200 of equipment on credit for the shop (using a long-term note payable). e. On August 5, Expressions opened for business. Cash received from haircutting services in the first

week and a half of business (ended August 15) was $825. f. On August 15, it provided $100 of haircutting services on account. g. On August 17, it received a $100 check for services previously rendered on account.

DEMONSTRATION PROBLEM

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Chapter 1 Introducing Accounting in Business 25

h. On August 17, it paid $125 cash to an assistant for hours worked during the grand opening. i. Cash received from services provided during the second half of August was $930. j. On August 31, it paid a $400 installment toward principal on the note payable entered into on August 4. k. On August 31, it paid $900 cash in dividends 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; Note Payable; Common Stock; Dividends; Reve- nues; 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.

SOLUTION TO DEMONSTRATION PROBLEM 1.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Furni- 1 Store 5 Note 1 Common 2 Dividends 1 Revenues 2 Expenses Receiv- ture Equip- Payable Stock able ment

a. $3,000 $15,000 $18,000

b. 2 600 1 $600 ______ _____ _______ ________ Bal. 2,400 1 1 600 1 15,000 5 18,000

c. 2 500 2 $500 ______ _____ _______ ________ _____ Bal. 1,900 1 1 600 1 15,000 5 18,000 2 500

d. 1 1,200 1$1,200 ______ _____ _______ _________ ________ _____ Bal. 1,900 1 1 600 1 16,200 5 1,200 1 18,000 2 500

e. 1 825 1 $ 825 ______ _____ _______ _________ ________ _______ _____ Bal. 2,725 1 1 600 1 16,200 5 1,200 1 18,000 1 825 2 500

f. 1 $100 1 100 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 2,725 1 100 1 600 1 16,200 5 1,200 1 18,000 1 925 2 500

g. 1 100 2 100 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 2,825 1 0 1 600 1 16,200 5 1,200 1 18,000 1 925 2 500

h. 2 125 2 125 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 2,700 1 0 1 600 1 16,200 5 1,200 1 18,000 1 925 2 625

i. 1 930 1 930 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 3,630 1 0 1 600 1 16,200 5 1,200 1 18,000 1 1,855 2 625

j. 2 400 2 400 ______ _____ _____ _______ _________ ________ _______ _____ Bal. 3,230 1 0 1 600 1 16,200 5 800 1 18,000 1 1,855 2 625

k. 2 900 2 $900 ______ _____ _____ _______ _________ ________ _____ _______ _____ Bal. $ 2,330 1 0 1 $600 1 $ 16,200 5 $ 800 1 $ 18,000 2 $900 1 $1,855 2 $625 ______ _____ _____ _______ _________ ________ _____ _______ _____ ______ _____ _____ _______ _________ ________ _____ _______ _____

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26 Chapter 1 Introducing Accounting in Business

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

2.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . $ 2,330 Note 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

4.

EXPRESSIONS Statement of Cash Flows

For Month Ended August 31

Cash flows from operating activities Cash received from customers . . . . . . . . . . . . . . . . . . . . . $1,855 Cash paid for rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500) Cash paid for wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (125) Net cash provided by operating activities . . . . . . . . . . . . $1,230 Cash flows from investing activities Cash paid for furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . (600) Cash flows from financing activities Cash investments from stockholders . . . . . . . . . . . . . . . . 3,000 Cash dividends to stockholders . . . . . . . . . . . . . . . . . . . . (900) Partial repayment of (long-term) note payable . . . . . . . . (400) Net cash provided by financing activities . . . . . . . . . . . . . 1,700 Net increase in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330 Cash balance, August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Cash balance, August 31. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330

5.

3.

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1* . . . . . . . . $ 0 Plus: Net income . . . . . . . . . . . . . . . . 1,230 1,230 Less: Dividend to owner . . . . . . . . . . 900 Retained earnings, August 31 . . . . . . . . . $ 330

* If Expressions had been an existing business from a prior period, the beginning retained earnings balance would equal the retained earnings balance from the end of the prior period.

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Chapter 1 Introducing Accounting in Business 27

6. Return on assets 5 Net income

Average assets 5

$1,230

($18,000* 1 $19,130)y2 5

$1,230

$18,565 5 6.63%

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

APPENDIX

Return and Risk Analysis This appendix explains return and risk analysis and its role in business and accounting. Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest return such as 4%. If we invest in a savings account or in U.S. Treasury bills, we expect a return of around 2% to 7%. We could also invest in a company’s stock, or even start our own business. How do we decide among these investment options? The answer depends on our trade-off between return and risk. 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 from default). If we buy a share of eBay or any other company, we might obtain a large return. However, we have no guarantee of any return; there is even the risk of loss.

The bar graph in Exhibit 1A.1 shows recent re- turns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds provide a low expected return, but they also offer low risk since they are backed by the U.S. govern- ment. High-risk corporate bonds offer a much larger potential return but with much higher risk. The trade-off between return and risk is a nor- mal 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.

1A 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% 2% 4% 6% 8% 10%12%

10.9%

8.3%

5.8%

3.8%

APPENDIX

Business Activities and the Accounting Equation This appendix explains how the accounting equation is derived from business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning involves defining an organization’s ideas, goals, and actions. Most public corporations use the Management Discussion and Analysis section in their annual reports to communicate plans. However, planning is not cast in stone. This adds risk to both setting plans and analyzing them.

Financing Financing activities provide the means organizations use to pay for resources such as land, buildings, and equipment to carry out plans. Organizations are careful in acquiring and managing financ- ing activities because they can determine success or failure. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources contributed by creditors (lenders). Financial management is the task of planning how to obtain these resources and to set the right mix between owner and creditor financing.

Investing Investing activities are the acquiring and disposing of resources (assets) that an organization uses to acquire and sell its products or services. Assets are funded by an organization’s financing. Organiza- tions differ on the amount and makeup of assets. Some require land and factories to operate. Others need only an office. Determining the amount and type of assets for operations is called asset management. Invested

1B

Point: Management must understand accounting data to set financial goals, make financing and investing decisions, and evaluate operating performance.

C5 Identify and describe the three major activities of organizations.

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28 Chapter 1 Introducing Accounting in Business

amounts are referred to as assets. Financing is made up of creditor and owner financing, which hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This basic equality is called the accounting equation and can be written as: Assets 5 Liabilities 1 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. Strategic man- agement is the process of determining the right mix of operating activities for the type of organization, its plans, and its market.

Exhibit 1B.1 summarizes business activities. Planning is part of each activity and gives them meaning and focus. In- vesting (assets) and financing (liabilities and equity) are set opposite each other to stress their balance. Operating activities are below investing and financing activities to show that oper- ating activities are the result of investing and financing.

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

P lan

n in

gP la

n n

in g

Planning

In v o

ic e

B il l

In v o

ic e

B il l

Lones

Bes t Bu

y S toc

k

EXHIBIT 1B.1 Activities of Organizations

A Summary organized by learning objectives concludes each chapter.

C1 Explain the purpose and importance of accounting. Account-ing is an information and measurement system that aims to iden- tify, record, and communicate relevant, reliable, and comparable information about business activities. It helps assess opportunities, products, investments, and social and community responsibilities.

C2 Identify users and uses of, and opportunities in, accounting. Users of accounting are both internal and external. Some users and uses of accounting include (a) managers in controlling, monitor- ing, and planning; (b) lenders for measuring the risk and return of loans; (c) shareholders for assessing the return and risk of stock; (d) directors for overseeing management; and (e) employees for judging employment opportunities. Opportunities in accounting include finan- cial, managerial, and tax accounting. They also include accounting- related fields such as lending, consulting, managing, and planning.

C3 Explain why ethics are crucial to accounting. The goal of accounting is to provide useful information for decision mak- ing. For information to be useful, it must be trusted. This demands ethical behavior in accounting.

C4 Explain generally accepted accounting principles and de-fine and apply several accounting principles. Generally ac- cepted accounting principles are a common set of standards applied by accountants. Accounting principles aid in producing relevant, reli- able, and comparable information. Four principles underlying finan- cial statements were introduced: cost, revenue recognition, matching, and full disclosure. Financial statements also reflect four assump- tions: going-concern, monetary unit, time period, and business entity.

C5B Identify and describe the three major activities of organizations. Organizations carry out three major activities: financing, investing, and operating. Financing is the means used to pay for resources such as land, buildings, and machines. Investing

Summary refers to the buying and selling of resources used in acquiring and selling products and services. Operating activities are those neces- sary for carrying out the organization’s plans.

A1 Define and interpret the accounting equation and each of its components. The accounting equation is: Assets 5 Liabilities 1 Equity. Assets are resources owned by a company. Liabilities are credi- tors’ claims on assets. Equity is the owner’s claim on assets (the resid- ual ). The expanded accounting equation is: Assets 5 Liabilities 1 [Common Stock 2 Dividends 1 Revenues 2 Expenses].

A2 Compute and interpret return on assets. Return on assets is computed as net income divided by average assets. For exam- ple, if we have an average balance of $100 in a savings account and it earns $5 interest for the year, the return on assets is $5/$100, or 5%.

A3A Explain the relation between return and risk. Return refers to income, and risk is the uncertainty about the return we hope to make. All investments involve risk. The lower the risk of an investment, the lower is its expected return. Higher risk implies higher, but riskier, expected return.

P1 Analyze business transactions using the accounting equa-tion. A transaction is an exchange of economic consideration between two parties. Examples include exchanges of products, ser- vices, money, and rights to collect money. Transactions always have at least two effects on one or more components of the accounting equation. This equation is always in balance.

P2 Identify and prepare basic financial statements and explain how they interrelate. Four financial statements report on an organization’s activities: balance sheet, income statement, statement of retained earnings, and statement of cash flows.

Entrepreneur (p. 13) You should probably form the business as a corporation if potential lawsuits are of prime concern. The corporate form of organization protects your personal property from lawsuits

directed at the business and places only the corporation’s resources at risk. A downside of the corporate form is double taxation: The corpo- ration must pay taxes on its income, and you normally must pay taxes

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 1 Introducing Accounting in Business 29

on any money distributed to you from the business (even though the corporation already paid taxes on this money). You should also exam- ine the ethical and socially responsible aspects of starting a business in which you anticipate injuries to others. Formation as an LLC or S corp. should also be explored.

Business Owner (p. 24) The 19% return on assets for the manu- facturer exceeds the 14% industry return (and many others). This is a

positive factor for a potential purchase. Also, the purchase of this manufacturer is an opportunity to spread your risk over two busi- nesses as opposed to one. Still, you should hesitate to purchase a business whose return of 19% is lower than your current resort’s return of 21%. You are probably better off directing efforts to in- crease investment in your resort, assuming you can continue to earn a 21% return.

1. Accounting is an information and measurement system that identifies, records, and communicates relevant information to help people make better decisions.

2. Recordkeeping, also called bookkeeping, is the recording of financial transactions and events, either manually or electro n- ically. Recordkeeping is essential to data reliability; but accounting is this and much more. Accounting includes identi- fying, measuring, recording, reporting, and analyzing business events and transactions.

3. Technology offers increased accuracy, speed, efficiency, and convenience in accounting.

4. External users of accounting include lenders, shareholders, di- rectors, customers, suppliers, regulators, lawyers, brokers, and the press. Internal users of accounting include managers, offi- cers, and other internal decision makers involved with strategic and operating decisions.

5. Internal users (managers) include those from research and de- velopment, purchasing, human resources, production, distribu- tion, marketing, and servicing.

6. Internal controls are procedures set up to protect assets, ensure reliable accounting reports, promote efficiency, and encourage adherence to company policies. Internal controls are crucial for relevant and reliable information.

7. Ethical guidelines are threefold: (1) identify ethical concerns using personal ethics, (2) analyze options considering all good and bad consequences, and (3) make ethical decisions after weighing all consequences.

8. Ethics and social responsibility yield good behavior, and they often result in higher income and a better working environment.

9. For accounting to provide useful information for decisions, it must be trusted. Trust requires ethics in accounting.

10. Two major participants in setting rules include the SEC and the FASB. (Note: Accounting rules reflect society’s needs, not those of accountants or any other single constituency.)

11. Most U.S. companies are not directly affected by international accounting standards. International standards are put forth as preferred accounting practices. However, stock exchanges and other parties are increasing the pressure to narrow differences in worldwide accounting practices. International accounting stan- dards are playing an important role in that process.

12. The objectivity concept and cost principle are related in that most users consider information based on cost as objective. Information prepared using both is considered highly reliable and often relevant.

13. Users desire information about the performance of a specific entity. If information is mixed between two or more entities, its usefulness decreases.

14. The revenue recognition principle gives preparers guidelines on when to recognize (record) revenue. This is important; for ex- ample, if revenue is recognized too early, the statements report revenue sooner than it should and the business looks more prof- itable than it is. The reverse is also true.

15. The three basic forms of business organization are sole propri- etorships, partnerships, and corporations.

16. Owners of corporations are called shareholders (or stockhold- ers). Corporate ownership is divided into units called shares (or stock). The most basic of corporate shares is common stock (or capital stock).

17. The accounting equation is: Assets 5 Liabilities 1 Equity. This equation is always in balance, both before and after each transaction.

18. A transaction that changes the makeup of assets would not affect liability and equity accounts. FastForward’s transactions 2 and 3 are examples. Each exchanges one asset for another.

19. Earning revenue by performing services, as in FastForward’s trans- action 5, increases equity (and assets). Incurring expenses while servicing clients, such as in transactions 6 and 7, decreases equity (and assets). Other examples include owner investments (stock is- suances) that increase equity and dividends that decrease equity.

20. Paying a liability with an asset reduces both asset and liability totals. One example is FastForward’s transaction 10 that reduces a payable by paying cash.

21. An income statement reports a company’s revenues and ex- penses along with the resulting net income or loss. A statement of retained earnings shows changes in retained earnings, includ- ing that from net income or loss. Both statements report trans- actions occurring over a period of time.

22. The balance sheet describes a company’s financial position (as- sets, liabilities, and equity) at a point in time. The retained earn- ings amount in the balance sheet is obtained from the statement of retained earnings.

23. Cash flows from operating activities report cash receipts and payments from the primary business the company engages in. Cash flows from investing activities involve cash transactions from buying and selling long-term assets. Cash flows from fi- nancing activities include long-term cash borrowings and re- payments to lenders and the cash investments from, and dividends to, the stockholders.

Guidance Answers to Quick Checks

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30 Chapter 1 Introducing Accounting in Business

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 47 mhhe.com/wildFINMAN5e

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 build- ing for $450,000. The purchaser records the building at:

a. $50,000 b. $400,000 c. $450,000 d. $475,000 e. $500,000 2. On December 30, 2012, KPMG signs a $150,000 contract to

provide accounting services to one of its clients in 2013. KPMG has a December 31 year-end. Which accounting principle or assumption requires KPMG to record the accounting services revenue from this client in 2013 and not 2012?

a. Business entity assumption b. Revenue recognition principle c. Monetary unit assumption d. Cost principle e. Going-concern assumption 3. If the assets of a company increase by $100,000 during the

year and its liabilities increase by $35,000 during the same

year, then the change in equity of the company during the year must have been:

a. An increase of $135,000. b. A decrease of $135,000. c. A decrease of $65,000. d. An increase of $65,000. e. An increase of $100,000. 4. Brunswick borrows $50,000 cash from Third National Bank.

How does this transaction affect the accounting equation for Brunswick?

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

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

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

d. No effect on assets; liabilities increase by $50,000; equity increases by $50,000.

e. No effect on assets; liabilities increase by $50,000; equity decreases by $50,000.

Accounting (p. 4)

Accounting equation (p. 15)

Assets (p. 15)

Audit (p. 13)

Auditors (p. 13)

Balance sheet (p. 20)

Bookkeeping (p. 4)

Business entity assumption (p. 12)

Common stock (p. 13)

Conceptual framework (p. 10)

Contributed capital (p. 15)

Corporation (p. 12)

Cost-benefit constraint (p. 13)

Cost principle (p. 11)

Dividends (p. 15)

Dodd-Frank Wall Street Reform and Consumer Protection Act (p. 14)

Equity (p. 15)

Ethics (p. 7)

Events (p. 16)

Expanded accounting equation (p. 15)

Expense recognition principle (p. 11)

Expenses (p. 15)

External transactions (p. 16)

External users (p. 5)

Financial accounting (p. 5)

Financial Accounting Standards Board (FASB) (p. 9)

Full disclosure principle (p. 11)

Generally accepted accounting principles (GAAP) (p. 9)

Going-concern assumption (p. 12)

Income (p. 15)

Income statement (p. 20)

Internal transactions (p. 16)

Internal users (p. 6)

International Accounting Standards Board (IASB) (p. 9)

International Financial Reporting Standards (IFRS) (p. 9)

Liabilities (p. 15)

Managerial accounting (p. 6)

Matching principle (p. 11)

Materiality constraint (p. 13)

Measurement principle (p. 11)

Monetary unit assumption (p. 12)

Net income (p. 15)

Net loss (p. 15)

Partnership (p. 12)

Proprietorship (p. 12)

Recordkeeping (p. 4)

Retained earnings (p. 15)

Return (p. 27)

Return on assets (p. 24)

Revenue recognition principle (p. 11)

Revenues (p. 15)

Risk (p. 27)

Sarbanes–Oxley Act (p. 13)

Securities and Exchange Commission (SEC) (p. 9)

Shareholders (p. 13)

Shares (p. 13)

Sole proprietorship (p. 12)

Statement of cash flows (p. 20)

Statement of retained earnings (p. 20)

Stock (p. 13)

Stockholders (p. 13)

Time period assumption (p. 12)

Key Terms

A list of key terms with page references concludes each chapter (a complete glossary is at the end of the book).

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Chapter 1 Introducing Accounting in Business 31

5. Geek Squad performs services for a customer and bills the customer for $500. How would Geek Squad record this transaction?

a. Accounts receivable increase by $500; revenues increase by $500.

b. Cash increases by $500; revenues increase by $500.

c. Accounts receivable increase by $500; revenues decrease by $500.

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

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

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 accounting

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 addi-

tion to preparing tax returns? 13. What does the concept of objectivity imply for information

reported in financial statements? Why? 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 assump- tion justifies this treatment?

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

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

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

Discussion Questions

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

Icon denotes assignments that involve decision making.

18. What events or transactions change equity? 19. Identify the two main categories of accounting principles. 20. What do accountants mean by the term revenue? 21. Define net income and explain its computation. 22. Identify the four basic financial statements of a business. 23. What information is reported in an income statement? 24. Give two examples of expenses a business might incur. 25. What is the purpose of the statement of 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 the financial statements of Polaris in

Appendix A near the end of the book. To what level of significance are dollar amounts rounded? What time period does its income statement cover?

33. Identify the dollar amounts of Arctic Cat’s 2011 assets, liabilities, and equity as reported in its statements in Appendix A near the end of the book.

34. Refer to KTM’s 2011 balance sheet in Appendix A near the end of the book. Confirm that its total as- sets equal its total liabilities plus total equity.

35. Access the SEC EDGAR database (www.sec. gov) and retrieve Polaris’s 2011 10-K (filed Febru- ary 27, 2012). Identify its auditor. What responsibility does its independent auditor claim regarding Polaris’s financial statements?

Polaris

Polaris

Arctic Cat

KTM

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.

Reading and interpreting accounting reports requires some knowledge of accounting terminology. (a)  Identify the meaning of these accounting-related acronyms: GAAP, SEC, FASB, IASB and IFRS. (b) Briefly explain the importance of the knowledge base or organization that is referred to for each of the accounting-related acronyms.

QUICK STUDY

QS 1-1 Identifying accounting terms C1

Quick Study exercises give readers a brief test of key elements.

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32 Chapter 1 Introducing Accounting in Business

QS 1-2 Identifying accounting users

C2

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

QS 1-4 Accounting opportunities C2

There are many job opportunities for those with accounting knowledge. Identify at least three main areas of opportunities for accounting professionals. For each area, identify at least three job possibilities linked to accounting.

QS 1-5 Identifying ethical concerns C3

Accounting professionals must sometimes choose between two or more acceptable methods of accounting for business transactions and events. Explain why these situations can involve difficult matters of ethical concern.This icon highlights

assignments that enhance decision-making skills.

QS 1-6 Identifying accounting principles

C4

Identify which accounting principle or assumption best describes each of the following practices: a. In December 2012, Chavez Landscaping received a customer’s order and cash prepayment to install

sod at a new house that would not be ready for installation until March 2013. Chavez should record the revenue from the customer order in March 2013, not in December 2012.

b. If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000. c. Jo Keene owns both Sailing Passions and Dockside Supplies. In preparing financial statements for

Dockside Supplies, Keene makes sure that the expense transactions of Sailing Passions are kept sepa- rate from Dockside’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?

QS 1-9 Identifying transactions and events P1

Accounting provides information about an organization’s business transactions and events that both affect the accounting equation and can be reliably measured. Identify at least two examples of both (a) business transactions and (b) business events that meet these requirements.

QS 1-10 Identifying and computing assets, liabilities, and equity P1

Use Polaris’s December 31, 2011, financial statements, in Appendix A near the end of the book, to answer the following: a. Identify the dollar amounts of Polaris’ 2011 (1) assets, (2) liabilities, and (3) equity. b. Using Polaris’ amounts from part a, verify that Assets 5 Liabilities 1 Equity.

QS 1-8 Applying the accounting equation

A1

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

Company

3

1 2

85,000

$ 75,000 (b)

20,000

$ (a) 25,000

(c)

$ 40,000 70,000

Assets 5 1Liabilities Equity

QS 1-11 Identifying items with financial statements

P2

Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), statement of retained earnings (E), or statement of cash flows (CF). a. Assets d. Equipment g. Net decrease (or increase) in cash b. Cash from operating activities e. Expenses h. Revenues c. Dividends f. Liabilities i. Total liabilities and equity

QS 1-3 Explaining internal control

C1

An important responsibility of many accounting professionals is to design and implement internal control procedures for organizations. Explain the purpose of internal control procedures. Provide two examples of internal controls applied by companies.

Polaris

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Chapter 1 Introducing Accounting in Business 33

In a recent year’s financial statements, Home Depot reported the following results. Compute and interpret Home Depot’s return on assets (assume competitors average a 8.0% return on assets).

Sales . . . . . . . . . . . . . . . . . . . . . . $67,997 million

Net income . . . . . . . . . . . . . . . . 3,338 million

Average total assets . . . . . . . . . . 40,501 million

QS 1-12 Computing and interpreting return on assets

A2

Part A. Identify the following users of accounting information as either an internal (I) or an exter- nal (E) user. _______ 1. Research and development director _______ 5. Distribution managers _______ 2. Human resources director _______ 6. Creditors _______ 3. Nonexecutive employee _______ 7. Production supervisors _______ 4. Shareholders _______ 8. Purchasing manager

Part B. Identify the following questions as most likely to be asked by an internal (I) or an external (E) user of accounting information. _______ 1. What are reasonable payroll benefits

and wages? _______ 2. Should we make a five-year loan

to that business? _______ 3. What are the costs of our product’s

ingredients? _______ 4. Do income levels justify the current

stock price?

_______ 5. Should we spend further research on our product?

_______ 6. Which firm reports the highest sales and income?

_______ 7. What are the costs of our service to customers?

Exercise 1-3 Identifying accounting users and uses

C2

_______ 6. Establishing revenues generated from a product.

_______ 7. Determining employee tasks behind a service.

Exercise 1-2 Classifying activities reflected in the accounting system

C1

Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities. 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. Maintaining a log of service costs. _______ 4. Measuring the costs of a product. _______ 5. Preparing financial statements.

Answer each of the following questions related to international accounting standards. a. The International Accounting Standards Board (IASB) issues preferred accounting practices that are

referred to as what? b. The FASB and IASB are working on a convergence process for what purpose? c. The SEC has proposed a roadmap for use of IFRS by U.S. companies. What is the proposed time period

(as suggested by the SEC) for the FASB to endorse IFRS (with necessary exceptions) as U.S. GAAP?

QS 1-13 International accounting standards C4

This icon highlights assignments that focus on IFRS-related content.

EXERCISES

Exercise 1-1 Describing accounting responsibilities

C2

Many accounting professionals work in one of the following three areas: A. Managerial accounting B. Financial accounting C. Tax accounting Identify the area of accounting that is most involved in each of the following responsibilities:

1. Internal auditing. 5. Investigating violations of tax laws. 2. External auditing. 6. Planning transactions to minimize taxes. 3. Cost accounting. 7. Preparing external financial statements. 4. Budgeting. 8. Reviewing reports for SEC compliance.

Assume the following role and describe a situation in which ethical considerations play an important part in guiding your decisions and actions: a. You are a student in an introductory accounting course. b. You are a manager with responsibility for several employees. c. You are an accounting professional preparing tax returns for clients. d. You are an accounting professional with audit clients that are competitors in business.

Exercise 1-4 Identifying ethical concerns

C3

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34 Chapter 1 Introducing Accounting in Business

Exercise 1-6 Learning the language of business

C1 – C3

Match each of the numbered descriptions with the term or phrase it best reflects. Indicate your answer by writing the letter for the term or phrase in the blank provided. A. Audit C. Ethics E. SEC G. Net income B. GAAP D. Tax accounting F. Public accountants H. IASB

1. Principles that determine whether an action is right or wrong. 2. Accounting professionals who provide services to many clients. 3. An accounting area that includes planning future transactions to minimize taxes paid. 4. An examination of an organization’s accounting system and records that adds credibility to

financial statements. 5. Amount a business earns after paying all expenses and costs associated with its sales and revenues.

Exercise 1-5 Identifying accounting principles and assumptions

C4

Match each of the numbered descriptions with the principle or assumption it best reflects. Enter the letter for the appropriate principle or assumption in the blank space next to each description. A. General accounting principle E. Specific accounting principle B. Cost principle F. Matching principle C. Business entity assumption G. Going-concern assumption D. Revenue recognition principle H. Full disclosure principle

1. Usually created by a pronouncement from an authoritative body. 2. Financial statements reflect the assumption that the business continues operating. 3. Derived from long-used and generally accepted accounting practices. 4. Every business is accounted for separately from its owner or owners. 5. Revenue is recorded only when the earnings process is complete. 6. Information is based on actual costs incurred in transactions. 7. A company records the expenses incurred to generate the revenues reported. 8. A company reports details behind financial statements that would impact users’ decisions.

Exercise 1-7 Distinguishing business organizations

C4

The following describe several different business organizations. Determine whether the description refers to a sole proprietorship, partnership, or corporation. a. Ownership of Zander Company is divided into 1,000 shares of stock. b. Wallingford is owned by Trent Malone, who is personally liable for the company’s debts. c. Micah Douglas and Nathan Logan own Financial Services, a financial services provider. Neither

Douglas nor Logan has personal responsibility for the debts of Financial Services. d. Riley and Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the

business. e. IBC Services does not have separate legal existence apart from the one person who owns it. f. Physio Products does not pay income taxes and has one owner. g. AJ pays its own income taxes and has two owners.

Exercise 1-8 Using the accounting equation

A1 P1

Answer the following questions. (Hint: Use the accounting equation.) a. Office Store has assets equal to $123,000 and liabilities equal to $47,000 at year-end. What is the total

equity for Office Store at year-end? b. 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 the end of the year? 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

Exercise 1-9 Using the accounting equation

A1

Determine the missing amount from each of the separate situations a, b, and c below.

Assets (a) $ ? (b) 100,000 (c) 154,000

$ 20,000 34,000

?

$ 45,000 ? 40,000

5 1Liabilities Equity

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Chapter 1 Introducing Accounting in Business 35

Provide an example of a transaction that creates the described effects for the separate cases a through g. a. Decreases an asset and decreases equity. e. Increases an asset and decreases an asset. b. Increases an asset and increases a liability. f. Increases a liability and decreases equity. c. Decreases a liability and increases a liability. g. Increases an asset and increases equity. d. Decreases an asset and decreases a liability.

Exercise 1-10 Identifying effects of transactions on the accounting equation

P1

Check Net income, $6,000

Exercise 1-11 Identifying effects of transactions using the accounting equation

P1

Lena Holden began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Holden (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 trans-

action 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 a table like the one in Exhibit 1.9, using the following headings for columns: Cash; Accounts Re- ceivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Then use additions and subtractions to show the effects of the transactions on individual items of the accounting equation. Show new balances after each transaction.

Assets 5 Liabilities 1 Equity

Accounts Office Office Trans- Receiv- Sup- Furni- Accounts Common action Cash 1 able 1 plies 1 ture 5 Payable 1 Stock 1 Revenues

a. $40,000 1 $ 0 1 $ 0 1 $ 0 5 $ 0 1 $40,000 1 $ 0

b. 38,000 1 0 1 3,000 1 0 5 1,000 1 40,000 1 0

c. 30,000 1 0 1 3,000 1 8,000 5 1,000 1 40,000 1 0

d. 30,000 1 6,000 1 3,000 1 8,000 5 1,000 1 40,000 1 6,000

e. 31,000 1 6,000 1 3,000 1 8,000 5 1,000 1 40,000 1 7,000

Exercise 1-12 Analysis using the accounting equation

P1

Zen began a new consulting firm on January 5. The accounting equation showed the following balances after each of the company’s first five transactions. Analyze the accounting equation for each transaction and describe each of the five transactions with their amounts.

Exercise 1-13 Identifying effects of transactions on accounting equation

P1

The following table shows the effects of five transactions (a through e) on the assets, liabilities, and equity of Trista’s Boutique. Write short descriptions of the probable nature of each transaction.

Assets 5 Liabilities 1 Equity

Cash 1 Accounts 1 Office 1 Land 5 Accounts 1 Common 1 Revenues Receivable Supplies Payable Stock

$ 21,000 1 $ 0 1 $3,000 1 $19,000 5 $ 0 1 $43,000 1 $ 0 a. 2 4,000 1 4,000 b. 1 1,000 11,000 c. 1 1,900 1 1,900 d. 2 1,000 21,000 e. 1 1,900 2 1,900 ________ _______ _______ ________ _________ _______ _______ $ 17,900 1 $ 0 1 $4,000 1 $23,000 5 $ 0 1 $43,000 1 $1,900 ________ _______ _______ ________ _________ _______ _______ ________ _______ _______ ________ _________ _______ _______

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36 Chapter 1 Introducing Accounting in Business

Exercise 1-15 Preparing a statement of retained earnings P2

Use the information in Exercise 1-14 to prepare an October statement of retained earnings for Real Answers.

Check Net income, $2,110

Exercise 1-14 Preparing an income statement

P2

On October 1, Keisha King organized Real Answers, a new consulting firm; on October 3, the owner con- tributed $84,000 cash. On October 31, the com pany’s records show the following 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 fees earned . . . . . . . . . . 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 1-16 Preparing a balance sheet P2

Use the information in Exercise 1-14 (if completed, you can also use your solution to Exercise 1-15) to prepare an October 31 balance sheet for Real Answers.

Exercise 1-19 Identifying sections of the statement of cash flows

P2

Indicate the section where each of the following would appear on the statement of cash flows. O. Cash flows from operating activity I. Cash flows from investing activity F. Cash flows from financing activity

1. Cash paid for advertising 5. Cash paid for rent 2. Cash paid for wages 6. Cash paid on an account payable 3. Cash paid for dividends 7. Cash received from stock issued 4. Cash purchase of equipment 8. Cash received from clients

Exercise 1-18 Analysis of return on assets

A2

Swiss Group reports net income of $40,000 for 2013. At the beginning of 2013, Swiss Group had $200,000 in assets. By the end of 2013, assets had grown to $300,000. What is Swiss Group’s 2013 return on assets? How would you assess its performance if competitors average a 10% return on assets?

Exercise 1-17 Preparing a statement of cash flows

P2

Use the information in Exercise 1-14 to prepare an October 31 statement of cash flows for Real Answers. Also assume the following: a. The owner’s initial investment consists of $38,000 cash and $46,000 in land in exchange for its com-

mon 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.Check Net increase in cash, $11,360

Exercise 1-20B

Identifying business activities

C5

Match each transaction or event to one of the following activities of an organization: financing activities (F), investing activities (I), or operating activities (O). a. An owner contributes resources to the business in exchange for its common stock. b. An organization sells some of its land. c. An organization purchases equipment. d. An organization advertises a new product. e. The organization borrows money from a bank.

Exercise 1-21 Preparing an income statement for a global company

P2

Nintendo Company reports the following income statement accounts for the year ended March 31, 2011. (Japanese yen in millions.)

Use this information to prepare Nintendo’s income statement for the year ended March 31, 2011.

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¥1,014,345 Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 626,379 Selling, general and administrative expenses . . . . . . . . . 216,889 Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,456

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Chapter 1 Introducing Accounting in Business 37

Check (1b) $41,500

(2c) $1,600

(3) $55,875

Required

1. Answer the following questions about Company A: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is the amount of liabilities on December 31, 2013? 2. Answer the following questions about Company B: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is net income for year 2013? 3. Calculate the amount of assets for Company C on December 31, 2013. 4. Calculate the amount of stock issuances for Company D during year 2013. 5. Calculate the amount of liabilities for Company E on December 31, 2012.

The following financial statement information is from five separate companies:

Company Company Company Company Company A B C D E

December 31, 2012

Assets . . . . . . . . . . . . . . . . . . . . . . . . . $55,000 $34,000 $24,000 $60,000 $119,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . 24,500 21,500 9,000 40,000 ?

December 31, 2013

Assets . . . . . . . . . . . . . . . . . . . . . . . . . 58,000 40,000 ? 85,000 113,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . ? 26,500 29,000 24,000 70,000

During year 2013

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

PROBLEM SET A

Problem 1-1A Computing missing information using accounting knowledge

A1 P1

Problem Set B located at the end of Problem Set A is provided for each problem to reinforce the learning process.

Identify how each of the following separate transactions affects financial statements. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from financing activities, and cash flows from investing activities. For increases, place a “1” in the column or columns. For decreases, place a “2” in the column or columns. If both an increase and a decrease occur, place a “1y2” in the column or columns. The first transaction is completed as an example.

Problem 1-2A Identifying effects of transactions on financial statements

A1 P1

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Financing Investing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests cash for its stock 1 1 1

2 Receives cash for services provided

3 Pays cash for employee wages

4 Incurs legal costs on credit

5 Borrows cash by signing long-term note payable

6 Pays cash dividend

7 Buys land by signing note payable

8 Provides services on credit

9 Buys office equipment for cash

10 Collects cash on receivable from (8)

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38 Chapter 1 Introducing Accounting in Business

Problem 1-3A Preparing an income statement

P2

The following is selected financial information for Elko Energy Company for the year ended December 31, 2013: revenues, $55,000; expenses, $40,000; net income, $15,000.

Required

Prepare the 2013 calendar-year income statement for Elko Energy Company.

Problem 1-4A Preparing a balance sheet

P2

The following is selected financial information for Amity Company as of December 31, 2013: liabilities, $44,000; equity, $46,000; assets, $90,000.

Required

Prepare the balance sheet for Amity Company as of December 31, 2013.

Problem 1-5A Preparing a statement of cash flows

P2

Following is selected financial information of ABM Company for the year ended December 31, 2013.

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, 2012 . . . . . . . . . . . . . . 2,300

Required

Prepare the 2013 statement of cash flows for ABM Company. Check Cash balance, Dec. 31, 2013, $3,500

Problem 1-6A Preparing a statement of retained earnings

P2

Following is selected financial information for Kasio Co. for the year ended December 31, 2013.

Retained Earnings, Dec. 31, 2013 . . . . . . . . $14,000 Cash dividends . . . . . . . . . . . . . . . . . . . . . $1,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Retained Earnings, Dec. 31, 2012 . . . . . . . . 7,000

Required

Prepare the 2013 statement of retained earnings for Kasio.

Holden Graham started The Graham Co., a new business that began operations on May 1. The Graham Co. completed the following transactions during its first month of operations.

May 1 H. Graham 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 advertising in this month’s (May) local paper on credit; cash

payment is due June 1. 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).

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Office Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Show effects of the transactions on the accounts of the accounting equation by recording increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

3. Prepare an income statement for May, a statement of retained earnings for May, a May 31 balance sheet, and a statement of cash flows for May.

Problem 1-7A Analyzing transactions and preparing financial statements

C4 P1 P2

mhhe.com/wildFINMAN5e

Check (2) Ending balances: Cash, $42,780; Expenses, $5,110

(3) Net income, $5,990; Total assets, $44,670

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Chapter 1 Introducing Accounting in Business 39

Helga Ander started a new business and completed these transactions during December.

Dec. 1 Helga Ander transferred $65,000 cash from a personal savings account to a checking account in the name of Ander 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).

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Re- ceivable; Office Supplies; Office Equipment; Electrical Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions to show the effects of each transaction on the accounts in the account- ing equation. Show new balances after each transaction.

3. Use the increases and decreases in the columns of the table from part 2 to prepare an income state- ment, a statement of retained earnings, and a statement of cash flows—each of these for the current month. Also prepare a balance sheet as of the end of the month.

Analysis Component

4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $65,000 and that Ander Electric obtained another $16,000 in cash by borrowing it from a bank. Explain the effect of this change on total assets, total liabilities, and total equity.

Problem 1-8A Analyzing transactions and preparing financial statements

C4 P1 P2

mhhe.com/wildFINMAN5e

Check (2) Ending balances: Cash, $59,180, Accounts Payable, $8,550

(3) Net income, $4,160; Total assets, $76,760

Problem 1-9A Analyzing effects of transactions

C4 P1 P2 A1

Isabel Lopez started Biz Consulting, a new business, and completed the following transactions during its first year of operations. a. I. Lopez invests $70,000 cash and office equipment valued at $10,000 in the company in exchange for

its common stock. b. The company purchased a $150,000 building to use as an office. Biz paid $20,000 in cash and signed

a note payable promising to pay the $130,000 balance over the next ten years. 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 an $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 a table like the one in Exhibit 1.9, using the following headings for the columns: Cash; Ac- counts Receivable; Office Supplies; Office Equipment; Building; Accounts Payable; Notes Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions within the table created in part 1 to show the dollar effects of each trans- action on individual items of the accounting equation. Show new balances after each transaction.

3. Once you have completed the table, determine the company’s net income.

Check (2) Ending balances: Cash, $34,525; Expenses, $2,300; Notes Payable, $130,000

(3) Net income, $4,500

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40 Chapter 1 Introducing Accounting in Business

Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures (in $ millions) for these businesses over the past year follow.

Key Figures ($ millions) 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 1-10A Computing and interpreting return on assets

A2

Check (1a) 11.3%; (1b) 9.2%

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?

Check (3) $410,000 (4) $250,000

Problem 1-11A Determining expenses, liabilities, equity, and return on assets

A1 A2

Problem 1-13AB

Describing organizational activities

C5

A start-up company often engages in the following transactions in its first year of operations. Classify those transactions in one of the three major categories of an organization’s business activities. F. Financing I. Investing O. Operating

1. Owner investing land in business. 5. Purchasing equipment. 2. Purchasing a building. 6. Selling and distributing products. 3. Purchasing land. 7. Paying for advertising. 4. Borrowing cash from a bank. 8. Paying employee wages.

Problem 1-12AA

Identifying risk and return

A3

All business decisions involve aspects of risk and return.

Required

Identify both the risk and the return in each of the following activities: 1. Investing $2,000 in a 5% savings account. 2. Placing a $2,500 bet on your favorite sports team. 3. Investing $10,000 in Yahoo! stock. 4. Taking out a $15,000 college loan toward earning an accounting degree.

Problem 1-14AB

Describing organizational activities C5

An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity.

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Chapter 1 Introducing Accounting in Business 41

The following financial statement information is from five separate companies. PROBLEM SET B

Problem 1-1B Computing missing information using accounting knowledge

A1 P1

Company Company Company Company Company V W X Y Z

December 31, 2012

Assets . . . . . . . . . . . . . . . . . . . . . . . . $54,000 $80,000 $141,500 $92,500 $144,000

Liabilities . . . . . . . . . . . . . . . . . . . . . 25,000 60,000 68,500 51,500 ?

December 31, 2013

Assets . . . . . . . . . . . . . . . . . . . . . . . . 59,000 100,000 186,500 ? 170,000

Liabilities . . . . . . . . . . . . . . . . . . . . . 36,000 ? 65,800 42,000 42,000

During year 2013

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

Check (1b) $23,000

(2c) $22,000

(4) $135,100

Required

1. Answer the following questions about Company V: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is the net income or loss for the year 2013? 2. Answer the following questions about Company W: a. What is the amount of equity on December 31, 2012? b. What is the amount of equity on December 31, 2013? c. What is the amount of liabilities on December 31, 2013? 3. Calculate the amount of stock issuances for Company X during 2013. 4. Calculate the amount of assets for Company Y on December 31, 2013. 5. Calculate the amount of liabilities for Company Z on December 31, 2012.

Identify how each of the following separate transactions affects financial statements. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from financing activities, and cash flows from investing activities. For increases, place a “1” in the column or columns. For de- creases, place a “2” in the column or columns. If both an increase and a decrease occur, place “1y2” in the column or columns. The first transaction is completed as an example.

Problem 1-2B Identifying effects of transactions on financial statements A1 P1

Income Balance Sheet Statement Statement of Cash Flows

Total Total Total Net Operating Financing Investing Transaction Assets Liab. Equity Income Activities Activities Activities

1 Owner invests cash for its stock 1 1 1

2 Buys building by signing note payable

3 Pays cash for salaries incurred

4 Provides services for cash

5 Pays cash for rent incurred

6 Incurs utilities costs on credit

7 Buys store equipment for cash

8 Pays cash dividend

9 Provides services on credit

10 Collects cash on receivable from (9)

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42 Chapter 1 Introducing Accounting in Business

Problem 1-4B Preparing a balance sheet

P2

The following is selected financial information for TLC Company as of December 31, 2013.

Required

Prepare the balance sheet for TLC Company as of December 31, 2013.

Liabilities . . . . . . . . $64,000 Equity . . . . . . . . $50,000 Assets . . . . . . . . $114,000

Problem 1-5B Preparing a statement of cash flows

P2

Selected financial information of HalfLife Company for the year ended December 31, 2013, follows.

Required

Prepare the 2013 statement of cash flows for HalfLife Company.

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, 2012 . . . . . . . . . . . . . . 1,300

Problem 1-6B Preparing a statement of retained earnings

P2 Retained Earnings, Dec. 31, 2013 . . . . . . . . $47,000 Cash dividends . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Retained Earnings, Dec. 31, 2012 . . . . . . . . 49,000

Following is selected financial information of ATV Company for the year ended December 31, 2013.

Required

Prepare the 2013 statement of retained earnings for ATV Company.

Problem 1-7B Analyzing transactions and preparing financial statements

C4 P1 P2

Holly Nikolas launched a new business, Holly’s Maintenance Co., that began operations on June 1. The following transactions were completed by the company during that first month.

June 1 H. Nikolas 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 1-3B Preparing an income statement

P2 Revenues . . . . . . . $68,000 Expenses . . . . . . . . $40,000 Net income . . . . . . . $28,000

Selected financial information for Offshore Co. for the year ended December 31, 2013, follows.

Required

Prepare the 2013 income statement for Offshore Company.

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Chapter 1 Introducing Accounting in Business 43

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Re- ceivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Show the effects of the transactions on the accounts of the accounting equation by recording increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance.

3. Prepare a June income statement, a June statement of retained earnings, a June 30 balance sheet, and a June statement of cash flows.

Check (2) Ending balances: Cash, $130,060; Expenses, $9,790

(3) Net income, $7,135; Total assets, $133,135

Truro Excavating Co., owned by Raul Truro, began operations in July and completed these transactions during that first month of operations.

July 1 R. Truro invested $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 excavating 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).

Required

1. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Re- ceivable; Office Supplies; Office Equipment; Excavating Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions to show the effects of each transaction on the accounts in the account- ing equation. Show new balances after each transaction.

3. Use the increases and decreases in the columns of the table from part 2 to prepare an income state- ment, a statement of retained earnings, and a statement of cash flows—each of these for the current month. Also prepare a balance sheet as of the end of the month.

Analysis Component

4. Assume that the $5,000 purchase of excavating equipment on July 3 was financed from an owner in- vestment of another $5,000 cash in the business in exchange for more common stock (instead of the purchase conditions described in the transaction). Explain the effect of this change on total assets, total liabilities, and total equity.

Problem 1-8B Analyzing transactions and preparing financial statements

C4 P1 P2

Check (2) Ending balances: Cash, $87,545; Accounts Payable, $7,100

(3) Net income, $18,245; Total assets, $103,545

Problem 1-9B Analyzing effects of transactions

C4 P1 P2 A1

Nico Mitchell started a new business, Nico’s Solutions, and completed the following transactions during its first year of operations. a. N. Mitchell invests $90,000 cash and office equipment valued at $20,000 in the company in exchange

for its common stock. b. The company purchased a $150,000 building to use as an office. It paid $40,000 in cash and signed

a note payable promising to pay the $110,000 balance over the next ten years. c. The company purchased office equipment for $25,000 cash.

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44 Chapter 1 Introducing Accounting in Business

Key Figures ($ millions) AT&T Verizon

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $126,723 $110,875

Net income . . . . . . . . . . . . . . . . . . . 4,184 10,198

Average assets . . . . . . . . . . . . . . . . . 269,868 225,233

AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures (in $ millions) for these businesses over the past year follow.

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 1-10B Computing and interpreting return on assets

A2

Check (1a) 1.6%; (1b) 4.5%

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 a table like the one in Exhibit 1.9, using the following headings for the columns: Cash; Ac- counts Receivable; Office Supplies; Office Equipment; Building; Accounts Payable; Notes Payable; Common Stock; Dividends; Revenues; and Expenses.

2. Use additions and subtractions within the table created in part 1 to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction.

3. Once you have completed the table, determine the company’s net income.

Check (2) Ending balances: Cash, $15,350; Expenses, $3,250; Notes Payable, $110,000 (3) Net income, $3,550

Problem 1-11B Determining expenses, liabilities, equity, and return on assets

A1 A2

Carbondale Company manufactures, markets, and sells snowmobile and snowmobile equipment and accessories. The average total assets for Carbondale is $3,000,000. In its most recent year, Carbondale reported net income of $201,000 on revenues of $1,400,000.

Required

1. What is Carbondale Company’s return on assets? 2. Does return on assets seem satisfactory for Carbondale given that its competitors average a 9.5% re-

turn on assets? 3. What are the total expenses for Carbondale Company in its most recent year? 4. What is the average total amount of liabilities plus equity for Carbondale Company?

Check (3) $1,199,000

(4) $3,000,000

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Chapter 1 Introducing Accounting in Business 45

SP 1 On October 1, 2013, Adria Lopez launched a computer services company, Success Systems, that is organized as a corporation and provides consulting services, computer system installations, and custom program development. Lopez adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2013.

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 created to show the dollar effects for each of the following October transactions for Success Systems on the indi- vidual items of the accounting equation. Show new balances after each transaction.

Oct. 1 A. Lopez invested $55,000 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 $1,940 cash for advertisements published in the local newspaper.

This serial problem starts in this chapter and continues throughout most chapters of the book. It is most readily solved if you use the Working Papers that accompany this book (but working papers are not required).

SERIAL PROBLEM Success Systems

C4 P1

Problem 1-14BB

Describing organizational 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.

Problem 1-13BB

Describing organizational activities

C5

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. 5. Supervising workers. 2. Obtaining a bank loan. 6. Owner investing money in business. 3. Purchasing machinery. 7. Renting office space. 4. Research for its products. 8. Paying utilities expenses.

Problem 1-12BA

Identifying risk and return

A3

All business decisions involve aspects of risk and return.

Required

Identify both the risk and the return in each of the following activities: 1. Stashing $500 cash under your mattress. 2. Placing a $250 bet on a horse running in the Kentucky Derby. 3. Investing $20,000 in Nike stock. 4. Investing $35,000 in U.S. Savings Bonds.

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46 Chapter 1 Introducing Accounting in Business

BTN 1-2 Key comparative figures ($ thousands) for both Polaris and Arctic Cat follow.

Required

1. What is the total amount of assets invested in (a) Polaris and (b) Arctic Cat? 2. What is the return on assets for (a) Polaris and (b) Arctic Cat? Polaris’s beginning-year assets equal

$1,061,647 (in thousands) and Arctic Cat’s beginning-year assets equal $246,084 (in thousands). 3. How much are expenses for (a) Polaris and (b) Arctic Cat? 4. Is return on assets satisfactory for (a) Polaris and (b) Arctic Cat? (Assume competitors average an 18%

return.) 5. What can you conclude about Polaris and Arctic Cat from these computations?

Key Figure Polaris Arctic Cat

Liabilities 1 Equity . . . . . . . . . . $1,228,024 $272,906

Net income . . . . . . . . . . . . . . . 227,575 13,007

Revenues and sales . . . . . . . . . 2,656,949 464,651

COMPARATIVE ANALYSIS A1 A2 A3

Check (2b) 5.0%

Polaris Arctic Cat

Beyond the Numbers

Required

1. What is the total amount of assets invested in Polaris? 2. What is Polaris’s return on assets for 2011? Its assets at December 31, 2010, equal $1,061,647

(in thousands). 3. How much are total expenses for Polaris for the year ended December 31, 2011? 4. Does Polaris’s return on assets for 2011 seem satisfactory if competitors average an 18% return?

Fast Forward

5. Access Polaris’s financial statements (Form 10-K) for years ending after December 31, 2011, from its Website (Polaris.com) or from the SEC Website (www.sec.gov) and compute its return on assets for those years. Compare the December 31, 2011, year-end return on assets to any subsequent years’ re- turns you are able to compute, and interpret the results.

Check (2) 19.9%

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.

BTN 1-1 Key financial figures for Polaris’s fiscal year ended December 31, 2011, follow.

Key Figure In Thousands

Liabilities 1 Equity . . . . . . . . . $1,228,024

Net income . . . . . . . . . . . . . . 227,575

Revenues . . . . . . . . . . . . . . . . 2,656,949

REPORTING IN ACTION A1 A2 A3

Polaris

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).

Check Ending balances: Cash, $52,560; Revenues, $11,408; Expenses, $3,620

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Chapter 1 Introducing Accounting in Business 47

BTN 1-6 Teamwork is important in today’s business world. Successful teams schedule convenient meetings, maintain regular communications, and cooperate with and support their members. This as- signment aims to establish support/learning teams, initiate discussions, and set meeting times.

Required

1. Form teams and open a team discussion to determine a regular time and place for your team to meet between each scheduled class meeting. Notify your instructor via a memorandum or e-mail message as to when and where your team will hold regularly scheduled meetings.

2. Develop a list of telephone numbers and/or e-mail addresses of your teammates.

TEAMWORK IN ACTION C1

BTN 1-5 Visit the EDGAR database at (www.sec.gov). Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker RMCF) filed on May 24, 2011, covering its 2011 fiscal year.

Required

1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2007–2011. How would you 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 Refer to this chapter’s opening feature about Twitter. Assume that the owners desire to expand their online services to meet people’s demands regarding online services. They eventually decide to meet with their banker to discuss a loan to allow Twitter to expand.

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 Twitter.

COMMUNICATING IN PRACTICE A1 C2

BTN 1-3 Craig 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.

ETHICS CHALLENGE C3 C4

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48 Chapter 1 Introducing Accounting in Business

BTN 1-9 KTM (KTM.com) is a leading manufacturer of offroad and street motorcycles, and it com- petes to some extent with both Polaris and Arctic Cat. Key financial figures for KTM follow.

Required

1. Identify any concerns you have in comparing KTM’s income and revenue figures to those of Polaris and Arctic Cat (in BTN 1-2) for purposes of making business decisions.

2. Identify any concerns you have in comparing KTM’s return on assets ratio to those of Polaris and Arctic Cat (computed for BTN 1-2) for purposes of making business decisions.

Key Figure* Euro in Thousands

Average assets . . . . . . . . . . . . . . . . . . 465,550

Net income . . . . . . . . . . . . . . . . . . . . 20,818

Revenue . . . . . . . . . . . . . . . . . . . . . . . 526,801

Return on assets . . . . . . . . . . . . . . . . 4.5%

* Figures prepared in accordance with International Financial Reporting Standards.

GLOBAL DECISION A1 A2 A3

KTM Polaris Arctic Cat

BTN 1-8 You are to interview a local business owner. (This can be a friend or relative.) Opening lines of communication with members of the business community can provide personal benefits of business net- working. If you do not know the owner, you should call ahead to introduce yourself and explain your posi- tion 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 C2

BTN 1-7 Refer to this chapter’s opening feature about Twitter. Assume that the owners decide to open a new Website devoted to micro-blogging for accountants and those studying accounting. This new com- pany will be called AccounTwit.

Required

1. AccounTwit obtains a $500,000 loan and the three owners contribute $250,000 in total from their own savings in exchange for common stock in the new company.

a. What is the new company’s total amount of liabilities plus equity? b. What is the new company’s total amount of assets? 2. If the new company earns $80,250 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 P1

Check (2) 10.7%

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Chapter 1 Introducing Accounting in Business 49

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

4. a 5. a

Assets 5 Liabilities 1 Equity

1$100,000 5 135,000 1 ?

Change in equity 5 $100,000 2 $35,000 5 $65,000

ANSWERS TO MULTIPLE CHOICE QUIZ

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Learning Objectives

CONCEPTUAL

C1 Explain the steps in processing transactions and the role of source documents. (p. 52)

C2 Describe an account and its use in recording transactions. (p. 53) C3 Describe a ledger and a chart of accounts. (p. 56) C4 Define debits and credits and explain double-entry accounting. (p. 57)

ANALYTICAL

A1 Analyze the impact of transactions on accounts and financial statements. (p. 61) A2 Compute the debt ratio and describe its use in analyzing financial condition. (p. 71)

PROCEDURAL

P1 Record transactions in a journal and post entries to a ledger. (p. 58) P2 Prepare and explain the use of a trial balance. (p. 67) P3 Prepare financial statements from business transactions. (p. 68)

A Look at This Chapter

This chapter focuses on the accounting process. We describe transactions and source documents, and we explain the analysis and recording of transactions. The accounting equation, T-account, general ledger, trial balance, and debits and credits are key tools in the accounting process.

A Look Back

Chapter 1 defined accounting and introduced financial statements. We described forms of organizations and identified users and uses of accounting. We defined the accounting equation and applied it to transaction analysis.

Analyzing and Recording Transactions 2

A Look Ahead

Chapter 3 extends our focus on processing information. We explain the importance of adjusting accounts and the procedures in preparing financial statements.

50

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Some Like It Hot

LOS ANGELES—“We call our customers Nomsters!” exclaims Misa. “There’s an entire Nom Nom movement.” Nom Nom Truck (NomNomTruck.com) is a mobile food business and the brainchild of Misa Chien and Jennifer Green. (Nom Nom is drawn from the sound “nom nom nom” when eating something “oh so tasty.”) Their specialty is the Vietnamese baguette sand- wich, called banh mi, a sort of Vietnamese subsandwich. “It’s portable, it’s fast, and has a fresh taste that you can’t get from a burrito or hamburger,” states Jennifer. To pursue their business ambitions, Misa and Jennifer took business courses. They learned about recordkeeping processes, transaction analysis, inventory accounting, and financial state- ment reporting. “We did lose a lot of money initially,” explains Misa. “We didn’t have the right pricing structure.” With careful analysis of their accounting reports, Misa and Jennifer solved the problem. Their business is now profitable and they have a reliable accounting system to help them make good business decisions. “We had to account for product expenses, trucking ex- penses, supplier payments, and other expenses such as sala- ries, rent and insurance,” explains Misa. At the same time, the

two have grown sales and expanded their food offerings. “Sales have definitely increased,” says Misa. “People totally embraced us!” The two insist that it is crucial to track and account for all revenues and expenses, including what is invested in the busi- ness. They maintain that success requires proper accounting for and analysis of the financial side. “There was a point when we couldn’t keep up,” recounts Misa. Given the importance of ac- counting, “we [now] have a bookkeeper and an accountant!” The women emphasize the value of a great business model along with a sound accounting system. “It’s really easy to bal- ance both now that we’ve been in the business for awhile,” ex- plains Misa. “The bigger message of our company”, says Jennifer, “is that each of us can succeed no matter what our starting point”. “You have to be responsible for yourself,” adds Misa. “We want to make people happy through our food!”

[Sources: Nom Nom Truck Website, January 2013; Inc., June 2011; Bundle.com, October 2010; VirgoBlue.net, September 2011; CNNMoney, October 2011.]

“You can still excel if you work really hard and follow your dreams!”

—MISA CHIEN (ON LEFT)

Decision Insight

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Chapter Preview

Financial statements report on the financial performance and condition of an organization. Knowledge of their preparation, organization, and analysis is important. A main goal of this chapter is to illustrate how transactions are recorded, how

they are reflected in financial statements, and how they impact analysis of financial statements. Debits and credits are intro- duced and identified as a tool in helping analyze and process transactions.

Analyzing and Recording Transactions

Analyzing and Processing Transactions

• General ledger • Double-entry accounting • Journalizing and posting • An illustration

Analyzing and Recording Process

• Source documents • The account and its

analysis • Types of accounts

Trial Balance

• Trial balance preparation • Search for and correction

of errors • Trial balance use

The accounting process identifies business transactions and events, analyzes and records their effects, and summarizes and presents information in reports and financial statements. These re- ports and statements are used for making investing, lending, and other business decisions. The steps in the accounting process that focus on analyzing and recording transactions and events are shown in Exhibit 2.1.

EXHIBIT 2.1 The Analyzing and Recording Process

Record relevant transact ions and events in a journal

Post journal information to ledger accounts

Prepare and analyze the trial balance

Analyze each transaction

and event from source documents

Journal Dec. 1 30,000

30,000 Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Journal Dec. 1 30,000

30,000 Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Ledger

Cash no.101

Supplies no.126

Journal Dec. 1 30,000

30,000 Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Ledger

Cash no.101

Supplies no.126

FastForward Trial Balance

Cash $ 3,950 Supplies 9,720 Prepaid Insurance 2,400 Equipment 26,000

Date Debit Credit

1 Deposit 30,000

Total 30,000

Services Contract Bank Statement

1 Deposit 30,000

Total 30,000

1 Deposit 30,000

Total 30,000

Client Billing Bank Statement

1 Deposit 30,000

Total 30,000

1 Deposit 30,000

Total 30,000

Note Payable Bank Statement

1 Deposit 30,000

Total 30,000

1 Deposit 30,000

Total 30,000

Purchase Ticket

1 Deposit 30,000

Total 30,000

Bank Statement

C1 Explain the steps in processing transactions and the role of source documents.

ANALYZING AND RECORDING PROCESS

Business transactions and events are the starting points. Relying on source documents, the transactions and events are analyzed using the accounting equation to understand how they affect company performance and financial position. These effects are recorded in accounting records, informally referred to as the accounting books, or simply the books. Additional steps such as posting and then preparing a trial balance help summarize and classify the effects of transactions and events. Ultimately, the accounting process provides information in useful reports or financial statements to decision makers.

Source Documents Source documents identify and describe transactions and events entering the accounting process. They are the sources of accounting information and can be in either hard copy or electronic form. Examples are sales tickets, checks, purchase orders, bills from suppliers, employee earnings 52

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Chapter 2 Analyzing and Recording Transactions 53

records, and bank statements. To illustrate, when an item is purchased on credit, the seller usually prepares at least two copies of a sales invoice. One copy is given to the buyer. Another copy, often sent electronically, results in an entry in the seller’s information system to record the sale. Sellers use invoices for recording sales and for control; buyers use them for recording purchases and for monitoring purchasing activity. Many cash registers record information for each sale on a tape or electronic file locked inside the register. This record can be used as a source document for recording sales in the accounting records. Source documents, especially if obtained from outside the organiza- tion, provide objective and reliable evidence about transactions and events and their amounts.

Point: To ensure that all sales are rung up on the register, most sellers require customers to have their receipts to exchange or return purchased items.

Asset Accounts Assets are resources owned or controlled by a company, and those re- sources have expected future benefits. Most accounting systems include (at a minimum) sepa- rate accounts for the assets described here.

Cash A Cash account reflects a company’s cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any medium of exchange that a bank accepts for deposit (coins, checks, money orders, and checking account balances).

Accounts Receivable Accounts receivable are held by a seller and refer to promises of payment from customers to sellers. These transactions are often called credit sales or sales on account (or on credit). Accounts receivable are increased by credit sales and are decreased by customer payments. A company needs a separate record for each customer, but for now, we use the simpler practice of recording all increases and decreases in receivables in a single account called Accounts Receivable.

Note Receivable A note receivable, or promissory note, is a written promise of another entity to pay a definite sum of money on a specified future date to the holder of the note. A company holding a promissory note signed by another entity has an asset that is recorded in a Note (or Notes) Receivable account.

Prepaid Accounts Prepaid accounts (also called prepaid expenses) are assets that represent pre- payments of future expenses (not current expenses). When the expenses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts include prepaid insurance, prepaid rent, and prepaid services (such as club memberships). Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal tickets). When financial statements are prepared, prepaid accounts are adjusted so that (1) all expired and used prepaid accounts are recorded as regular expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future use in future periods). To illustrate,

Point: Customers and others who owe a company are called its debtors.

Point: A college parking fee is a prepaid account from the student’s standpoint. At the beginning of the term, it represents an asset that entitles a student to park on or near campus. The benefits of the parking fee expire as the term progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.

EXHIBIT 2.2 Accounts Organized by the Accounting Equation5 1

SuppliesInventoryAccounts ReceivableCash Wages PayableUnearned RevenuesAccounts Payable

Asset Accounts Liability Accounts

Paid-In CapitalDividendsCommon Stock

Equity Accounts

The Account and Its Analysis An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item. Information from an account is analyzed, summarized, and presented in reports and financial statements. The general ledger, or simply ledger, is a record containing all ac- counts used by a company. The ledger is often in electronic form. While most companies’ led- gers contain similar accounts, a company often uses one or more unique accounts because of its type of operations. As shown in Exhibit 2.2, accounts are classified into three general categories based on the accounting equation: asset, liability, or equity.

C2 Describe an account and its use in recording transactions.

Cashier Your manager requires that you, as cashier, immediately enter each sale. Recently, lunch hour traf- fic 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, the register will always match the cash amount when the manager arrives at three o’clock. What do you do? ■ [Answer—p. 76]

Decision Ethics

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54 Chapter 2 Analyzing and Recording Transactions

when an insurance fee, called a premium, is paid in advance, the cost is typically recorded in the asset account Prepaid Insurance. Over time, the expiring portion of the insurance cost is removed from this asset account and reported in expenses on the income statement. Any unexpired portion remains in Prepaid Insurance and is reported on the balance sheet as an asset. (An exception exists for prepaid accounts that will expire or be used before the end of the current accounting period when financial statements are prepared. In this case, the prepayments can be recorded immediately as expenses.)

Supplies Accounts Supplies are assets until they are used. When they are used up, their costs are reported as expenses. The costs of unused supplies are recorded in a Supplies asset account. Supplies are often grouped by purpose — for example, office supplies and store supplies. Office supplies include stationery, paper, toner, and pens. Store supplies include packaging materials, plastic and paper bags, gift boxes and cartons, and cleaning materials. The costs of these unused supplies can be recorded in an Office Supplies or a Store Supplies asset account. When supplies are used, their costs are transferred from the asset accounts to expense accounts.

Equipment Accounts Equipment is an asset. When equipment is used and gets worn down, its cost is gradually reported as an expense (called depreciation). Equipment is often grouped by its purpose — for example, office equipment and store equipment. Office equipment includes computers, print ers, desks, chairs, and shelves. Costs incurred for these items are recorded in an Office Equip ment asset account. The Store Equipment account includes the costs of assets used in a store, such as counters, showcases, ladders, hoists, and cash registers.

Buildings Accounts Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits to those who control or own them. Their costs are recorded in a Buildings asset account. When several buildings are owned, separate accounts are sometimes kept for each of them.

Land The cost of land owned by a business is recorded in a Land account. The cost of build- ings located on the land is separately recorded in one or more building accounts.

Point: Prepaid accounts that apply to current and future periods are assets. These assets are adjusted at the end of each period to reflect only those amounts that have not yet expired, and to record as expenses those amounts that have expired.

Point: Some assets are described as intangible because they do not have physical existence or their benefits are highly uncertain. A recent balance sheet for Coca-Cola Company shows nearly $1 billion in intangible assets.

Liability Accounts Liabilities are claims (by creditors) against assets, which means they are obligations to transfer assets or provide products or services to others. Creditors are indi- viduals and organizations that have rights to receive payments from a company. If a company fails to pay its obligations, the law gives creditors a right to force the sale of that company’s as- sets to obtain the money to meet creditors’ claims. When assets are sold under these conditions, creditors are paid first, but only up to the amount of their claims. Any remaining money, the residual, goes to the owners of the company. Creditors often use a balance sheet to help decide whether to loan money to a company. A loan is less risky if the borrower’s liabilities are small in comparison to assets because this means there are more resources than claims on resources. Common liability accounts are described here.

Accounts Payable Accounts payable refer to oral or implied promises to pay later, which usu- ally arise from purchases of merchandise. Payables can also arise from purchases of supplies, equipment, and services. Accounting systems keep separate records about each creditor. We describe these individual records in Chapter 4.

Note Payable A note payable refers to a formal promise, usually denoted by the signing of a promissory note, to pay a future amount. It is recorded in either a short-term Note Payable account or a long-term Note Payable account, depending on when it must be repaid. We explain details of short- and long-term classification in Chapter 3.

Point: Accounts payable are also called trade payables.

Women Entrepreneurs The Center for Women’s Business Research reports that women-owned businesses, such as Nom Nom Truck, are growing and that they:

• Total approximately 11 million and employ nearly 20 million workers. • Generate $2.5 trillion in annual sales and tend to embrace technology. • Are philanthropic—70% of owners volunteer at least once per month. • Are more likely funded by individual investors (73%) than venture firms (15%). ■

Decision Insight

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Chapter 2 Analyzing and Recording Transactions 55

Unearned Revenue Accounts Unearned revenue refers to 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 revenue recognition principle requires that the seller consider this payment as unearned revenue. Examples of unearned revenue include magazine subscrip tions collected in advance by a publisher, sales of gift certificates by stores, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions, Unearned Store Sales, and Unearned Ticket Revenue. When prod- ucts and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees, Store Sales, and Ticket Sales.1

Accrued Liabilities Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These are often recorded in separate liability accounts by the same title. If they are not large in amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial state- ments often have amounts reported that are a summation of several ledger accounts.)

Point: If a subscription is canceled, the publisher is expected to refund the unused portion to the subscriber.

1 In practice, account titles vary. As one example, Subscription Fees is sometimes called Subscription Fees Revenue, Subscription Fees Earned, or Earned Subscription Fees. As another example, Rent Earned is sometimes called Rent Revenue, Rental Revenue, or Earned Rent Revenue. We must use good judgment when reading financial statements because titles can differ even within the same industry. For example, product sales are called sales at Polaris, net sales at Arctic Cat, and net revenues at Piaggio. Generally, the term revenues or fees is more commonly used with service businesses, and net sales or sales with product businesses.

EXHIBIT 2.3 Expanded Accounting Equation

Paid-In CapitalDividendsCommon Stock

� � SuppliesInventoryAccounts ReceivableCash

Asset Accounts

Equity Accounts

Wages PayableUnearned RevenuesAccount Payable

Liability Accounts

� � � � Common Stock Revenues Expenses

Common Stock

Dividends

Dividends Revenues Expenses

Point: Equity is also called net assets.Equity Accounts The owner’s claim on a company’s assets is called equity, or stockholders’ equity, or shareholders’ equity. Equity is the owners’ residual interest in the assets of a business after deducting liabilities. Equity is impacted by four types of accounts: common stock, divi- dends, revenues, and expenses. We show this visually in Exhibit 2.3 by expanding the accounting equation. (As Chapter 1 explains, the accounts for dividends, revenues, and expenses are re- flected in the retained earnings account, and that account is reported in the balance sheet.)

Revenue Spread The New York Giants have Unearned Revenues of about $100 million in advance ticket sales. When the team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenues. ■

Decision Insight

Common Stock When an owner invests in a company in exchange for common stock, the invested amount is recorded in an account titled Common Stock. Any further owner invest- ments are recorded in this account.

Dividends When the company pays any cash dividends, it decreases both the company’s assets and its total equity. Dividends are not expenses of the business. They are simply the opposite of owner investments. A Dividends account is used in recording asset distributions to stockholders (owners).

Revenue Accounts Revenues and expenses also impact equity. Examples of revenue accounts are Sales, Commissions Earned, Profess ional Fees Earned, Rent Revenue, and Interest Revenue. Revenues increase equity and result from products and services provided to customers.

Point: The Dividends account is some- times referred to as a contra equity ac- count because it reduces the normal balance of equity.

Point: The withdrawal of assets by the owners of a corporation is called a dividend.

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56 Chapter 2 Analyzing and Recording Transactions

Expense Accounts Examples of expense accounts are Advertising Expense, Store Supplies Ex- pense, Office Salaries Expense, Office Supplies Expense, Rent Expense, Utilities Expense, and In- surance Expense. Expenses decrease equity and result from assets and services used in a company’s operations. The variety of revenues and expenses can be seen by looking at the chart of accounts that follows the index at the back of this book. (Different companies sometimes use different ac- count titles than those in this book’s chart of accounts. For example, some might use Interest Rev- enue instead of Interest Earned, or Rental Expense instead of Rent Expense. It is important only that an account title describe the item it represents.)

These numbers provide a three-digit code that is useful in recordkeeping. In this case, the first digit assigned to asset accounts is a 1, the first digit assigned to liability accounts is a 2, and so on. The second and third digits relate to the accounts’ subcategories. Exhibit 2.4 shows a partial

Asset accounts Liability accounts Equity accounts Revenue accounts Expense accounts

Chart of Accounts

101–199 201–299 301–399 401–499 501–699

This section explains several tools and processes that comprise an accounting system. These in- clude a ledger, T-account, debits and credits, double-entry accounting, journalizing, and posting.

Ledger and Chart of Accounts The collection of all accounts and their balances for an information system is called a ledger (or general ledger). If accounts are in files on a hard drive, the sum of those files is the ledger. If the accounts are pages in a file, that file is the ledger. A company’s size and diversity of operations affect the number of accounts needed. A small company can get by with as few as 20 or 30 ac- counts; a large company can require several thousand. The chart of accounts is a list of all ledger accounts and includes an identification number assigned to each account. A small busi- ness might use the following numbering system for its accounts:

ANALYZING AND PROCESSING TRANSACTIONS

C3 Describe a ledger and a chart of accounts.

EXHIBIT 2.4 Partial Chart of Accounts for FastForward

406 Rental revenue 622 Salaries expense 637 Insurance expense 640 Rent expense 652 Supplies expense 690 Utilities expense

236 Unearned consulting revenue 307 Common stock 318 Retained earnings 319 Dividends 403 Consulting revenue

Acct. No. Account Name

101 Cash 106 Accounts receivable 126 Supplies 128 Prepaid insurance 167 Equipment 201 Accounts payable

Acct. No. Account Name

Chart of Accounts

Acct. No. Account Name

Sporting Accounts The Miami Heat, Los Angeles Lakers, and the other NBA teams have the following major revenue and expense accounts:

Revenues Expenses

Basketball ticket sales Team salaries TV & radio broadcast fees Game costs Advertising revenues NBA franchise costs Basketball playoff receipts Promotional costs ■

Decision Insight

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Chapter 2 Analyzing and Recording Transactions 57

chart of accounts for FastForward, the focus company of Chapter 1. (Please review the more complete chart of accounts that follows the index at the back of this book.)

Debits and Credits A T-account represents a ledger account and is a tool used to understand the effects of one or more transactions. Its name comes from its shape like the letter T. The layout of a T- account, shown in Exhibit 2.5, is (1) the account title on top, (2) a left, or debit side, and (3) a right, or credit, side. The left side of an account is called the debit side, often abbreviated Dr. The right side is called the credit side, abbreviated Cr.2 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. Do not make the error of thinking that the terms debit and credit mean increase or decrease. Whether a debit or a credit is an increase or decrease depends on the account. For an account where a debit is an increase, the credit is a decrease; for an account where a debit is a decrease, the credit is an in- crease. The difference between total debits and total credits for an account, including any begin- ning balance, is the account balance. When the sum of debits exceeds the sum of credits, the account has a debit balance. It has a credit balance when the sum of credits exceeds the sum of debits. When the sum of debits equals the sum of credits, the account has a zero balance.

Double-Entry Accounting Double-entry accounting requires that for each transaction:

● At least two accounts are involved, with at least one debit and one credit. ● The total amount debited must equal the total amount credited. ● The accounting equation must not be violated.

This means the sum of the debits for all entries must equal the sum of the credits for all entries, and the sum of debit account balances in the ledger must equal the sum of credit account balances. The system for recording debits and credits follows from the usual accounting equation — see Exhibit 2.6. Two points are important here. First, like any simple mathematical relation, net increases or decreases on one side have equal net effects on the other side. For example, a net increase in assets must be accompanied by an identical net increase on the liabilities and equity

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

EXHIBIT 2.5 The T-Account

Point: Think of debit and credit as accounting directions for left and right.

“Total debits equal total credits for

each entry.”

EXHIBIT 2.6 Debits and Credits in the Accounting EquationDebit for

increases

Credit for decreases

� �

� �

Debit for decreases

Credit for increases

� �

Debit for decreases

Credit for increases

Assets Liabilities Equity

Normal Normal Normal

2 These abbreviations are remnants of 18th-century English recordkeeping practices where the terms debitor and creditor were used instead of debit and credit. The abbreviations use the first and last letters of these terms, just as we still do for Saint (St.) and Doctor (Dr.).

side. Recall that some transactions affect only one side of the equation, meaning that two or more accounts on one side are affected, but their net effect on this one side is zero. Second, the left side is the normal balance side for assets, and 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 of this equation, and liabilities and equity are on the right. Recall that equity increases from revenues and stock issuances, and it decreases from ex- penses and dividends. These important equity relations are conveyed by expanding the accounting equation to include debits and credits in double-entry form as shown in Exhibit 2.7. Increases (credits) to common stock and revenues increase equity; increases (debits) to dividends and expenses decrease equity. The normal balance of each account (asset, liability, common stock, dividends, revenue, or expense) refers to the left or right (debit or credit) side

Point: Debits and credits do not mean favorable or unfavorable. A debit to an asset increases it, as does a debit to an expense. A credit to a liability increases it, as does a credit to a revenue.

(Left side) (Right side)

Debit Credit

Account Title

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58 Chapter 2 Analyzing and Recording Transactions

where increases are recorded. Understanding these diagrams and rules is required to prepare, analyze, and interpret financial statements. 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 in its Cash account are $36,100, the total decreases are $31,300, and the account’s debit balance is $4,800. (We illustrate use of T-accounts later in this chapter.)

2

5 1 2 1 2 Dr. for

increases Cr. for

decreases

Assets Liabilities Dividends Revenues ExpensesCommon Stock

1 12 12 2 12 21

Dr. for decreases

Cr. for increases

1

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

Point: The ending balance is on the side with the larger dollar amount. Also, a plus (1) and minus (2) 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

1. Identify examples of accounting source documents. 2. Explain the importance of source documents. 3. Identify each of the following as either an asset, a liability, or equity: (a) Prepaid Rent,

(b) Unearned Fees, (c) Building, (d) Wages Payable, and (e) Office Supplies. 4. What is an account? What is a ledger? 5. What determines the number and types of accounts a company uses? 6. Does debit always mean increase and credit always mean decrease? 7. Describe a chart of accounts.

Quick Check Answers — p. 77

Journalizing and Posting Transactions Processing transactions is a crucial part of accounting. The four usual steps of this process are depicted in Exhibit 2.9. Steps 1 and 2 — involving transaction analysis and the accounting equation— were introduced in prior sections. This section extends that discussion and focuses on steps 3 and 4 of the accounting process. Step 3 is to record each transaction chronologically in a journal. A journal gives a complete record of each transaction in one place. It also shows debits and credits for each transaction. The process of recording transactions in a journal is called journalizing. Step 4 is to transfer (or post) entries from the journal to the ledger. The process of transferring journal entry information to the ledger is called posting.

Journalizing Transactions The process of journalizing transactions requires an under- standing of a journal. While companies can use various journals, every company uses a general journal. It can be used to record any transaction and includes the following information about each transaction: a date of transaction, b titles of affected accounts, c dollar amount of each

P1 Record transactions in a journal and post entries to a ledger.

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Chapter 2 Analyzing and Recording Transactions 59

debit and credit, and d explanation of the transaction. Exhibit 2.10 shows how the first two trans- actions of FastForward are recorded in a general journal. This process is similar for manual and computerized systems. Computerized journals are often designed to look like a manual journal page, and also include error-checking routines that ensure debits equal credits for each entry. Shortcuts allow recordkeepers to select account names and numbers from pull-down menus.

EXHIBIT 2.10 Partial General Journal for FastForward

Dec. 1

Dec. 2

Cash

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

2013 a

b

d

c

General Journal

To record entries in a general journal, apply these steps; refer to the entries in Exhibit 2.10 when reviewing these steps.

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 distinguish 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.

Point: There are no exact rules for writing journal entry explanations. An explanation should be short yet describe why an entry is made.

Services Contract

Step 3: Record journal entry.

Dec. 1 30,000 30,000

Cash Common Stock

2,500 2,500

SuppliesDec. 2 Cash

Step 1: Identify transactions and source documents.

Deposit

TOTAL

30,0001

t

Step 4: Post entry to ledger.

S

Debit for

increase s

1

Credit fo r

decrease s

2

5 1

2 1 Debit for

decrease s

Credit fo r

increase s

2 1 Debit for

decrease s

Credit fo r

increase s

Assets Liabiliti

es Equity

ep 2: Analyze transactions using the accounting equation.

Bank Statement

Client Billing Note Payable

Purchase Ticket

General Journal General Journa

l

Ledger

Assets = Liabilities + Equity

Cas h

EXHIBIT 2.9 Steps in Processing Transactions

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60 Chapter 2 Analyzing and Recording Transactions

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.

Point: The fundamental concepts of a manual (pencil-and-paper) 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 columns. It also has a column with the balance of the account after each entry is recorded. To illustrate, FastForward’s Cash account in Exhibit 2.11 is debited on December 1 for the $30,000 owner investment, yield- ing 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 again, this time 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.

Point: Explanations are typically included in ledger accounts only for unusual transactions or events.

EXHIBIT 2.11 Cash Account in Balance Column Format

Dec. 2 Dec. 3 Dec. 10

Dec. 1 2013

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 2.12 Posting an Entry to the Ledger

Dec. 1 2013

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

2013

G1 30,000 30,000

Date PR

Cash

Debit Credit

Account no. 101

BalanceExplanation

Dec. 1

2013

G1 30,000 30,000

Date PR

Common Stock

Debit Credit

Account no. 307

BalanceExplanation

Key: Enter the debit account number from the Ledger in the PR column of the journal.

3

4

1

2

Identify credit account in Ledger: enter date, journal page, amount, and balance. Enter the credit account number from the Ledger in the PR column of the journal.

4

3

1

2

Identify debit account in Ledger: enter date, journal page, amount, and balance.

IFRS IFRS requires that companies report the following four basic financial statements with explanatory notes:

• Balance sheet • Statement of changes in equity (or statement of recognized revenue and expense) • Income statement • Statement of cash flows

IFRS does not prescribe specific formats; and comparative information is required for the preceding period only. ■

Balance Column Account T-accounts are simple and direct means to show how the accounting process works. However, actual accounting systems need more structure and there- fore use balance column accounts, such as that in Exhibit 2.11.

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Chapter 2 Analyzing and Recording Transactions 61

The heading of the Balance column does not show whether it is a debit or credit balance. In- stead, an account is assumed to have a normal balance. Unusual events can sometimes temporarily give an account an abnormal balance. An abnormal balance refers to a balance on the side where decreases are recorded. For example, a customer might mistakenly overpay a bill. This gives that customer’s account receivable an abnormal (credit) balance. An abnormal balance is often identified by circling it or by entering it in red or some other unusual color. A zero bal- ance for an account is usually shown by writing zeros or a dash in the Balance column to avoid confusion between a zero balance and one omitted in error.

Posting Journal Entries Step 4 of processing transactions is to post journal entries to ledger accounts (see Exhibit 2.9). To ensure that the ledger is up-to-date, entries are posted as soon as pos- sible. This might be daily, weekly, or when time permits. All entries must be posted to the ledger before financial statements are prepared to ensure that account balances are up-to-date. When en- tries are posted to the ledger, the debits in journal entries are transferred into ledger accounts as debits, and credits are transferred into ledger accounts as credits. Exhibit 2.12 shows the four steps to post a journal entry. First, identify the ledger account that is debited in the entry; then, 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. (The letter G shows it came from the General Journal.) Second, enter the ledger account number in the PR column of the journal. Steps 3 and 4 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.

Analyzing Transactions — An Illustration We return to the activities of FastForward to show how double-entry accounting is useful in analyz- ing 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).

Study each transaction thoroughly before proceeding to the next. The first 11 transactions are from Chapter 1, and we analyze five additional December transactions of FastForward (num- bered 12 through 16) that were omitted earlier.

Point: A journal is often referred to as the book of original entry. The ledger is referred to as the book of final entry because financial statements are pre- pared from it.

Point: In the Demonstration Problem at the chapter end we show how to use “balance column accounts” for the ledger.

Point: Computerized systems often provide a code beside a balance such as dr. or cr. to identify its balance. Posting is automatic and immediate with accounting software.

A1 Analyze the impact of transactions on accounts and financial statements.

FASTForward1. Receive investment by Owner

2 Analyze Assets 5 Liabilities 1 Equity Cash Common Stock 130,000 5 0 130,000

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 5 Liabilities 1 Equity Cash Supplies 22,500 12,500 5 0 1 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

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62 Chapter 2 Analyzing and Recording Transactions

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 5 Liabilities 1 Equity Supplies Accounts

Payable 17,100 5 17,100 1 0

Date Account Titles and Explanation PR Debit Credit

5. Provide Services for Cash

1 Identify FastForward provides consulting services and immediately collects $4,200 cash.

2 Analyze Assets 5 Liabilities 1 Equity Cash Consulting Revenue 14,200 5 0 14,200

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

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 5 Liabilities 1 Equity Cash Equipment

226,000 126,000 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

6. Payment of Expense in Cash

1 Identify FastForward pays $1,000 cash for December rent.

2 Analyze Assets 5 Liabilities 1 Equity Cash Rent Expense 21,000 5 0 21,000

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

Point: Salary usually refers to compensation for an employee who receives a fixed amount for a given time period, whereas wages usually refers to compensation based on time worked.

7. Payment of Expense in Cash

1 Identify FastForward pays $700 cash for employee salary.

2 Analyze Assets 5 Liabilities 1 Equity Cash Salaries Expense 2700 5 0 2700

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

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Chapter 2 Analyzing and Recording Transactions 63

3 Record (11) Dividends 319 200 Cash 101 200

Date Account Titles and Explanation PR Debit Credit

11. Payment of Cash Dividend

1 Identify FastForward pays $200 cash for dividends.

2 Analyze

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 5 Liabilities 1 Equity

Cash Dividends 2200 5 0 2200

8. Provide Consulting and Rental Services on Credit

Point: Transaction 8 is a compound journal entry, which affects three or more accounts.

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 5 Liabilities 1 Equity

Accounts Consulting Rental Receivable Revenue Revenue

11,900 5 0 11,600 1300

Date Account Titles and Explanation PR Debit Credit

Point: The revenue recognition principle requires revenue to be recognized when earned, which is when the company provides products and services to a customer. This is not necessarily the same time that the customer pays. A customer can pay before or after products or services are provided.

9. Receipt of Cash on Account

1 Identify FastForward receives $1,900 cash from the client 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 5 Liabilities 1 Equity

Accounts Cash Receivable

11,900 21,900 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

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 5 Liabilities 1 Equity

Cash Accounts Payable 2900 5 2900 1 0

Date Account Titles and Explanation PR Debit Credit

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64 Chapter 2 Analyzing and Recording Transactions

Point: Luca Pacioli, a 15th-century monk, is considered a pioneer in accounting and the first to devise double-entry accounting.

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 obligates FastForward to perform future services and is a liability. No revenue is earned 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 5 Liabilities 1 Equity

Unearned Cash Consulting Revenue

13,000 5 13,000 1 0

Date Account Titles and Explanation PR Debit Credit

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 incurred 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 5 Liabilities 1 Equity

Prepaid Cash Insurance

22,400 12,400 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

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 5 Liabilities 1 Equity

Cash Supplies 2120 1120 5 0 1 0

Date Account Titles and Explanation PR Debit Credit

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Chapter 2 Analyzing and Recording Transactions 65

Accounting Equation Analysis 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 major columns corresponding to the accounting equation: assets, liabilities, and equity. Note several important points. First, as with each transaction, the totals for the three columns must obey the accounting equation. Specifically, assets equal $42,470 ($4,350 1 $0 1 $9,720 1 $2,400 1 $26,000); liabilities equal $9,200 ($6,200 1 $3,000); and equity equals $33,270 ($30,000 2 $200 1 $5,800 1 $300 2 $1,400 2 $1,000 2 $230). These numbers prove the ac- counting equation: Assets of $42,470 5 Liabilities of $9,200 1 Equity of $33,270. Second, the common stock, dividends, revenue, and expense accounts reflect the transactions that change equity. The latter three account categories underlie the statement of retained earnings. Third, the revenue and expense account balances will be summarized and reported in the income state- ment. Fourth, increases and decreases in the cash account make up the elements reported in the statement of cash flows.

Point: Technology does not provide the judgment required to analyze most business transactions. Analysis requires the expertise of skilled and ethical professionals.

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

15. Payment of Expense in Cash

1 Identify FastForward pays $230 cash for December utili- ties expense.

3 Record (15) Utilities Expense 690 230 Cash 101 230

(15) 230

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) 230

Cash 101

4 Post

2 Analyze Assets 5 Liabilities 1 Equity Utilities Cash Expense 2230 5 0 2230

Date Account Titles and Explanation PR Debit Credit

16. Payment of Expense in Cash

2 Analyze Assets 5 Liabilities 1 Equity Cash Salaries Expense 2700 5 0 2700

1 Identify FastForward pays $700 cash in employee salary for work performed in the latter part of December.

Point: We could merge transactions 15 and 16 into one compound entry.

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) 230

(16) 700

Cash 101

4 Post

Date Account Titles and Explanation PR Debit Credit

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66 Chapter 2 Analyzing and Recording Transactions

8. What types of transactions increase equity? What types decrease equity? 9. Why are accounting systems called double-entry? 10. For each transaction, double-entry accounting requires which of the following? (a) Debits

to asset accounts must create credits to liability or equity accounts, (b) a debit to a liability account must create a credit to an asset account, or (c) total debits must equal total credits.

11. An owner invests $15,000 cash along with equipment having a market value of $23,000 in a company in exchange for common stock. Prepare the necessary journal entry.

12. Explain what a compound journal entry is. 13. Why are posting reference numbers entered in the journal when entries are posted to ledger

accounts?

Quick Check Answers — p. 77

EXHIBIT 2.13 Ledger for FastForward (in T-Account Form)

Assets 5 Liabilities 1 Equity

$42,470 5 $9,200 1 $33,270

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) 230

(16) 700

Balance 4,350

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

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) 230

Accounts in this white area reflect those reported on the income statement.

Salaries Expense 622

(7) 700

(16) 700

Balance 1,400

Unearned Consulting Revenue 236

(12) 3,000

General Ledger

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Chapter 2 Analyzing and Recording Transactions 67

Double-entry accounting requires the sum of debit account balances to equal the sum of credit account balances. A trial balance is used to confirm this. A trial balance is a list of accounts and their balances at a point in time. Account balances are reported in their appropriate debit or credit columns of a trial balance. A trial balance can be used to confirm this and to follow up on any abnormal or unusual balances. Exhibit 2.14 shows the trial balance for FastForward after its 16 entries have been posted to the ledger. (This is an unadjusted trial balance — Chapter 3 ex- plains the necessary adjustments.)

TRIAL BALANCE

Preparing a Trial Balance Preparing a trial balance involves three steps:

1. List each account title and its amount (from 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 entirely).

2. Compute the total of debit balances and the total of credit balances. 3. Verify ( prove) total debit balances equal total credit balances.

The total of debit balances equals the total of credit balances for the trial balance in Exhibit 2.14. Equality of these two totals does not guarantee that no errors were made. For example, the column totals still will be equal when a debit or credit of a correct amount is made to a wrong account. Another error that does not cause unequal column totals occurs when equal debits and credits of an incorrect amount are entered.

Searching for and Correcting Errors If the trial balance does not balance (when its columns are not equal), the error (or errors) must be found and corrected. An efficient way to search for an error is to check the journalizing, posting, and trial balance preparation

Point: A trial balance is not a financial statement but a mechanism for checking equality of debits and credits in the ledger. Financial statements do not have debit and credit columns.

Point: The ordering of accounts in a trial balance typically follows their identification number from the chart of accounts.

EXHIBIT 2.14 Trial Balance (Unadjusted)

Cash

Accounts receivable

Supplies

Prepaid insurance

Equipment

Accounts payable

Unearned consulting revenue

Common stock

Dividends

Consulting revenue

Rental revenue

Salaries expense

Rent expense

Utilities expense

45,300

6,200

3,000

30,000

5,800

300

FASTFORWARD Trial Balance

December 31, 2013

Debit Credit

Totals

$

4,350

0

9,720

2,400

26,000

200

1,400

1,000

230

45,300$

$

$

P2 Prepare and explain the use of a trial balance.

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68 Chapter 2 Analyzing and Recording Transactions

in reverse order. Step 1 is to verify that the trial balance columns are correctly added. If step 1 fails to 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. If the error is still undiscovered, 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.3

If an error in a journal entry is discovered before the error is posted, it can be corrected in a manual system by drawing a line through the incorrect information. The correct information is written above it to create a record of change for the auditor. Many computerized systems allow the operator to replace the incorrect information directly. If an error in a journal entry is not discovered until after it is posted, we do not strike through both erroneous entries in the journal and ledger. Instead, we correct this error by creating a cor- recting entry that removes the amount from the wrong account and records it to the correct ac- count. As an example, suppose a $100 purchase of supplies is journalized with an incorrect debit to Equipment, and then this incorrect entry is posted to the ledger. The Supplies ledger account balance is understated by $100, and the Equipment ledger account balance is overstated by $100. The correcting entry is: debit Supplies and credit Equipment (both for $100).

Using a Trial Balance to Prepare Financial Statements This section shows how to prepare financial statements from the trial balance in Exhibit 2.14 and from information on the December transactions of FastForward. These statements differ from those in Chapter 1 because of several additional transactions. These statements are also more precisely called unadjusted statements because we need to make some further accounting adjust- ments (described in Chapter 3).

How financial statements are linked in time is illustrated in Exhibit 2.15. A balance sheet reports on an organiza- tion’s financial position at a point in time. The income statement, statement of retained earnings, and statement of cash flows report on financial perfor- mance over a period of time. The three statements in the middle column of Ex- hibit 2.15 link balance sheets from the beginning to the end of a reporting pe- riod. They explain how financial posi- tion changes from one point to another.

Preparers and users (including regu- latory agencies) determine the length of the reporting period. A one-year, or annual, reporting period is common, as are semiannual, quarterly, and monthly periods. The one-year reporting period

Example: If a credit to Unearned Revenue was incorrectly posted from the journal as a credit to the Revenue ledger account, would the ledger still balance? Would the financial statements be correct? Answers: The ledger would balance, but liabilities would be under- stated, equity would be overstated, and income would be overstated (all because of overstated revenues).

Point: The IRS requires companies to keep records that can be audited.

3 Transposition occurs when two digits are switched, or transposed, within a number. If transposition is the only error, it yields a difference between the two trial balance totals that is evenly divisible by 9. For example, assume that a $691 debit in an entry is incorrectly posted to the ledger as $619. Total credits in the trial balance are then larger than total debits by $72 ($691 2 $619). The $72 error is evenly divisible by 9 (72y9 5 8). The first digit of the quotient (in our example it is 8) equals the difference between the digits of the two transposed numbers (the 9 and the 1). The number of digits in the quotient also tells the location of the transposition, starting from the right. The quotient in our example had only one digit (8), so it tells us the transposition is in the first digit. Consider another example where a transposi- tion error involves posting $961 instead of the correct $691. The difference in these numbers is $270, and its quotient is 30 (270y9). The quotient has two digits, so it tells us to check the second digit from the right for a transposition of two numbers that have a difference of 3.

EXHIBIT 2.15 Links between Financial Statements across Time

Point in time Point in timePeriod of time

Beginning balance sheet

Ending balance sheet

Income statement

Statement of retained earnings

Statement of cash flows

P3 Prepare financial statements from business transactions.

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Chapter 2 Analyzing and Recording Transactions 69

FASTFORWARD Balance Sheet

December 31, 2013

Assets Liabilities

Cash . . . . . . . . . . . . $ 4,350 Accounts payable . . . . . . . . $ 6,200

Supplies . . . . . . . . . . 9,720 Unearned revenue . . . . . . . 3,000

Prepaid insurance . . 2,400 Total liabilities . . . . . . . . . . . 9,200

Equipment . . . . . . . 26,000 Equity

Common stock . . . . . . . . . . 30,000

Retained earnings . . . . . . . . 3,270

Total equity . . . . . . . . . . . . . 33,270

Total assets . . . . . . . $42,470 Total liabilities and equity . . $42,470

is known as the accounting, or fiscal, year. Businesses whose accounting year begins on January 1 and ends on December 31 are known as calendar-year companies. Polaris is a calendar-year company. Many companies choose a fiscal year ending on a date other than December 31. Arctic Cat is a noncalendar-year company as reflected in the headings of its March 31 year-end financial statements in Appendix A near the end of the book.

Income Statement An income statement reports the revenues earned less the expenses incurred by a business over a period of time. FastForward’s income statement for December is shown at the top of Exhibit 2.16. Information about revenues and expenses is conveniently taken from the trial balance in Exhibit 2.14. Net income of $3,470 is reported at the bottom of the statement. Owner investments and dividends are not part of income.

Statement of Retained Earnings The statement of retained earnings reports informa- tion about how retained earnings change over the reporting period. FastForward’s statement of retained earnings is the second report in Exhibit 2.16. It shows the $3,470 of net income, the

Point: A statement’s heading lists the 3 W’s: Who — name of organization, What — name of statement, When — statement’s 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.

EXHIBIT 2.16 Financial Statements and Their Links

FASTFORWARD Income Statement

For Month Ended December 31, 2013

Revenues Consulting revenue ($4,200 1 $1,600) . . . . . . . . . $ 5,800

Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

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

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,630

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,470

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2013

Retained earnings, December 1, 2013 . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,470

3,470

Less: Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . 200

Retained earnings, December 31, 2013 . . . . . . . . . . . $ 3,270

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70 Chapter 2 Analyzing and Recording Transactions

$200 dividend, and the $3,270 end-of-period balance. (The beginning balance in the statement of retained earnings is rarely zero; an exception is for the first period of operations. The begin- ning balance in January 2014 is $3,270, which is December’s ending balance.)

Balance Sheet The balance sheet reports the financial position of a company at a point in time, usually at the end of a month, quarter, or year. FastForward’s balance sheet is the third report in Exhibit 2.16. This statement refers to financial condition at the close of business on December 31. The left side of the balance sheet lists its assets: cash, supplies, prepaid insur- ance, 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 balance of $33,270. Note the link between the ending balance of the statement of retained earnings and the retained earnings balance. (Recall that this presentation of the bal- ance 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. Either presentation is acceptable.)

14. Where are dollar signs typically entered in financial statements? 15. If a $4,000 debit to Equipment in a journal entry is incorrectly posted to the ledger as a

$4,000 credit, and the ledger account has a resulting debit balance of $20,000, what is the effect of this error on the Trial Balance column totals?

16. Describe the link between the income statement and the statement of retained earnings. 17. Explain the link between the balance sheet and the statement of retained earnings. 18. Define and describe revenues and expenses. 19. Define and describe assets, liabilities, and equity.

Quick Check Answers — p. 77

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. The usual practice is to put dollar signs beside only the first and last numbers in a column. Polaris’s financial statements in Ap- pendix A show this. When amounts are entered in a journal, ledger, or trial balance, commas are optional to indicate thousands, millions, and so forth. However, commas are always used in fi- nancial statements. Companies also commonly round amounts in reports to the nearest dollar, or even to a higher level. Polaris is typical of many companies in that it rounds its financial state- ment amounts to the nearest thousand (or million). This decision is based on the perceived im- pact of rounding for users’ business decisions.

Point: Knowing how financial statements are prepared improves our analysis of them.

Point: An income statement is also called an earnings statement, a statement of operations, or a P&L (profit and loss) statement. A balance sheet is also called a statement of financial position.

Point: While revenues increase equity, and expenses decrease equity, the amounts are not reported in detail in the statement of retained earnings. In- stead, their effects are reflected through net income.

Financial accounting according to U.S. GAAP is similar, but not identical, to IFRS. This section discusses differences in analyzing and recording transactions, and with the preparation of financial statements.

Analyzing and Recording Transactions Both U.S. GAAP and IFRS include broad and similar guidance for financial accounting. As the FASB and IASB work toward a common conceptual framework over the next few years, even those differences will fade. Further, both U.S. GAAP and IFRS apply transaction

GLOBAL VIEW

Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. You find that most of your customers demand to buy on credit. How can you use the balance sheets of these customers to decide which ones to extend credit to? ■ [Answer—p. 76]

Decision Maker

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Chapter 2 Analyzing and Recording Transactions 71

Decision AnalysisDebt Ratio

analysis and recording as shown in this chapter—using the same debit and credit system and accrual account- ing. Although some variations exist in revenue and expense recognition and other accounting principles, all of the transactions in this chapter are accounted for identically under these two systems.

Financial Statements Both U.S. GAAP and IFRS prepare the same four basic financial state- ments. A few differences within each statement do exist and we will discuss those throughout the book. For example, both U.S. GAAP and IFRS require balance sheets to separate current items from noncurrent items. However, while U.S. GAAP balance sheets report current items first, IFRS balance sheets normally (but are not required to) present noncurrent items first, and equity before liabilities. To illustrate, a con- densed version of Piaggio’s balance sheet follows (numbers using Euros in thousands).

PIAGGIO Balance Sheet (in thousands of Euros)

December 31, 2011

Assets Equity and Liabilities

Noncurrent assets . . . . . . . . 1,010,476 Total equity . . . . . . . . . . . . . . . . . . . 446,218

Current assets . . . . . . . . . . . . 509,708 Noncurrent liabilities . . . . . . . . . . . . 429,689

Current liabilities . . . . . . . . . . . . . . . 644,277

Total assets . . . . . . . . . . . . . . 1,520,184 Total equity and liabilities . . . . . . . . 1,520,184

Accounting Controls and Assurance Accounting systems depend on control procedures that assure the proper principles were applied in processing accounting information. The passage of SOX leg- islation strengthened U.S. control procedures in recent years. However, global standards for control are diverse and so are enforcement activities. Consequently, while global accounting standards are converg- ing, their application in different countries can yield different outcomes depending on the quality of their auditing standards and enforcement.

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

An important business objective is gathering information to help 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 rela- tively large portion of its assets with liabilities is said to have a high degree of financial leverage. Higher financial leverage involves greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). The risk that a company might not be able to meet such required payments is higher if it has more liabilities (is more highly leveraged). One way to assess the risk associ- ated with a company’s use of liabilities is to compute the debt ratio as in Exhibit 2.17.

Debt ratio 5 Total liabilities

Total assets

EXHIBIT 2.17 Debt Ratio

Accounting Control Recording valid transactions, and not recording fraudulent transactions, enhances the quality of financial statements. The graph here shows the percentage of employ- ees in  information technology that report observing specific types of misconduct within the past year [Source: KPMG 2009]. ■

Percent Citing Misconduct

0% 10% 30%20%

Breaching database controls 23%

Mishandling private information 22%

Breaching customer privacy 16%

Falsifying accounting data 9%

Decision Insight

PIAGGIO

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72 Chapter 2 Analyzing and Recording Transactions

To see how to apply the debt ratio, let’s look at Skechers’s liabilities and assets. The company designs, markets, and sells footwear for men, women, and children under the Skechers brand. Exhibit 2.18 com- putes and reports its debt ratio at the end of each year from 2006 to 2011.

Point: Compare the equity amount to the liability amount to assess the extent of owner versus nonowner financing.

Skechers’s debt ratio ranges from a low of 0.23 to a high of 0.39—also, see graph in margin. Its ratio is lower, compared with the industry ratio. This analysis implies a low risk from its financial leverage. Is financial leverage good or bad for Skechers? To answer that question we need to compare the com- pany’s return on the borrowed money to the rate it is paying creditors. If the company’s return is higher, it is successfully borrowing money to make more money. A company’s success with making money from borrowed money can quickly turn unprofitable if its own return drops below the rate it is paying creditors.

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

$ in millions 2011 2010 2009 2008 2007 2006

Total liabilities . . . . . . . . . . . . $ 389 $ 359 $246 $204 $201 $288

Total assets . . . . . . . . . . . . . . $1,282 $1,305 $996 $876 $828 $737

Debt ratio . . . . . . . . . . . . . 0.30 0.28 0.25 0.23 0.24 0.39

Industry debt ratio . . . . . . . . 0.47 0.49 0.51 0.50 0.46 0.48

Liabilities($)Skechers: Assets($) Debt ratio(%)

$0 2008200920102011 2007 2006

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$1000 $1100 $1200

$1300

$900 00

15%

0.0%

30%

45%

$800

(This problem extends the demonstration problem of Chapter 1.) After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred dur- ing its first month.

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

b. On August 2, Expressions paid $600 cash for furniture for the shop. c. On August 3, Expressions paid $500 cash to rent space in a strip mall for August. d. On August 4, it purchased $1,200 of equipment on credit for the shop (using a long-term note payable). e. On August 5, Expressions opened for business. Cash received from haircutting services in the first week

and a half of business (ended August 15) was $825. f. On August 15, it provided $100 of haircutting services on account. g. On August 17, it received a $100 check for services previously rendered on account. h. On August 17, it paid $125 to an assistant for hours worked during the grand opening. i. Cash received from services provided during the second half of August was $930. j. On August 31, it paid a $400 installment toward principal on the note payable entered into on August 4. k. On August 31, it paid $900 cash in dividends 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); Note Payable (240); Common Stock (307); Dividends (319); Haircutting Services Revenue (403); Wages Expense (623); and Rent Expense (640). Prepare general journal entries for the transactions.

2. Post the journal entries from (1) to the ledger accounts.

DEMONSTRATION PROBLEM

Investor You consider buying stock in Converse. As part of your analysis, you compute its debt ratio for 2011, 2012, and 2013 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 aver- ages 0.40.) ■ [Answer—p. 76]

Decision Maker

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Chapter 2 Analyzing and Recording Transactions 73

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 experience 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 TO DEMONSTRATION PROBLEM 1. General journal entries:

Aug. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 3,000

Store Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 15,000

Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 18,000

Owner’s investment 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

Note Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 1,200

Purchased additional equipment on credit.

15 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 825

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . 403 825

Cash receipts from first half of August.

Date Account Titles and Explanation PR Debit Credit Page 1

[continued on next page]

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74 Chapter 2 Analyzing and Recording Transactions

15 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

Haircutting Services Revenue . . . . . . . . . . . . . . . . . . . . . 403 100

To record revenue for services provided on account.

17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 100

To record cash received as payment on account.

17 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 Note Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 400

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 400

Paid an installment on the note payable.

31 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 900

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 900

Paid cash dividend.

[continued from previous page]

2. Post journal entries from part 1 to the ledger accounts:

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

17 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. 15 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

Note Payable Account No. 240

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 15 G1 100 925 31 G1 930 1,855

Wages Expense Account No. 623

Date PR Debit Credit Balance

Aug. 17 G1 125 125

Rent Expense Account No. 640

Date PR Debit Credit Balance

Aug. 3 G1 500 500

General Ledger

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Chapter 2 Analyzing and Recording Transactions 75

3. Prepare a trial balance from the ledger:

EXPRESSIONS Trial Balance

August 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,330

Accounts receivable . . . . . . . . . . . . . . . 0

Furniture . . . . . . . . . . . . . . . . . . . . . . . . 600

Store equipment . . . . . . . . . . . . . . . . . . 16,200

Note payable . . . . . . . . . . . . . . . . . . . . $ 800

Common stock . . . . . . . . . . . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . 900

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

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

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

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . $20,655 $20,655

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

4.

5.

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

6.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities

Cash . . . . . . . . . . . . . . . . . . $ 2,330 Note 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

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76 Chapter 2 Analyzing and Recording Transactions

7. Debt ratio 5

Total liabilities

Total assets 5

$800

$19,130 5 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

C1 Explain the steps in processing transactions and the role of source documents. The accounting process identifies business transactions and events, analyzes and records their effects, and sum- marizes and prepares information useful in making decisions. Trans- actions and events are the starting points in the accounting process. Source documents identify and describe transactions and events. Examples are sales tickets, checks, purchase orders, bills, and bank statements. Source documents provide objective and reliable evi- dence, making information more useful. The effects of transactions and events are recorded in journals. Posting along with a trial bal- ance helps summarize and classify these effects.

C2 Describe an account and its use in recording transactions. An account is a detailed record of increases and decreases in a specific asset, liability, equity, revenue, or expense. Information from accounts is analyzed, summarized, and presented in reports and financial statements for decision makers.

C3 Describe a ledger and a chart of accounts. The ledger (or general ledger) is a record containing all accounts used by a company and their balances. It is referred to as the books. The chart of accounts is a list of all accounts and usually includes an identifi- cation number assigned to each account.

C4 Define debits and credits and explain double-entry account-ing. Debit refers to left, and credit refers to right. Debits in- crease assets, expenses, and dividends while credits decrease them. Credits increase liabilities, common stock, and revenues; debits decrease them. Double-entry accounting means each transaction affects at least two accounts and has at least one debit and one credit. The system for recording debits and credits follows from the accounting equation. The left side of an account is the normal

Summary balance for assets, dividends, and expenses, and the right side is the normal balance for liabilities, common stock, and revenues.

A1 Analyze the impact of transactions on accounts and finan-cial statements. We analyze transactions using concepts of double-entry accounting. This analysis is performed by determining a transaction’s effects on accounts. These effects are recorded in journals and posted to ledgers.

A2 Compute the debt ratio and describe its use in analyzing financial condition. A company’s debt ratio is computed as total liabilities divided by total assets. It reveals how much of the assets are financed by creditor (nonowner) financing. The higher this ratio, the more risk a company faces because liabilities must be repaid at specific dates.

P1 Record transactions in a journal and post entries to a ledger. Transactions are recorded in a journal. Each entry in a journal is posted to the accounts in the ledger. This provides infor- mation that is used to produce financial statements. Balance column accounts are widely used and include columns for debits, credits, and the account balance.

P2 Prepare and explain the use of a trial balance. A trial bal-ance is a list of accounts from the ledger showing their debit or credit balances in separate columns. The trial balance is a sum- mary of the ledger’s contents and is useful in preparing financial statements and in revealing recordkeeping errors.

P3 Prepare financial statements from business transactions. The balance sheet, the statement of retained earnings, the income statement, and the statement of cash flows use data from the trial balance (and other financial statements) for their preparation.

Cashier The advantages to the process proposed by the assistant manager include improved customer service, fewer delays, and less work for you. However, you should have serious concerns about internal control and the potential for fraud. In particular, the assis- tant manager could steal cash and simply enter fewer sales to match the remaining cash. You should reject her suggestion without the manager’s approval. Moreover, you should have an ethical concern about the assistant manager’s suggestion to ignore store policy.

Entrepreneur We can use the accounting equation (Assets 5 Liabilities 1 Equity) to help us identify risky customers to whom we

would likely not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would extend credit. A low equity means the business has little value that does not already have creditor claims to it.

Investor The debt ratio suggests the stock of Converse is of higher risk than normal and that this risk is rising. The average in- dustry ratio of 0.40 further supports this conclusion. The 2013 debt ratio for Converse is twice the industry norm. Also, a debt ratio ap- proaching 1.0 indicates little to no equity.

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 2 Analyzing and Recording Transactions 77

Account (p. 53)

Account balance, or Balance (p. 60)

Balance column account (p. 60)

Chart of accounts (p. 56)

Compound journal entry (p. 63)

Credit (p. 57)

Creditors (p. 54)

Debit (p. 57)

Debt ratio (p. 71)

Dividends (p. 55)

Double-entry accounting (p. 57)

General journal (p. 58)

General ledger (p. 53)

Journal (p. 58)

Journalizing (p. 58)

Posting (p. 58)

Posting reference (PR) column (p. 60)

Source documents (p. 52)

T-accounts (p. 57)

Trial balance (p. 67)

Unearned revenue (p. 55)

Key Terms

1. Examples of source documents are sales tickets, checks, purchase orders, charges to customers, bills from suppliers, employee earnings records, and bank statements.

2. Source documents serve many purposes, including record- keeping and internal control. Source documents, especially if obtained from outside the organization, provide objective and reliable evidence about transactions and their amounts.

3.

Assets a,c,e

Liabilities

b,d

Equity —

4. An account is a record in an accounting system that records and stores the increases and decreases in a specific asset, liability, equity, revenue, or expense. The ledger is a collection of all the accounts of a company.

5. A company’s size and diversity affect the number of accounts in its accounting system. The types of accounts depend on infor- mation the company needs to both effectively operate and re- port its activities in financial statements.

6. No. Debit and credit both can mean increase or decrease. The particular meaning in a circumstance depends on the type of account. For example, a debit increases the balance of asset, dividends, and expense accounts, but it decreases the balance of liability, common stock, and revenue accounts.

7. A chart of accounts is a list of all of a company’s accounts and their identification numbers.

8. Equity is increased by revenues and by owner investments. Equity is decreased by expenses and dividends.

9. The name double-entry is used because all transactions affect at least two accounts. There must be at least one debit in one ac- count and at least one credit in another account.

10. The answer is (c). 11.

12. A compound journal entry affects three or more accounts. 13. Posting reference numbers are entered in the journal when post-

ing to the ledger as a cross-reference that allows the record- keeper or auditor to trace debits and credits from one record to another.

14. At a minimum, dollar signs are placed beside the first and last numbers in a column. It is also common to place dollar signs beside any amount that appears after a ruled line to indicate that an addition or subtraction has occurred.

15. The Equipment account balance is incorrectly reported at $20,000 — it should be $28,000. The effect of this error under- states the trial balance’s Debit column total by $8,000. This results in an $8,000 difference between the column totals.

16. An income statement reports a company’s revenues and ex- penses along with the resulting net income or loss. A statement of retained earnings reports changes in retained earnings, in- cluding that from net income or loss. Both statements report transactions occurring over a period of time.

17. The balance sheet describes a company’s financial position (assets, liabilities, and equity) at a point in time. The retained earnings amount in the balance sheet is obtained from the state- ment of retained earnings.

18. Revenues are inflows of assets in exchange for products or ser- vices provided to customers as part of the main operations of a business. Expenses are outflows or the using up of assets that result from providing products or services to customers.

19. Assets are the resources a business owns or controls that carry expected future benefits. Liabilities are the obligations of a business, representing the claims of others against the assets of a business. Equity reflects the owner’s claims on the assets of the business after deducting liabilities.

Guidance Answers to Quick Checks

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000

Common Stock . . . . . . . . . . . . . . . . . . . . . 38,000

Investment by owner of cash and equipment.

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78 Chapter 2 Analyzing and Recording Transactions

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 account 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 en-

tries? 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, (c) equity, and (d ) net assets. 15. Which financial statement is sometimes called the statement of

financial position? 16. Review the Polaris balance sheet in Appen-

dix A. Identify three accounts on its balance sheet that carry debit balances and three accounts on its bal- ance sheet that carry credit balances.

17. Review the Arctic Cat balance sheet in Appen- dix A. Identify an asset with the word receivable in its account title and a liability with the word payable in its account title.

18. Locate KTM’s income statement in Appendix A. What is the title of its revenue account?

19. Refer to Piaggio’s balance sheet in Appen dix A. What does Piaggio title its current asset refer- ring to merchandise available for sale?

Discussion Questions

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 93 mhhe.com/wildFINMAN5e

1. Amalia Company received its utility bill for the current period 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 Common Stock for $700. 2. On May 1, Mattingly Lawn Service collected $2,500 cash from a

customer in advance of five months of lawn service. 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 Common Stock for $2,500. 3. Liang Shue contributed $250,000 cash and land worth $500,000

to open his new business, Shue Consulting Corporation. 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 being 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, liabili-

ties of $400,000, and equity of $600,000. What is its debt ratio (rounded to a whole percent)?

a. 250% b. 167% c. 67% d. 150% e. 40%

Icon denotes assignments that involve decision making.

Polaris

Arctic Cat

KTM

PIAGGIO

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Chapter 2 Analyzing and Recording Transactions 79

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 ticket d. Telephone bill g. Balance sheet b. Income statement e. Invoice from supplier h. Prepaid insurance c. Trial balance f. Company revenue account i. Bank statement

QS 2-2 Identifying financial statement items

C2 P3

Identify the financial statement(s) where each of the following items appears. Use I for income statement, E for statement of retained earnings, and B for balance sheet. a. Office equipment d. Prepaid insurance g. Cash b. Cash dividends e. Office supplies h. Unearned rent revenue c. Revenue f. Rent expense i. Accounts payable

QS 2-6 Preparing journal entries

P1

Prepare journal entries for each of the following selected transactions. a. On May 15, DeShawn Tyler opens a landscaping company called Elegant Lawns by investing $70,000

cash along with equipment having a $30,000 value in exchange for common stock. b. On May 21, Elegant Lawns purchases office supplies on credit for $280. c. On May 25, Elegant Lawns receives $7,800 cash for performing landscaping services. d. On May 30, Elegant Lawns receives $1,000 cash in advance of providing landscaping ser vices to a

customer.

QS 2-5 Analyzing debit or credit by account

A1

Identify whether a debit or credit yields 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 Office Expense h. To decrease Accounts Receivable d. To increase Fees Earned i. To increase Common Stock e. To decrease Unearned Revenue j. To increase Store Equipment

QS 2-7 Identifying a posting error

P2

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 is 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 is 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 in a journal entry is 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 2-3 Identifying normal balance

C4

Identify the normal balance (debit or credit) for each of the following accounts. a. Office Supplies d. Wages Expense g. Wages Payable b. Dividends e. Accounts Receivable h. Building c. Fees Earned f. Prepaid Rent i. Common Stock

QS 2-4 Linking debit or credit with normal balance

C4

Indicate whether a debit or credit decreases the normal balance of each of the following accounts. a. Service Revenue e. Common Stock i. Dividends b. Interest Payable f. Prepaid Insurance j. Unearned Revenue c. Accounts Receivable g. Buildings k. Accounts Payable d. Salaries Expense h. Interest Revenue l. Land

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80 Chapter 2 Analyzing and Recording Transactions

QS 2-8 Classifying accounts in financial statements

P3

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

Exercise 2-2 Identifying and classifying accounts

C2

Enter the number for the item that best completes each of the descriptions below. 1. Asset 3. Account 5. Three 2. Equity 4. Liability a. An is a record of increases and decreases in a specific asset, liability, equity, revenue, or

expense item. b. Accounts payable, unearned revenue, and note payable are examples of accounts. c. Accounts receivable, prepaid accounts, supplies, and land are examples of accounts. d. Accounts are arranged into general categories. e. Common stock and dividends are examples of accounts.

Exercise 2-3 Identifying a ledger and chart of accounts

C3

Enter the number for the item that best completes each of the descriptions below. 1. Chart 2. General ledger a. The is a record containing all accounts used by a company. b. A of accounts is a list of all accounts a company uses.

Exercise 2-5 Analyzing account entries and balances

A1

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 Receiv- able was $89,000. Determine the amount of sales on account that occurred in October.

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.

Exercise 2-4 Identifying type and normal balances of accounts

C4

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. Cash e. Accounts Receivable i. Fees Earned b. Legal Expense f. Dividends j. Equipment c. Prepaid Insurance g. License Fee Revenue k. Notes Payable d. Land h. Unearned Revenue l. Common Stock

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. Analyze each transaction from source documents. b. Prepare and analyze the trial balance. c. Record relevant transactions in a journal. d. Post journal information to ledger accounts.

QS 2-9 International accounting standards

C4

Answer each of the following questions related to international accounting standards. a. What type of entry system is applied when accounting follows IFRS? b. Identify the number and usual titles of the financial statements prepared under IFRS. c. How do differences in accounting controls and enforcement impact accounting reports prepared across

different countries?

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Chapter 2 Analyzing and Recording Transactions 81

Exercise 2-7 Preparing general journal entries

P1

Prepare general journal entries for the following transactions of a new company called Pose-for-Pics.

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 2-8 Preparing T-accounts (ledger) and a trial balance P2

Use the information in Exercise 2-7 to prepare an August 31 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, post the general journal entries to these T-accounts (which will serve as the ledger), and prepare the trial balance.

Exercise 2-10 Preparing a trial balance P2

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, 2013, as its report date.

Exercise 2-6 Analyzing effects of transactions on accounts

A1

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) computer equipment worth $80,000, and (3) to assume responsibility for a $28,000 note payable related to the computer equipment. The entry Groro makes to record this transaction includes which one or more of the following? a. $28,000 increase in a liability account d. $62,000 increase in an asset account b. $10,000 increase in the Cash account e. $62,000 increase in a revenue account c. $10,000 increase in a revenue account f. $62,000 increase in an equity account

Exercise 2-9 Recording effects of transactions in T-accounts

A1

Prepare general journal entries to record the transactions below for Spade Company by using the fol- lowing 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 serves 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 $10,000 cash in dividends to Spade (sole shareholder).

Check Cash ending balance, $94,850

Exercise 2-11 Analyzing and journalizing revenue transactions

A1 P1

Examine the following transactions and identify those that create revenues for Valdez Services, a company owned by Brina Valdez. Prepare general journal entries to record those revenue transactions and explain why the other transactions did not create revenues. a. Brina Valdez invests $39,350 cash in the company in exchange for common stock. b. The company provided $2,300 of services on credit. c. The company provided services to a client and immediately received $875 cash. d. The company received $10,200 cash from a client in payment for services to be provided next year. e. The company received $3,500 cash from a client in partial payment of an account receivable. f. The company borrowed $120,000 cash from the bank by signing a promissory note.

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82 Chapter 2 Analyzing and Recording Transactions

Exercise 2-15 Preparing a balance sheet P3

Use the information in Exercise 2-13 (if completed, you can also use your solution to Exercise 2-14) to prepare an August 31 balance sheet for Help Today.

Exercise 2-13 Preparing an income statement

C3 P3

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 accounts and amounts for the month of August. Use this information to prepare an August income statement for the business.

Cash . . . . . . . . . . . . . . . . . . . . . . $ 25,360 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000

Accounts receivable . . . . . . . . . 22,360 Consulting fees earned . . . . . . . . . . . . . . . . . . . . . 27,000

Office supplies . . . . . . . . . . . . . . 5,250 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,550

Land . . . . . . . . . . . . . . . . . . . . . . 44,000 Salaries expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600

Office equipment . . . . . . . . . . . 20,000 Telephone expense . . . . . . . . . . . . . . . . . . . . . . . . 860

Accounts payable . . . . . . . . . . . 10,500 Miscellaneous expenses. . . . . . . . . . . . . . . . . . . . . 520

Common stock . . . . . . . . . . . . . 102,000 Check Net income, $10,470

Exercise 2-16 Computing net income

A1

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

Determine the net income earned or net loss incurred by the business during the year for each of the follow- ing 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 ex-

change for common stock. d. Dividends were $1,250 cash per month and the owner invested an additional $35,000 cash in ex-

change for common stock.

Exercise 2-17 Analyzing changes in a company’s equity

P3

Compute the missing amount for each of the following separate companies a through d.

Owner investments for stock during the year Dividends during the year

Exercise 2-12 Analyzing and journalizing expense transactions

A1 P1

Examine the following transactions and identify those that create expenses for Valdez Services. Prepare general journal entries to record those expense transactions and explain why the other transactions did not create expenses. a. The company paid $12,200 cash for payment on a 16-month old liability for office supplies. b. The company paid $1,233 cash for the just completed two-week salary of the receptionist. c. The company paid $39,200 cash for equipment purchased. d. The company paid $870 cash for this month’s utilities. e. The company paid $4,500 cash in dividends.

Exercise 2-14 Preparing a statement of retained earnings P3

Use the information in Exercise 2-13 to prepare an August statement of retained earnings for Help Today. (The owner invested a total of $102,000 in the company in exchange for common stock on August 1.)

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Chapter 2 Analyzing and Recording Transactions 83

Exercise 2-19 Preparing general journal entries

P1

Use information from the T-accounts in Exercise 2-18 to prepare general journal entries for each of the seven transactions a through g.

Exercise 2-21 Analyzing a trial balance error

A1 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 a $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. Answer each of the following questions and compute the dollar amount of any misstatement.

Exercise 2-20 Identifying effects of posting errors on the trial balance

A1 P2

Posting errors are identified in the following table. In column (1), enter the amount of the difference between 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.

(1) (2) (3) (4) Difference between Column with Identify Amount that Debit and Credit the Larger Account(s) Account(s) Is Description of Posting Error Columns Total Incorrectly Over- or 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.

Exercise 2-18 Interpreting and describing transactions from T-accounts

A1

Assume the following T-accounts reflect Belle Co.’s general ledger and that seven transactions a through g are posted to them. Provide a short description of each transaction. Include the amounts in your descriptions.

(a) 6,000

(e) 4,500

(b) 4,800

(c) 900

(f ) 1,600

(g) 820

Cash

(a) 12,000

Automobiles

(c) 900

(d) 300

Office Supplies

(f ) 1,600 (d) 10,000

Accounts Payable

(b) 4,800

Prepaid Insurance

(a) 25,600

Common Stock

(a) 7,600

(d) 9,700

Equipment

(e) 4,500

Delivery Services Revenue

(g) 820

Gas and Oil Expense

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84 Chapter 2 Analyzing and Recording Transactions

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?

b. Of the six companies, which business relies most heavily on creditor financing? c. Of the six companies, which business relies most heavily on equity financing? d. Which two companies indicate the greatest risk? e. Which two companies earn the highest return on assets? f. Which one company would investors likely prefer based on the risk–return relation?

Exercise 2-22 Interpreting the debt ratio and return on assets

A2

a. Calculate the debt ratio and the return on assets using the year-end information for each of the follow- ing six separate companies ($ thousands).

Case

Company 3

Company 5 Company 6

32,500

92,000 104,500

26,650

31,280 52,250

50,000

40,000 80,000

650

7,520 12,000

Company 1 $90,500 $11,765 $100,000 $20,000

Company 4 147,000 55,860 200,000 21,000

Company 2 64,000 46,720 40,000 3,800

Assets Liabilities Average Assets Net Income

Current liabilities . . . . . . . . €11,519 Noncurrent liabilities . . . . . . . . €7,767

Current assets . . . . . . . . . . . 17,682 Noncurrent assets . . . . . . . . . . 9,826

Total equity . . . . . . . . . . . . . 8,222

Exercise 2-23 Preparing a balance sheet following IFRS

P3

BMW reports the following balance sheet accounts for the year ended December 31, 2011 (euro in millions). Prepare the balance sheet for this company as of December 31, 2011, following the usual IFRS formats.

PROBLEM SET A

Problem 2-1A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Aracel Engineering completed the following transactions in the month of June. a. To launch the company, Jenna Aracel, the owner, invested $100,000 cash, office equipment with a

value of $5,000, and $60,000 of drafting equipment 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. 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 $9,480 cash in dividends.

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Chapter 2 Analyzing and Recording Transactions 85

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

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); 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.

Problem 2-3A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Karla Tanner opens a Web consulting business called Linkworks and completes the following transactions in its first month of operations.

April 1 Tanner invests $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 $5,500 cash in dividends. 29 The company purchased $600 of additional office supplies on credit. 30 The company paid $435 cash for this month’s utility bill.

(3) Trial balance totals, $261,733

Check (2) Ending balances: Cash, $22,945; Accounts Receivable, $29,000; Accounts Payable, $1,333

mhhe.com/wildFINMAN5e

Problem 2-2A Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Denzel Brooks opens a Web consulting business called Venture Consultants and completes the following transactions in March.

March 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 $5,100 cash in dividends. 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

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86 Chapter 2 Analyzing and Recording Transactions

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. (3) Total debits, $119,490

Check (2) Ending balances: Cash, $59,465; Accounts Receivable, $4,490; Accounts Payable, $600

Problem 2-4A 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, 2012 and 2013.

December 31 2012 2013

Cash . . . . . . . . . . . . . . . . . . . . $ 64,300 $ 15,640

Accounts receivable . . . . . . . . 26,240 19,390

Office supplies . . . . . . . . . . . . . 3,160 1,960

Office equipment . . . . . . . . . . 44,000 44,000

Trucks . . . . . . . . . . . . . . . . . . . 148,000 157,000

Building . . . . . . . . . . . . . . . . . . 0 80,000

Land . . . . . . . . . . . . . . . . . . . . . 0 60,000

Accounts payable . . . . . . . . . . 3,500 33,500

Note payable . . . . . . . . . . . . . . 0 40,000

(3) Debt ratio, 19.4%

Check (2) Net income, $23,290

Late in December 2013, the business purchased a small office building and land for $140,000. It paid $100,000 cash toward the purchase and a $40,000 note payable was signed for the balance. Mr. Nettle had to invest $35,000 cash in the business (in exchange for common stock) to enable it to pay the $100,000 cash. The business also pays $3,000 cash per month for dividends.

Required

1. Prepare balance sheets for the business as of December 31, 2012 and 2013. (Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.)

2. By comparing equity amounts from the balance sheets and using the additional information presented in this problem, prepare a calculation to show how much net income was earned by the business during 2013.

3. Compute the 2013 year-end debt ratio (in percent and rounded to one decimal).

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.

Required

1. Prepare a trial balance for this business as of the end of May.

Analysis Components

2. Analyze the accounts and their balances and prepare a list that describes each of the seven most likely transactions and their amounts.

3. Prepare a report of cash received and cash paid showing how the seven transactions in part 2 yield the $37,641 ending Cash balance.

Cash . . . . . . . . . . . . . . . . . . . . . . . $37,641

Office supplies . . . . . . . . . . . . . . . . 890

Prepaid insurance . . . . . . . . . . . . . 4,600

Office equipment . . . . . . . . . . . . . 12,900

Accounts payable . . . . . . . . . . . . . 12,900

Common stock . . . . . . . . . . . . . . . 18,000

Dividends . . . . . . . . . . . . . . . . . . . 3,329

Engineering fees earned . . . . . . . . 36,000

Rent expense . . . . . . . . . . . . . . . . 7,540

Problem 2-5A Analyzing account balances and reconstructing transactions

C1 C3 A1 P2

Check (1) Trial balance totals, $66,900

(3) Cash paid, $16,359

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Chapter 2 Analyzing and Recording Transactions 87

Problem 2-6A 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 exchange for com-

mon stock of a new company named HV Consulting. 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. 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 $2,800 cash in dividends.

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 column

format): Cash (101); Accounts Receivable (106); Office Supplies (108); Office Equipment (163); Automo- biles (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. (3) Trial balance totals, $291,350

Check (2) Ending balances: Cash, $12,665; Office Equipment, $50,900

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. 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 $6,230 cash in dividends. 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.

PROBLEM SET B

Problem 2-1B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

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88 Chapter 2 Analyzing and Recording Transactions

Check (2) Ending balances: Cash, $17,262; Accounts Receivable, $9,350; Accounts Payable, $580

(3) Trial balance totals, $141,080

Problem 2-3B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Humble Management Services opens for business and completes these transactions in September.

Sept. 1 Henry Humble, the owner, invests $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.)

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); Prepaid Insurance (108); Office Equipment (163); Computer Equipment (164); Building (170); Land (172); Accounts Payable (201); Notes Pay- able (250); Common Stock (307); Dividends (319); Fees Earned (402); Wages Expense (601); Com- puter 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.

Problem 2-2B Preparing and posting journal entries; preparing a trial balance

C3 C4 A1 P1 P2

Zucker Management Services opens for business and completes 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 $5,300 cash in dividends. 29 The company purchased $249 of additional office supplies on credit. 30 The company paid $831 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

column 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

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Chapter 2 Analyzing and Recording Transactions 89

December 31 2012 2013

Cash . . . . . . . . . . . . . . . . . . . . . $20,000 $ 5,000 Accounts receivable . . . . . . . . . 35,000 25,000 Office supplies . . . . . . . . . . . . . . 8,000 13,500 Office equipment . . . . . . . . . . . 40,000 40,000 Machinery . . . . . . . . . . . . . . . . . 28,500 28,500 Building . . . . . . . . . . . . . . . . . . . 0 250,000 Land . . . . . . . . . . . . . . . . . . . . . . 0 50,000 Accounts payable . . . . . . . . . . . 4,000 12,000 Note payable . . . . . . . . . . . . . . . 0 250,000

Problem 2-4B 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, 2012 and 2013.

Check (2) Net income, $10,500

(3) Debt ratio, 63.6%

Late in December 2013, the business purchased a small office building and land for $300,000. It paid $50,000 cash toward the purchase and a $250,000 note payable was signed for the balance. Joe Tama, the owner, had to invest an additional $15,000 cash (in exchange for common stock) to enable it to pay the $50,000 cash toward the purchase. The business also pays $250 cash per month for dividends.

Required

1. Prepare balance sheets for the business as of December 31, 2012 and 2013. (Hint: Report only total equity on the balance sheet and remember that total equity equals the difference between assets and liabilities.)

2. By comparing equity amounts from the balance sheets and using the additional information presented in the problem, prepare a calculation to show how much net income was earned by the business during 2013.

3. Calculate the December 31, 2013, debt ratio (in percent and rounded to one decimal).

Problem 2-5B Analyzing account balances and reconstructing transactions

C1 C3 A1 P2

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.

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 $5,300 cash in dividends. 29 The company purchased $550 of additional office supplies on credit. 30 The company paid $860 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

column 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); Service Fees Earned (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. (3) Total debits, $74,330

Check (2) Ending balances: Cash, $21,520; Accounts Receivable, $9,800; Accounts Payable, $550

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90 Chapter 2 Analyzing and Recording Transactions

SERIAL PROBLEM Success Systems

A1 P1 P2

(This serial problem started in Chapter 1 and continues through most of the chapters. If the Chapter 1 segment was not completed, the problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany this book.)

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 $1,100 cash in dividends.

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

column 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 bal- ance after each posting.

3. Prepare a trial balance as of the end of June.

Problem 2-6B Recording transactions; posting to ledger; preparing a trial balance

C3 A1 P1 P2

Check (2) Ending balances: Cash, $17,860; Office Equipment, $15,600

(3) Trial balance totals, $95,100

Required

1. Prepare a trial balance for this business as of the end of April.

Analysis Component

2. Analyze the accounts and their balances and prepare a list that describes each of the seven most likely transactions and their amounts.

3. Prepare a report of cash received and cash paid showing how the seven transactions in part 2 yield the $19,982 ending Cash balance.

Check (1) Trial balance total, $47,650

(3) Cash paid, $15,418

Cash . . . . . . . . . . . . . . . . . . . . . . . $19,982

Office supplies . . . . . . . . . . . . . . . . 760

Prepaid rent . . . . . . . . . . . . . . . . . 1,800

Office equipment . . . . . . . . . . . . . 12,250

Accounts payable . . . . . . . . . . . . . 12,250

Common stock . . . . . . . . . . . . . . . 15,000

Dividends . . . . . . . . . . . . . . . . . . . . 5,200

Consulting fees earned . . . . . . . . . 20,400

Operating expenses . . . . . . . . . . . 7,658

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Chapter 2 Analyzing and Recording Transactions 91

Required

1. Prepare journal entries to record each of the following transactions for Success Systems.

Oct. 1 Adria Lopez invested $55,000 cash, a $20,000 computer system, and $8,000 of office equip- ment in the company in exchange for its 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. 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 on its account. 17 The company paid $805 cash to repair computer equipment that was damaged when mov-

ing it. 20 The company paid $1,940 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 $3,600 cash in dividends. Nov. 1 The company reimbursed Adria Lopez in cash for business automobile mileage allowance

(Lopez 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 received notification from Alex’s Engineering Co. that Success Systems’ bid of

$3,950 for an upcoming project is accepted. 18 The company received $2,208 cash from IFM Company as partial payment of the October 28

bill. 22 The company donated $250 cash to the United Way in the company’s name. 24 The company completed work for Alex’s Engineering Co. and sent it a bill for $3,950. 25 The company sent another bill to IFM Company for the past-due amount of $3,000. 28 The company reimbursed Adria Lopez 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 $2,000 cash in dividends. 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., $48,052

(3) Trial bal. totals, $108,659

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

SP 2 On October 1, 2013, Adria Lopez launched a computer services company called Success Systems, which provides consulting services, computer system installations, and custom program development. Adria adopts the calendar year for reporting purposes and expects to prepare the company’s first set of financial statements on December 31, 2013. The company’s initial chart of accounts follows.

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92 Chapter 2 Analyzing and Recording Transactions

BTN 2-3 Review the Decision Ethics case from the first part of this chapter involving the cashier. The guidance answer suggests that you should not comply with the assistant manager’s request.

Required

Propose and evaluate two other courses of action you might consider, and explain why.

ETHICS CHALLENGE C1

BTN 2-1 Refer to Polaris’s financial statements in Appendix A for the following questions.

Required

1. What amount of total liabilities does it report for each of the fiscal years ended December 31, 2011 and 2010?

2. What amount of total assets does it report for each of the fiscal years ended December 31, 2011 and 2010?

3. Compute its debt ratio for each of the fiscal years ended December 31, 2011 and 2010. (Report ratio in percent and round it to one decimal.)

4. In which fiscal year did it employ more financial leverage (December 31, 2011 or 2010)? Explain.

Fast Forward

5. Access its financial statements (10-K report) for a fiscal year ending after December 31, 2011, from its Website (Polaris.com) or the SEC’s EDGAR database (www.sec.gov). Recompute its debt ratio for any subsequent year’s data and compare it with the debt ratio for 2010 and 2011.

Beyond the Numbers

REPORTING IN ACTION A1 A2

Polaris

1. What is the debt ratio for Polaris in the current year and for the prior year? 2. What is the debt ratio for Arctic Cat in the current year and for the prior year? 3. Which of the two companies has the higher degree of financial leverage? What does this imply?

BTN 2-2 Key comparative figures for Polaris and Arctic Cat follow.

Polaris Arctic Cat

Current Prior Current Prior ($ thousands) Year Year Year Year

Total liabilities . . . . . . . . . $ 727,968 $ 690,656 $ 89,870 $ 78,745

Total assets . . . . . . . . . . . 1,228,024 1,061,647 272,906 246,084

COMPARATIVE ANALYSIS A1 A2

Polaris Arctic Cat

BTN 2-4 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

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Chapter 2 Analyzing and Recording Transactions 93

BTN 2-6 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 components 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 Access EDGAR online (www.sec.gov) and locate the 2011 year 10-K report of Amazon.com (ticker AMZN) filed on February 1, 2012. Review its financial statements reported for years ended 2011, 2010, and 2009 to answer the following questions.

Required

1. What are the amounts of its net income or net loss reported for each of these three years? 2. Does Amazon’s operating activities provide cash or use cash for each of these three years? 3. If Amazon has a 2011 net income of more than $600 million and 2011 operating cash flows of nearly

$4,000 million, how is it possible that its cash balance at December 31, 2011, increases by less than $1,500 million relative to its balance at December 31, 2010?

TAKING IT TO THE NET A1

BTN 2-7 Assume Misa Chien and Jennifer Green of Nom Nom Truck plan on expanding their busi- ness to accommodate more product lines. They are considering financing their expansion in one of two ways: (1) contributing more of their own funds to the business or (2) borrowing the funds from a bank.

Required

Identify at least two issues that Misa and Jennifer should consider when trying to decide on the method for financing their expansion.

ENTREPRENEURIAL DECISION A1 A2 P3

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94 Chapter 2 Analyzing and Recording Transactions

BTN 2-9 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 classified clip- pings to your report). Alternatively, you may want to search the Web for the re quired information. One suitable Website is CareerOneStop (www.CareerOneStop.org). For documentation, you should 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 to you, the reason for its appeal, and its requirements.

HITTING THE ROAD C1

BTN 2-8 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 Martin to prepare a balance sheet and key financial ratios. Martin has not kept formal re- cords but is able to provide the following accounts and their amounts as of December 31, 2013.

Required

1. Prepare a balance sheet as of December 31, 2013, 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?

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, 2013.

ENTREPRENEURIAL DECISION A1 A2 P3

Key Figure KTM Polaris Arctic Cat

Return on assets . . . . . . . . . 4.3% 18.5% 4.8%

Debt ratio . . . . . . . . . . . . . . 54.8% 59.3% 32.9%

Required

1. Which company is most profitable according to its return on assets? 2. Which company is most risky according to the debt ratio? 3. Which company deserves increased investment based on a joint analysis of return on assets and the

debt ratio? Explain.

BTN 2-10 KTM (www.KTM.com) is a leading manufacturer of offroad and street motorcycles, and it competes to some extent with both Polaris and Arctic Cat. Key financial ratios for the current fiscal year follow.

GLOBAL DECISION A2

KTM Polaris Arctic Cat

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Chapter 2 Analyzing and Recording Transactions 95

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 5 $400,000y$1,000,000 5 40%

ANSWERS TO MULTIPLE CHOICE QUIZ

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Learning Objectives

CONCEPTUAL

C1 Explain the importance of periodic reporting and the time period assumption. (p. 98) C2 Explain accrual accounting and how it improves financial statements. (p. 99) C3 Identify steps in the accounting cycle. (p. 116) C4 Explain and prepare a classified balance sheet. (p. 117)

ANALYTICAL

A1 Explain how accounting adjustments link to financial statements. (p. 109) A2 Compute profit margin and describe its use in analyzing company performance. (p. 121) A3 Compute the current ratio and describe what it reveals about a company’s financial

condition. (p. 121)

PROCEDURAL

P1 Prepare and explain adjusting entries. (p. 100) P2 Explain and prepare an adjusted trial balance. (p. 110) P3 Prepare financial statements from an adjusted trial balance. (p. 110) P4 Describe and prepare closing entries. (p. 112) P5 Explain and prepare a post-closing trial balance. (p. 114) P6 Appendix 3A —Explain the alternatives in accounting for prepaids. (p. 125) P7 Appendix 3B—Prepare a work sheet and explain its usefulness. (p. 127) P8 Appendix 3C—Prepare reversing entries and explain their purpose. (p. 131)

A Look at This Chapter

This chapter explains the timing of reports and the need to adjust accounts. Adjusting accounts is important for recognizing revenues and expenses in the proper period. We describe how to prepare financial statements from an adjusted trial balance, and how the closing process works.

A Look Back

Chapter 2 explained the analysis and recording of transactions. We showed how to apply and interpret company accounts, T-accounts, double-entry accounting, ledgers, postings, and trial balances.

Adjusting Accounts and Preparing Financial Statements 3

A Look Ahead

Chapter 4 looks at accounting for merchandising activities. We describe the sale and purchase of merchandise and their implications for preparing and analyzing financial statements.

96

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Dorm Roomies to Fashion Divas

NEW YORK—”Never in a million years did I think that just three months after graduation I would already have my own business,” recalls Ashley Cook. “It is a lot of work, but a dream come true!” Ashley, along with Danielle Dankner, launched ash&dans (ashanddans.com), an affordable line of scarves and embel- lished jersey pieces, including tops and dresses. “We learn something new everyday,” explains Ashley. “We enjoy both the business side and the creative side and fill each day with equal amounts of both.” Ashley and Danielle explain how they set up an accounting system early on to account for all business activities, including cash, revenues, receivables, and payables. They also had to learn about the deferral and accrual of revenues and expenses. Setting up an accounting system was an important part of their success, explains Ashley. “The reason we were able to make things work was because we were extremely prudent with our money. We kept our costs down to a minimum . . . [and] because we were so careful with our buying, we were able to cover our costs by selling our product and keeping very little inventory.” “It is amazing how much we have developed our business savvy,” says Ashley. This includes monitoring the adjusting of accounts so that revenues and expenses are properly reported

so that good decisions are made. Adds Ashley, “We do every- thing inhouse . . . from design to marketing to PR to sales to accounting.” Financial statement preparation and analysis are tasks that Ashley and Danielle emphasize. Although they insist on timely and accurate accounting reports, Ashley says “we are very happy with how our business started and how it has grown.” To achieve that growth, Ashley and Danielle took time to under- stand accounting adjustments and their effects. It is part of the larger picture. “People love our story.” For that to continue, they insist that a reliable accounting system is necessary . . . other- wise the business side would fail. “We look forward to growing our brand, continually challeng- ing ourselves and coming up with innovative designs,” says Ashley. She also offers a little advice: “Educate yourself and surround yourself with people who know more than you do. Never be afraid to ask questions or take risks.” Adds Danielle, “The most difficult part was simply learning to block out the non-believers.”

[Sources: ash&dans Website, January 2013; Under30CEO, March 2010; ClosetVanity.com, December 2011; Washington Magazine, October 2010; YHP, December 2009]

“Do what you love and love what you do.” —ASHLEY COOK (ON RIGHT)

Decision Insight

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Chapter Preview

Chapters 1 and 2 described how transactions and events are ana- lyzed, journalized, and posted. This chapter describes important adjustments that are often necessary to properly reflect revenues when earned and expenses when incurred. This chapter also de- scribes financial statement preparation. It explains the closing

process that readies revenue, expense, and dividend accounts for the next reporting period and updates retained earnings. It also explains how accounts are classified on a balance sheet to in- crease their usefulness to decision makers.

This section describes the importance of reporting accounting information at regular intervals and its impact for recording revenues and expenses.

The Accounting Period The value of information is often linked to its timeliness. Useful information must reach decision makers frequently and promptly. To provide timely information, accounting systems prepare reports at regular intervals. This results in an accounting process impacted by the time

period (or periodicity) assumption. 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 report- ing, periods. Most organizations use a year as their primary accounting period. Reports covering a one-year period are known as annual financial statements. Many organizations also prepare interim financial statements covering one, three, or six months of activity.

C1 Explain the importance of periodic reporting and the time period assumption.

TIMING AND REPORTING

$0 2013 2012 2011 2010 2009

$100

Millions Ratio

$200 $300 $400 $500 $600 $700

$900

15%

0.0%

30%

45%

$800

Polaris

“Polaris announces annual income of . . .”

EXHIBIT 3.1 Accounting Periods

Jan. Mar. May June July Aug. Sept. Oct. Nov. TimeDec.

1

1 2 3 4

2 3 4 5 6 7 8 9 10 11 12 Monthly

Quarterly

1 2 Semiannually

1 Annually

Feb. Apr.

98

Adjusting Accounts

• Prepaid expenses • Unearned revenues • Accrued expenses • Accrued revenues • Adjusted trial

balance

Timing and Reporting

• Accounting period • Accrual versus

cash • Recognition of

revenues and expenses

Preparing Financial Statements

• Income statement • Statement of

retained earnings • Balance sheet

Closing Process

• Temporary and per- manent accounts

• Closing entries • Post-closing trial

balance • Accounting cycle

summary

Classified Balance Sheet

• Classification structure

• Classification categories

Adjusting Accounts and Preparing Financial Statements

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 99

The annual reporting period is not always a calendar year ending on December 31. An orga- nization can adopt a fiscal year consisting of any 12 consecutive months. It is also acceptable to adopt an annual reporting period of 52 weeks. For example, Gap’s fiscal year consistently ends the final week of January or the first week of February each year. Companies with little seasonal variation in sales often choose the calendar year as their fiscal year. Facebook, Inc., uses calendar year reporting. However, the financial statements of The Kellogg Company (the company that controls characters such as Tony the Tiger, Snap! Crackle! Pop!, and Keebler Elf) reflect a fiscal year that ends on the Saturday nearest December 31. Com- panies experiencing seasonal variations in sales often choose a natural business year end, which is when sales activities are at their lowest level for the year. The natural business year for retailers such as Walmart, Target, and Macy’s usually ends around January 31, after the holiday season.

Accrual Basis versus Cash Basis After external transactions and events are recorded, several accounts still need adjustments be- fore their balances appear in financial statements. This need arises because internal transactions and events remain unrecorded. Accrual basis accounting uses the adjusting process to recog- nize revenues when earned and expenses when incurred (matched with revenues). Cash basis accounting recognizes revenues when cash is received and records expenses when cash is paid. This means that cash basis net income for a period is the difference between cash receipts and cash payments. Cash basis accounting is not consistent with generally ac- cepted accounting principles (neither U.S. GAAP nor IFRS). It is commonly held that accrual accounting better reflects business performance than infor- mation about cash receipts and payments. Accrual accounting also increases the comparability of financial statements from one period to another. Yet cash basis accounting is useful for sev- eral business decisions — which is the reason companies must report a statement of cash flows. To see the difference between these two accounting systems, let’s consider FastForward’s Pre- paid Insurance account. FastForward paid $2,400 for 24 months of insurance coverage that began on December 1, 2013. Accrual accounting requires that $100 of insurance expense be reported on December 2013’s income statement. Another $1,200 of expense is reported in year 2014, and the remaining $1,100 is reported as expense in the first 11 months of 2015. Exhibit 3.2 illustrates this allocation of insurance cost across these three years. Any unexpired premium is reported as a Prepaid Insurance asset on the accrual basis balance sheet.

Alternatively, a cash basis income statement for December 2013 reports insurance expense of $2,400, as shown in Exhibit 3.3. The cash basis income statements for years 2014 and 2015 report no insurance expense. The cash basis balance sheet never reports an insurance asset because it is immediately expensed. This shows that cash basis income for 2013 – 2015 fails to match the cost of insurance with the insurance benefits received for those years and months.

Insurance Expense 2015

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 2013

2013 2014 2015

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 2014

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, 2013

Transaction:

EXHIBIT 3.2 Accrual Accounting for Allocating Prepaid Insurance to Expense

Insurance Expense 2015

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 2014

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 2013

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

2013 2014 2015

Paid $2,400 for 24 months’ insurance beginning

Dec. 1, 2013

Transaction:

EXHIBIT 3.3 Cash Accounting for Allocating Prepaid Insurance to Expense

C2 Explain accrual accounting and how it improves financial statements.

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100 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Recognizing Revenues and Expenses We use the time period assumption to divide a company’s activities into specific time periods, but not all activities are complete when financial statements are prepared. Thus, adjustments often are required to get correct account balances.

We rely on two principles in the adjusting process: revenue recognition and expense recogni- tion (the latter is often referred to as matching). Chapter 1 explained that the revenue recogni- tion principle requires that revenue be recorded when earned, not before and not after. Most companies earn revenue when they provide services and products to customers. A major goal of the adjusting process is to have revenue recognized (reported) in the time period when it is earned. The expense recognition (or matching) principle aims to record expenses in the same accounting period as the revenues that are earned as a result of those expenses. This matching of expenses with the revenue benefits is a major part of the adjusting process.

Matching expenses with revenues often requires us to predict certain events. When we use financial statements, we must understand that they require estimates and therefore include mea- sures that are not precise. Walt Disney’s annual report explains that its production costs from movies, such as its Pirates of the Caribbean series, are matched to revenues based on a ratio of current revenues from the movie divided by its predicted total revenues.

1. Describe a company’s annual reporting period. 2. Why do companies prepare interim financial statements? 3. What two accounting principles most directly drive the adjusting process? 4. Is cash basis accounting consistent with the matching principle? Why or why not? 5. If your company pays a $4,800 premium on April 1, 2013, for two years’ insurance coverage,

how much insurance expense is reported in 2014 using cash basis accounting?

Quick Check Answers — p. 132

Adjusting accounts is a three-step process:

ADJUSTING ACCOUNTS

Point: Recording revenue early over- states current-period revenue and income; recording it late understates current-period revenue and income.

Point: Recording expense early over- states current-period expense and understates current-period income; recording it late understates current- period expense and overstates current-period income.

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.

Framework for Adjustments Adjustments are necessary for transactions and events that extend over more than one period. It is helpful to group adjustments by the timing of cash receipt or cash payment in relation to the recognition of the related revenues or expenses. Exhibit 3.4 identifies four types of adjustments. The left half of this exhibit shows prepaid expenses (including depreciation) and unearned revenues, which reflect transactions when cash is paid or received before a related expense or

P1 Prepare and explain adjusting entries.

Diamond Foods, Inc., a popular snack maker, was recently investigated for postponing expenses related to payments to its walnut growers. This alleged late expense recognition caused income to be overstated in 2011. Further, this misstatement threatened completion of its recent acquisition of Pringles (for more details, see BusinessWeek, January 17, 2012). ■

Decision Insight

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 101

Adjustments

Paid (or received) cash after

expense (or revenue) recognized

Paid (or received) cash before

expense (or revenue) recognized

Accrued

expenses

Accrued

revenues

Unearned (Deferred)

revenues

Prepaid (Deferred)

expenses*

*Includes depreciation

EXHIBIT 3.4 Types of Adjustments

Assets 5 Liabilities 1 Equity 2100 2100

Adjustment (a)

Dec. 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 100

To record first month’s expired insurance.

Dec. 31 100

Insurance Expense 637

Dec. 6 2,400

Balance 2,300

Dec. 31 100

Prepaid Insurance 128

revenue is recognized. They are also called deferrals because the recognition of an expense (or revenue) is deferred until after the related cash is paid (or received). The right half of this ex hibit shows accrued expenses and accrued revenues, which reflect transactions when cash is paid or received after a related expense or revenue is recognized. Adjusting entries are nec- essary for each of these so that revenues, expenses, assets, and liabilities are correctly re- ported. Specifically, an adjusting entry is made at the end of an accounting period to reflect a transaction or event that is not yet recorded. Each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never the Cash account).

Prepaid (Deferred) Expenses Prepaid expenses refer to items paid for in advance of receiving their benefits. Prepaid expenses are assets. When these assets are used, their costs become expenses. Adjusting entries for prepaids increase expenses and de- crease assets as shown in the T-accounts of Exhibit 3.5. Such adjustments reflect transactions and events that use up pre- paid expenses (including passage of time). To illustrate the accounting for prepaid expenses, we look at prepaid insurance, supplies, and depreciation.

Prepaid Insurance We use our 3-step process for this and all accounting adjustments.

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, 2013.

Step 2: With the passage of time, 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, 2013. This expense is $100, or 1y24 of $2,400, which leaves $2,300.

Step 3: The adjusting entry to record this expense and reduce the asset, along with T-account postings, follows:

Asset

Unadjusted balance

Credit adjustment

Expense

Debit adjustment

Dr. Expense… # Cr. Asset….. #

Decreased Increased EXHIBIT 3.5 Adjusting for Prepaid Expenses

Insurance Dec. 6 Pay insurance premium and record asset

Dec. 31 Coverage expires and record expense

Two-Year Insurance Policy Total cost is $2,400 Monthly cost is $100

Point: Source documents provide information for most daily transactions, and in many businesses the recordkeep- ers record them. Adjustments require more knowledge and are usually handled by senior accounting professionals.

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

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102 Chapter 3 Adjusting Accounts and Preparing Financial Statements

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 (1) un- derstate expenses by $1,050 and overstate net income by $1,050 for the December income statement and (2) overstate both supplies and equity (because of net income) by $1,050 in the December 31 balance sheet. The following table highlights the adjustment for supplies.

Assets 5 Liabilities 1 Equity 21,050 21,050

Adjustment (b)

Dec. 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050

To 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

Prepaid Insurance 5 $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 ex- pense and $100 reduction in prepaid

amount.

Prepaid Insurance 5 $2,300

Reports $2,300 in coverage for remaining 23 months.

Before Adjustment Adjustment After Adjustment

Supplies 5 $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 5 $8,670

Reports $8,670 in supplies.

Before Adjustment Adjustment After Adjustment

Supplies

Dec. 2,6,26 Purchase supplies and record asset

Dec. 31 Supplies used and record expense

Supplies Supplies are a prepaid expense requiring adjustment.

Step 1: FastForward purchased $9,720 of supplies in December and some of them were used during this month. When financial statements are prepared at December 31, the cost of supplies used during December must be recognized.

Step 2: When FastForward computes (takes physical count of) 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:

Point: We assume that prepaid and unearned items are recorded in balance sheet accounts. An alternative is to record them in income statement accounts; Appendix 3A discusses this alternative. The adjusted financial state- ments are identical.

Other Prepaid Expenses Other prepaid expenses, such as Prepaid Rent, are accounted for exactly as Insurance and Supplies are. We should note that some prepaid expenses are both paid for and fully used up within a single accounting period. One ex ample is when a company pays monthly rent on the first day of each month. This payment creates a prepaid expense on the first day of each month that fully expires by the end of the month. In these special cases, we can record the cash paid with a debit to an expense account instead of an asset account. This practice is described more completely later in the chapter.

ad justment on or before December 31 would (1) understate expenses by $100 and overstate net in- come by $100 for the December income statement and (2) overstate both prepaid insurance (assets) and equity (because of net income) by $100 in the December 31 balance sheet. (Exhibit 3.2 showed that 2014’s adjustments must transfer a total of $1,200 from Prepaid Insurance to Insurance Ex- pense, and 2015’s adjustments must transfer the remaining $1,100 to Insurance Expense.) The fol- lowing table highlights the December 31, 2013, adjustment for prepaid insurance.

Point: Many companies record adjust- ing entries only at the end of each year because of the time and cost necessary.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 103

Depreciation A special category of prepaid expenses is plant assets, which refers to long- term tangible assets used to produce and sell products and services. Plant assets are expected to provide benefits for more than one period. Examples of plant assets are buildings, machines, vehicles, and fixtures. All plant assets, with a general ex ception for land, eventually wear out or decline in usefulness. The costs of these assets are deferred but are gradually reported as ex- penses in the income statement over the assets’ useful lives (benefit periods). Depreciation is the process of allocating the costs of these assets over their expected useful lives. Depreciation expense is recorded with an adjusting entry similar to that for other prepaid expenses.

Step 1: Recall that 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 four years and to be worth about $8,000 at the end of four years. This means the net cost of this equipment over its use- ful life is $18,000 ($26,000 2 $8,000). We can use any of several methods to allocate this $18,000 net cost to expense. FastForward uses a method called 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 48 months in the asset’s useful life gives a monthly cost of $375 ($18,000y48).

Step 3: The adjusting entry to record monthly depreciation expense, along with T-account post- ings, follows:

Explanation After posting the adjustment, the Equipment account ($26,000) less its Accumulated Depreciation ($375) account equals the $25,625 net cost (made up of $17,625 for the 47 remaining months in the benefit period plus the $8,000 value at the end of that time). The $375 balance in the Depreciation Expense account is reported in the December income state- ment. Not making the adjustment at December 31 would (1) understate expenses by $375 and overstate net income by $375 for the December income statement and (2) overstate both assets and equity (because of income) by $375 in the December 31 balance sheet. The following table highlights the adjustment for depreciation.

Point: Depreciation does not neces sarily measure decline in market value.

Point: An asset’s expected value at the end of its useful life is called salvage value.

Point: Plant assets are also called Plant & Equipment, or Property, Plant & Equipment.

Adjustment (c)

Dec. 31 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 375

Accumulated Depreciation — Equipment . . . . . . . . 375

To record monthly equipment depreciation.

Dec. 31 375

Depreciation 612 Expense — Equipment

Dec. 3 26,000

Equipment 167

Dec. 31 375

Accumulated 168 Depreciation — Equipment

Assets 5 Liabilities 1 Equity 2375 2375

Depreciation Dec. 3 Purchase equipment and record asset

Dec. 31 Allocate asset cost and record depreciation

Equipment, net 5 $26,000

Reports $26,000 in equipment.

Deduct $375 from Equipment, net Add $375 to Depreciation Expense

Record $375 in depreciation and $375 as accumulated depreciation, which is deducted

from equipment.

Equipment, net 5 $25,625

Reports $25,625 in equipment, net of accumulated depreciation.

Before Adjustment Adjustment After Adjustment

Accumulated depreciation is kept in a separate contra account. A contra account is an ac- count linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance. For instance, FastForward’s contra account of Accumulated Depreciation — Equipment is subtracted from the Equipment account in the bal- ance sheet (see Exhibit 3.7). This contra account allows balance sheet readers to know both the full costs of assets and the total depreciation.

Investor A small publishing company signs an aspiring Olympic gymnast to write a book. The company pays the gymnast $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.” Is this accounting for the signing bonus acceptable? How does it affect your analysis? ■ [Answer—p. 132]

Decision Maker

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104 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Unearned (Deferred) Revenues The term unearned revenues refers to cash received in advance of providing products and services. Unearned revenues, also called deferred revenues, are liabilities. When cash is accepted, an obliga- tion to provide products or services is accepted. As products or services are provided, the unearned

revenues become earned revenues. Adjusting entries for unearned revenues involve increas- ing revenues and decreasing unearned reve- nues, as shown in Exhibit 3.8.

An example of unearned revenues is from Gannett Co., Inc., publisher of USA TODAY, which reports unexpired (unearned subscrip-

tions) of $224 million: “Revenue is recognized in the period in which it is earned (as newspapers are delivered).” Unearned revenues are nearly 25% of the current liabilities for Gannett. Another example comes from the Boston Celtics. When the Celtics receive cash from advance ticket sales and broad- cast fees, they record it in an unearned revenue account called Deferred Game Revenues. The Celtics recognize this unearned revenue with adjusting entries on a game-by-game basis. Since the NBA regular season begins in October and ends in April, revenue recognition is mainly limited to this pe- riod. For a recent season, the Celtics’ quarterly revenues were $0 million for July – September; $34 million for October – December; $48 million for January – March; and $17 million for April – June.

EXHIBIT 3.6 Accounts after Three Months of Depreciation Adjustments Dec. 3 26,000

Equipment 167 Accumulated 168

Depreciation — Equipment

Dec. 31 375

Jan. 31 375

Feb. 28 375

Balance 1,125

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 services and record revenue

EXHIBIT 3.8 Adjusting for Unearned Revenues Liability

Debit adjustment

Unadjusted balance

Revenue

Credit adjustment

Decreased Increased

Dr. Liability….. # Cr. Revenue… #

Point: To defer is to postpone. We postpone reporting amounts received as revenues until they are earned.

EXHIBIT 3.7 Equipment and Accumulated Depreciation on February 28 Balance Sheet

Assets (at February 28, 2014)

Cash $ ....

Equipment $26,000

Less accumulated depreciation 1,125 24,875

Total Assets $

Commonly titled Equipment, net

The title of the contra account, Accumulated Depreciation, reveals that this account includes to- tal depreciation expense for all prior periods for which the asset was used. To illustrate, the Equip- ment and the Accumulated Depreciation accounts appear as in Exhibit 3.6 on February 28, 2014, after three months of adjusting entries. The $1,125 balance in the accumulated depreciation account can be subtracted from its related $26,000 asset cost. The difference ($24,875) between these two balances is the cost of the asset that has not yet been depreciated. This difference is called the book value, or the net amount, which equals the asset’s costs less its accumulated depreciation. These account balances are reported in the assets section of the February 28 balance sheet in Exhibit 3.7.

Point: The net cost of equipment is also called the depreciable basis.

Point: The cost principle requires an asset to be initially recorded at acquisi- tion cost. Depreciation causes the asset’s book value (cost less accumulated depre- ciation) to decline over time.

Entrepreneur You are preparing an offer to purchase a skate board shop. The depreciation schedule for the shop’s building and equipment shows costs of $175,000 and accumulated depreciation of $155,000. This leaves a net for building and equipment of $20,000. Is this information useful in helping you decide on a purchase offer? ■ [Answer—p. 132]

Decision Maker

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 105

Accounting for unearned revenues is crucial to many companies. For example, the National Retail Federation reports that gift card sales, which are unearned revenues for sellers, exceed $20 billion annually. Gift cards are now the top selling holiday gift; 57.3% of all gift givers planned to give at least one gift card in 2011 (source: NRF Website).

Accrued Expenses Accrued expenses refer to costs that are incurred in a period but are both unpaid and unre- corded. Accrued expenses must be reported on the income statement for the period when incurred. Adjusting entries for recording accrued expenses involve increasing expenses and

This advance payment increases cash and creates an obligation to do consulting work over the next 60 days.

Step 2: As time passes, FastForward earns this payment through consulting. By December 31, it has provided five days’ service and earned 5y60 of the $3,000 unearned revenue. This amounts to $250 ($3,000 3 5y60). The revenue recognition principle implies that $250 of unearned rev- enue must 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:

Explanation The adjusting entry transfers $250 from unearned revenue (a liability account) to a revenue account. Not making the adjustment (1) understates revenue and net income by $250 in the December income statement and (2) overstates unearned revenue and understates equity by $250 on the December 31 balance sheet. The following highlights the adjustment for unearned revenue.

Point: Accrued expenses are also called accrued liabilities.

Dec. 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Unearned Consulting Revenue . . . . . . . . . . . . . . . . 3,000

Received advance payment for services over the next 60 days.

Assets 5 Liabilities 1 Equity 13,000 13,000

Unearned Consulting Revenue 5 $3,000

Reports $3,000 in unearned revenue for consulting services promised for

60 days.

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 5 $2,750

Reports $2,750 in unearned revenue for consulting services owed over

next 55 days.

Before Adjustment Adjustment After Adjustment

Assets 5 Liabilities 1 Equity 2250 1250

Adjustment (d )

Dec. 31 Unearned Consulting Revenue . . . . . . . . . . . . . . . . . . . . 250

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 250

To record earned revenue that was received in advance ($3,000 3 5y60).

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

Returning to FastForward, it also has unearned revenues. It agreed on December 26 to pro- vide consulting services to a client for a fixed fee of $3,000 for 60 days.

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

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106 Chapter 3 Adjusting Accounts and Preparing Financial Statements

increasing liabilities as shown in Exhibit 3.9. This adjustment recognizes expenses in- curred in a period but not yet paid. Com- mon 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

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 (1) understates salaries expense and overstates net income by $210 in the December income statement and (2) understates salaries payable (liabilities) and overstates equity by $210 on the December 31 balance sheet. The following highlights the adjustment for salaries incurred.

Assets 5 Liabilities 1 Equity 1210 2210

Adjustment (e)

Dec. 31 Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

To record three days’ accrued salary (3 3 $70).

Dec. 12 700

26 700

31 210

Balance 1,610

Salaries Expense 622

Dec. 31 210

Salaries Payable 209

EXHIBIT 3.10 Salary Accrual and Paydays

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

Point: An employer records salaries expense and a vacation pay liability when employees earn vacation pay.

on Wednesday, December 31, yet this salary cost has not been paid or recorded. The financial statements would be incomplete if FastForward failed to report the added expense and liability to the employee for unpaid salary from December 29, 30, and 31.

Step 3: The adjusting entry to account for accrued salaries, along with T-account postings, follows:

Salaries Payable 5 $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 to employee, but not yet paid, at

$70 per day.

Salaries Payable 5 $210

Reports $210 salaries payable to employee but not yet paid.

Before Adjustment Adjustment After Adjustment

EXHIBIT 3.9 Adjusting for Accrued Expenses Expense

Debit adjustment

Liability

Credit adjustment

Increased Increased

Dr. Expense…. . # Cr. Liability… #

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 107

The $210 debit reflects the payment of the liability for the three days’ salary accrued on Decem- ber 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.

Accrued Revenues The term accrued revenues refers to 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 only when 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. The adjusting entries for accrued revenues increase assets and in- crease revenues as shown in Exhibit 3.11. Accrued revenues commonly arise from ser- vices, products, interest, and rent. We use service fees and interest to show how to ad- just for accrued revenues.

Accrued Services Revenue Accrued revenues are not recorded until 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 for them or the seller has not yet billed the buyer. FastForward provides an example.

Step 1: In the second week of December, it agreed to provide 30 days of consulting services to a local fitness club for a fixed fee of $2,700. The terms of the initial agreement call for FastForward to provide services from December 12, 2013, through January 10, 2014, or 30 days of service. The club agrees to pay FastForward $2,700 on January 10, 2014, when the ser vice period is complete.

Step 2: At December 31, 2013, 20 days of services have already been provided. Since the contracted 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 3 20y30). The revenue recognition principle implies that it must report the $1,800 on the December income statement. The balance sheet also must re- port that the club owes FastForward $1,800.

Point: Accrued revenues are also called accrued assets.

EXHIBIT 3.11 Adjusting for Accrued RevenuesAsset

Debit adjustment

Revenue

Credit adjustment

Increased Increased

Dr. Asset…. . . . . . # Cr. Revenue… #

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

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 in December.

Assets 5 Liabilities 1 Equity 2700 2210 2490

Accrued Interest Expense Companies commonly have accrued interest expense on notes payable and other long-term liabilities at the end of a period. Interest expense is incurred with the passage of time. 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 3 Annual interest rate 3 Fraction of year since last payment date.

To illustrate, if a company has a $6,000 loan from a bank at 6% annual interest, then 30 days’ accrued interest expense is $30 — computed as $6,000 3 0.06 3 30y360. The adjusting entry would be to debit Interest Expense for $30 and credit Interest Payable for $30.

Future Payment of Accrued Expenses Adjusting entries for accrued expenses foretell cash transactions in future periods. Specifically, accrued expenses at the end of one ac- counting period result in cash payment in a future period(s). To illustrate, recall that FastForward recorded accrued salaries of $210. On January 9, the first payday of the next period, the follow- ing entry settles the accrued liability (salaries payable) and records salaries expense for seven days of work in January:

Point: Interest computations assume a 360-day year; known as the bankers’ rule.

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108 Chapter 3 Adjusting Accounts and Preparing Financial Statements

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 the accrued asset and recorded earned consulting revenue for January.

Assets 5 Liabilities 1 Equity 12,700 1900 21,800

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 would understate (1) both consulting revenue and net income by $1,800 in the December income statement and (2) both accounts receivable (assets) and equity by $1,800 on the Decem- ber 31 balance sheet. The following table 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

Accrued Interest Revenue In addition to the accrued interest expense we described earlier, interest can yield an accrued revenue when a debtor owes money (or other assets) to a company. If a company is holding notes or accounts 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, we debit Interest Receiv- able (asset) and credit Interest Revenue.

Future Receipt of Accrued Revenues Accrued revenues at the end of one accounting period result in cash receipts in a future period(s). To illustrate, 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 recognize the revenue earned in January. The $2,700 debit reflects the cash received. The $1,800 credit reflects the re- moval of the receivable, and the $900 credit records the revenue earned in January.

Accounts Receivable 5 $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 consulting revenue, which is 20/30 of total

contract amount.

Accounts Receivable 5 $1,800

Reports $1,800 in accounts receivable from consulting

services provided.

Before Adjustment Adjustment After Adjustment

Assets 5 Liabilities 1 Equity 11,800 11,800

Adjustment (f )

Dec. 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Consulting Revenue . . . . . . . . . . . . . . . . . . . . . . . . 1,800

To 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

Step 3: The year-end adjusting entry to account for accrued services revenue is

Loan Officer The owner of a custom audio, video, and home theater store applies for a business loan. The store’s financial statements reveal large increases in current-year revenues and income. Analysis shows that these 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—p. 132]

Decision Maker

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 109

Links to Financial Statements The process of adjusting accounts is intended to bring an asset or liability account balance to its correct amount. It also updates a related expense or revenue account. These adjustments are necessary for transactions and events that extend over more than one period. (Adjusting entries are posted like any other entry.) Exhibit 3.12 summarizes the four types of transactions requiring adjustment. Understanding this exhibit is important to understanding the adjusting process and its importance to financial statements. Remember that each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never cash).

Information about some adjustments is not always available until several days or even weeks 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 utility bill on January 10 for costs incurred for the month of December. When it receives the bill, the com- pany records the expense and the payable as of December 31. Other examples include long- distance phone usage and costs of many Web billings. The December income statement reflects these additional expenses incurred, and the December 31 balance sheet includes these payables, although the amounts were not actually known on December 31.

A1 Explain how accounting adjustments link to financial statements.

BEFORE Adjusting

Category Balance Sheet Income Statement Adjusting Entry

Prepaid expenses† Asset overstated Expense understated Dr. Expense

Equity overstated Cr. Asset*

Unearned revenues† Liability overstated Revenue understated Dr. Liability

Equity understated Cr. Revenue

Accrued expenses Liability understated Expense understated Dr. Expense

Equity overstated Cr. Liability

Accrued revenues Asset understated Revenue understated Dr. Asset

Equity understated Cr. Revenue

* For depreciation, the credit is to Accumulated Depreciation (contra asset). † Exhibit assumes that prepaid expenses are initially recorded as assets and that unearned revenues are initially recorded as liabilities.

EXHIBIT 3.12 Summary of Adjustments and Financial Statement Links

6. If an adjusting entry for accrued revenues of $200 at year-end is omitted, what is this error’s effect on the year-end income statement and balance sheet?

7. What is a contra account? Explain its purpose. 8. What is an accrued expense? Give an example. 9. Describe how an unearned revenue arises. Give an example.

Quick Check Answers — p. 132

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 carry out these instructions. What do you do? ■ [Answer—p. 132]

Decision Ethics

Point: CFOs often feel pressure to pursue fraudulent accounting due to pressure applied by their superiors, such as overbearing CEOs or aggressive boards.

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110 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Adjusted Trial Balance An unadjusted trial balance is a list of accounts and balances prepared before adjustments are recorded. An adjusted trial balance is a list of accounts and balances prepared 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, 2013. The order of accounts in the trial balance is usually set up to match the order in the chart of accounts. Several new accounts arise from the adjusting entries.

EXHIBIT 3.13 Unadjusted and Adjusted Trial Balances

Dr. Cr. Dr. Cr.Cr. Dr.

FASTFORWARD Trial Balances

December 31, 2013

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

(f) $1,800

(d) 250

$ 0

0

200 200

6,200

3,000 30,000

0

$45,300

5,800

300

0 $ 4,350

9,720 2,400

26,000

0

0

0

1,400

1,000

230 $45,300 $3,785

(c) 375 (e) 210 (a) 100

(b) 1,050

1,800 $ 4,350

8,670 2,300

26,000

375 1,610

100 1,000 1,050

230 $47,685

(b) $1,050 (a) 100

(c) 375

(e) 210

$3,785

(d) 250 (f) 1,800

$ 375 6,200

210 2,750

30,000 0

$47,685

7,850

300

Acct. No. 101 106 126 128 167 168 201 209 236 307 318 319

Cash Account Title

Accounts receivable Supplies Prepaid insurance Equipment Accumulated depreciation—Equip. Accounts payable Salaries payable Unearned consulting revenue Common stock

403

406 612 622 637 640 652 690

Retained earnings Dividends Consulting revenue

Rental revenue Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals

Each adjustment (see middle columns) is identified by a letter in parentheses that links it to an adjusting entry explained earlier. Each amount in the Adjusted Trial Balance columns is com- puted by taking that account’s amount from the Unadjusted Trial Balance columns and adding or subtracting any adjustment(s). To illustrate, Supplies has a $9,720 Dr. balance in the unad- justed columns. Subtracting the $1,050 Cr. amount shown in the adjustments columns yields 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.

P2 Explain and prepare an adjusted trial balance.

P3 Prepare financial statements from an adjusted trial balance.

We can prepare financial statements directly from information in the adjusted trial balance. An adjusted trial balance (see the right-most columns in Exhibit 3.13) includes all accounts and balances appearing in financial statements, and is easier to work from than the entire ledger when preparing financial statements.

PREPARING FINANCIAL STATEMENTS

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 111

Exhibit 3.14 shows how revenue and expense balances are transferred from the adjusted trial bal- ance to the income statement (red lines). The net income and the dividends amount are then used to prepare the statement of retained earnings (black lines). Asset and liability balances on the adjusted trial balance are then transferred to the balance sheet (blue lines). The ending retained earnings is determined on the statement of retained earnings and transferred to the balance sheet (green lines).

EXHIBIT 3.14 Preparing Financial Statements (Adjusted Trial Balance from Exhibit 3.13)

Steps to Prepare Financial Statements

Prepare income statement using revenue and expense accounts from trial balance.

Prepare balance sheet using asset and liability accounts, and common stock, from trial balance; and pull updated retained earnings from step 2.

Prepare statement of retained earnings using retained earnings and dividends from trial balance; and 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

8,670 2,300

1,800 $ 4,350

26,000

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

$ 375

210 6,200

2,750 30,000

0 Common stock .................................307 Retained earnings .............................318

$47,685

375 1,610

100 1,000 1,050

230

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 7,850

$47,685

200Dividends .........................................319

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........................................

375 1,610 100

230

1,000 1,050

4,365 $3,785

$8,150

Liabilities

Equity

Step 3 Prepare balance sheet

Cash................................................ $ 4,350 Accounts receivable........................ 1,800

8,670 2,300

Supplies.......................................... Prepaid insurance...........................

Total assets ................................... $ 42,745 25,625

$26,000Equipment....................................... 375Less accumulated depreciation......

Accounts payable...........................

Unearned consulting revenue......... 2,750 Salaries payable.............................. 210

6,200

Total liabilities .................................. 9,160

$

Common stock ............................... Retained earnings .......................... Total equity .................................... Total liabilities and equity ..............

33,585

30,000 3,585

Step 2 Prepare statement of retained earnings

$

3,785

$3,585 200Less: Cash dividends ....................

Retained earnings, December 31 ...

Retained earnings, December 1 ..... Plus: Net income ............................ 3,785

0

$ 42,745

Acct.

No. Account Title Debit

FASTFORWARD

Adjusted Trial Balance

December 31, 2013

Credit Assets

FASTFORWARD

Balance Sheet

December 31, 2013

FASTFORWARD

Statement of Retained Earnings

For Month Ended December 31, 2013

FASTFORWARD

Income Statement

For Month Ended December 31, 2013

Point: Sarbanes-Oxley Act requires that financial statements filed with the SEC be certified by the CEO and CFO, including a declaration that the state- ments fairly present the issuer’s opera- tions and financial condition. Violators can receive fines and/or prison terms.

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112 Chapter 3 Adjusting Accounts and Preparing Financial Statements

10. Music-Mart records $1,000 of accrued salaries on December 31. Five days later, on January 5 (the next payday), salaries of $7,000 are paid. What is the January 5 entry?

11. Jordan Air has the following information in its unadjusted and adjusted trial balances. What are the adjusting entries that Jordan Air likely recorded?

Unadjusted Adjusted

Debit Credit Debit Credit

Prepaid insurance . . . . . . . . . . $6,200 $5,900 Salaries payable . . . . . . . . . . $ 0 $1,400

12. What accounts are taken from the adjusted trial balance to prepare an income statement? 13. In preparing financial statements from an adjusted trial balance, what statement is usually

prepared second?

Quick Check Answers — p. 132–133

Revenues Expenses Dividends Income Summary

Temporary Accounts (closed at period-end)

Assets Liabilities Common Stock Retained Earnings

Permanent Accounts (not closed at period-end)

The closing process is an important step at the end of an accounting period after financial state- ments have been completed. It prepares accounts for recording the transactions and the events of the next period. In the closing process we must (1) identify accounts for closing, (2) record and post the closing entries, and (3) prepare a post-closing trial balance. The purpose of the closing process is twofold. First, it resets revenue, expense, and dividends account balances to zero at the end of each period. This is done so that these accounts can properly measure income and dividends for the next period. Second, it helps in summarizing a period’s revenues and ex- penses. This section explains the closing process.

Temporary and Permanent Accounts Temporary (or nominal) accounts accumulate data related to one accounting period. They include all income statement accounts, the dividends account, and the Income Summary 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 (or real) accounts report on activities related to one or more future accounting periods. They carry their ending balances into the next period and generally consist of all balance sheet accounts. These asset, liability, and equity ac- counts are not closed.

Recording Closing Entries To record and post closing entries is to transfer the end-of-period balances in revenue, expense, and dividends accounts to the permanent retained earnings account. Closing entries are neces- sary 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.

CLOSING PROCESS

P4 Describe and prepare closing entries.

We prepare financial statements in the following order: income statement, statement of re- tained earnings, and balance sheet. This order makes sense because the balance sheet uses infor- mation 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 and, when financial statements are completed, each account will have been used once.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 113

An income statement aims to report revenues and expenses for a specific accounting period. The statement of retained earnings reports similar information, including dividends. Since rev- enue, expense, and dividends accounts must accumulate information separately for each pe- riod, they must start each period with zero balances. To close these accounts, we transfer their balances first to an account called Income Summary. Income Summary is a temporary ac- count (only used for the closing process) that contains a credit for the sum of all revenues (and gains) and a debit for the sum of all expenses (and losses). Its balance equals net income or net loss and it is transferred to retained earnings. Next the dividends account balance is transferred to retained earnings. After these closing entries are posted, the revenue, expense, dividends, and Income Summary accounts have zero balances. These accounts are then said to be closed or cleared. Exhibit 3.15 uses the adjusted account balances of FastForward (from the left side of Exhibit 3.14) to show the four steps necessary to close its temporary accounts. We explain each step.

Point: Retained Earnings is the only permanent account in Exhibit 3.15.

EXHIBIT 3.15 Four-Step Closing Process

Consulting Revenue

Rental Revenue

Balance 7,850

Balance 3004,365 8,150 Balance 3,785

7,850

300 3,785

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 0 200 3,785

Balance 3,585

Income Summary

Dividends

Revenue Accounts

Retained Earnings

1

3

4

Expense Accounts Depreciation Expense—Equip.

Balance 375

Salaries Expense

Balance 1,610

Insurance Expense

Balance 100

Rent Expense

Balance 1,000

Supplies Expense

Balance 1,050

Utilities Expense

Balance 230

375

1,610

100

1,000

1,050

230

2

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 journal entry is step 1 in Exhibit 3.16. This entry closes revenue accounts and leaves them with zero balances. The accounts are now ready to record revenues when they occur in the next period. The $8,150 credit entry to Income Summary equals total revenues for the 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 accumulate a record of expenses for the next period. This second closing entry for FastForward is step 2 in Exhibit 3.16. Exhibit 3.15 shows that posting this entry gives each expense account a zero balance.

Point: It is possible to close revenue and expense accounts directly to retained earnings. Computerized accounting systems do this.

Point: To understand the closing process, focus on its outcomes — updating the retained earnings account balance to its proper ending balance, and getting temporary accounts to show zero balances for purposes of accumulating data for the next period.

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114 Chapter 3 Adjusting Accounts and Preparing Financial Statements

$47,685

8,670 2,300

1,800 $ 4,350

26,000

200

375 1,610

100 1,000 1,050

230

Cash .................................................... Accounts receivable ............................ Supplies .............................................. Prepaid insurance ................................ Equipment ........................................... Accumulated depreciation—Equip...... Accounts payable ................................

Common stock ................................... Retained earnings ............................... Dividends ............................................ Consulting revenue ............................. Rental revenue .................................... Depreciation expense—Equip............. Salaries expense ................................. Insurance expense .............................. Rent expense ...................................... Supplies expense ................................ Utilities expense .................................. Totals ..................................................

FASTFORWARD

Adjusted Trial Balance

December 31, 2013 Dec. 31 Consulting Revenue................................ Rental Revenue....................................... Income Summary............................... To close revenue accounts.

To close Income Summary account.

7,850 300

1,610

8,150

Step 1:

Dec. 31 Income Summary...................................

Salaries Expense............................... Depreciation Expense—Equipment..

Insurance Expense............................ Rent Expense.................................... Supplies Expense.............................. Utilities Expense................................

4,365 375

100 1,000 1,050

230

Step 2:

Dec. 31 Income Summary................................... Retained Earnings..............................

3,785 3,785

Step 3:

$ 375 6,200

Salaries payable .................................. 210 Unearned consulting revenue ............. 2,750

30,000 0

300 7,850

$47,685

To close expense accounts.

CreditDebit

Retained Earnings...................................

To close the dividends account.

Dec. 31 Dividends............................................

200 200

Step 4:

General Journal

EXHIBIT 3.16 Preparing Closing Entries

P5 Explain and prepare a post-closing trial balance.

Step 3: Close Income Summary to Retained Earnings After steps 1 and 2, the bal- ance of Income Summary is equal to December’s 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 retained earnings. This entry closes the Income Summary account–see step 3 in Exhibit 3.16. The Income Summary account has a zero balance after posting this entry. It continues to have a zero balance until the closing process again occurs at the end of the next period. (If a net loss occurred because expenses exceeded revenues, the third entry is reversed: debit Retained Earnings and credit Income Summary.)

Step 4: Close Dividends Account to Retained Earnings The fourth closing en- try transfers any debit balance in the dividends account to retained earnings—see step 4 in Ex- hibit 3.16. This entry gives the dividends account a zero balance, and the account is now ready to accumulate next period’s dividends. This entry also reduces the retained earnings balance to the $3,585 amount reported on the balance sheet. We could also have selected the accounts and amounts needing to be closed by identifying individual revenue, expense, and dividends accounts in the ledger. This is illustrated in Exhibit 3.16 where we prepare closing entries using the adjusted trial balance. (Information for closing entries is also in the financial statement columns of a work sheet—see Appendix 3B.)

Post-Closing Trial Balance Exhibit 3.17 shows the entire ledger of FastForward as of December 31 after adjusting and clos- ing entries are posted. (The transaction entries are in Chapter 2.) The temporary accounts (rev- enues, expenses, and dividends) have ending balances equal to zero. A post-closing trial balance is a list of permanent accounts and their balances from the led- ger after all closing entries have been journalized and posted. It lists the balances for all ac- counts not closed. These accounts comprise a company’s assets, liabilities, and equity, which are identical to those in the balance sheet. The aim of a post-closing trial balance is to verify that

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EXHIBIT 3.17 General Ledger after the Closing Process for FastForward

Asset Accounts

Liability and Equity Accounts

Revenue and Expense Accounts (Including Income Summary)

Cash Acct. No. 101

Date Explan. PR Debit Credit Balance

2013

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 230 5,050

26 (16) G1 700 4,350

Accounts Receivable Acct. No. 106

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (8) G1 1,900 1,900

22 (9) G1 1,900 0

31 Adj.(f) G1 1,800 1,800

Supplies Acct. No. 126

Date Explan. PR Debit Credit Balance

2013

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

Prepaid Insurance Acct. No. 128

Date Explan. PR Debit Credit Balance

2013

Dec. 6 (13) G1 2,400 2,400

31 Adj.(a) G1 100 2,300

Equipment Acct. No. 167

Date Explan. PR Debit Credit Balance

2013

Dec. 3 (3) G1 26,000 26,000

Accumulated Depreciation — Equipment Acct. No. 168

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(c) G1 375 375

Accounts Payable Acct. No. 201

Date Explan. PR Debit Credit Balance

2013

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

2013

Dec. 31 Adj.(e) G1 210 210

Unearned Consulting Revenue Acct. No. 236

Date Explan. PR Debit Credit Balance

2013

Dec. 26 (12) G1 3,000 3,000

31 Adj.(d) G1 250 2,750

Retained Earnings Acct. No. 318

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Clos.(3) G1 3,785 3,785

31 Clos.(4) G1 200 3,585

Dividends Acct. No. 319

Date Explan. PR Debit Credit Balance

2013

Dec. 24 (11) G1 200 200

31 Clos.(4) G1 200 0

Consulting Revenue Acct. No. 403

Date Explan. PR Debit Credit Balance

2013

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

Salaries Expense Acct. No. 622

Date Explan. PR Debit Credit Balance

2013

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

Supplies Expense Acct. No. 652

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(b) G1 1,050 1,050

31 Clos.(2) G1 1,050 0

Rental Revenue Acct. No. 406

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (8) G1 300 300

31 Clos.(1) G1 300 0

Depreciation Expense — Equipment Acct. No. 612

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(c) G1 375 375

31 Clos.(2) G1 375 0

Insurance Expense Acct. No. 637

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Adj.(a) G1 100 100

31 Clos.(2) G1 100 0

Utilities Expense Acct. No. 690

Date Explan. PR Debit Credit Balance

2013

Dec. 26 (15) G1 230 230

31 Clos.(2) G1 230 0

Income Summary Acct. No. 901

Date Explan. PR Debit Credit Balance

2013

Dec. 31 Clos.(1) G1 8,150 8,150

31 Clos.(2) G1 4,365 3,785

31 Clos.(3) G1 3,785 0

Rent Expense Acct. No. 640

Date Explan. PR Debit Credit Balance

2013

Dec. 12 (6) G1 1,000 1,000

31 Clos.(2) G1 1,000 0

Common Stock Acct. No. 307

Date Explan. PR Debit Credit Balance

2013

Dec. 1 (1) G1 30,000 30,000

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116 Chapter 3 Adjusting Accounts and Preparing Financial Statements

(1) total debits equal total credits for permanent accounts and (2) all temporary accounts have zero balances. FastForward’s post-closing trial balance is shown in Exhibit 3.18. The post- closing trial balance usually is the last step in the accounting process.

EXHIBIT 3.18 Post-Closing Trial Balance

FASTFORWARD Post-Closing Trial Balance

December 31, 2013

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,350

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,670

Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000

Accumulated depreciation—Equipment . . . . . . . . $ 375

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 6,200

Salaries payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Unearned consulting revenue . . . . . . . . . . . . . . . . . 2,750

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . 3,585

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $43,120 $43,120

EXHIBIT 3.19 Steps in the Accounting Cycle*

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 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 statements Use adjusted trial balance to prepare financial statements.   8. Close Journalize and post entries to close temporary accounts.   9. Prepare post-closing trial balance Test clerical accuracy of the closing procedures. 10. Reverse (optional) 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.

2. Journalize

10. Reverse (Optional)

1. Analyze transactions

Accounting Cycle

3. Post

4. Prepare unadjusted

trial balance

5. Adjust

6. Prepare adjusted

trial balance

9. Prepare post-

closing trial balance

7. Prepare statements

8. Close

Accounting Cycle The term accounting cycle refers to 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, beginning with analyzing trans actions and ending with a post-closing trial balance or

C3 Identify steps in the accounting cycle.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 117

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

reversing entries. Steps 1 through 3 usually occur regularly as a company enters into transac- tions. 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.

Most operating cycles are less than one year. This means most companies use a one-year period in deciding which assets and liabilities are current. A few companies have an operating cycle longer than one year. For instance, producers of certain beverages (wine) and products (ginseng) that require aging for several years have operating cycles longer than one year. A bal- ance sheet lists current assets before noncurrent assets and current liabilities before noncurrent liabilities. This consistency in presentation allows users to quickly identify current assets that are most easily converted to cash and current liabilities that are shortly coming due. Items in current assets and current liabilities are listed in the order of how quickly they will be converted to, or paid in, cash.

14. What are the major steps in preparing closing entries? 15. Why are revenue and expense accounts called temporary? Identify and list the types of

temporary accounts.

16. What accounts are listed on the post-closing trial balance?

Quick Check Answers — p. 133

Our discussion to this point has been limited to unclassified financial statements. This section describes a classified balance sheet. The next chapter describes a classified income statement. An unclassified balance sheet is one whose items are broadly grouped 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 important subgroups that provide more information to decision makers.

Classification Structure A classified balance sheet has no required layout, but it usually contains the categories in Exhibit 3.20. One of the more important classifications is the separation between current and non- current items for both assets and liabilities. Current items are those 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. “Operating” refers to company operations and “cycle” refers to the circular flow of cash used for company inputs and then cash received from its outputs. The length of a company’s operating cycle depends on its activities. For a ser- vice company, the operating cycle is the time span between (1) paying em ployees who perform the services and (2) receiv ing cash from customers. For a merchandiser selling products, the operating cycle is the time span between (1) paying suppliers for merchandise and (2) receiving cash from customers.

CLASSIFIED BALANCE SHEET

C4 Explain and prepare a classified balance sheet.

Point: Current and Noncurrent are also referred to as Short-Term and Long- Term, respectively.

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118 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Classification Categories This section describes the most common categories in a classified balance sheet. 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 of assets and liabilities for their balance sheets. K2 Sports, a manufacturer of snowboards, reported a balance sheet with only three asset classes: current assets; property, plant and equipment; 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 lon- ger. Examples are cash, short-term investments, accounts receivable, short-term notes

EXHIBIT 3.21 Example of a Classified Balance Sheet

SNOWBOARDING COMPONENTS Balance Sheet

January 31, 2013

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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

Liabilities

Current liabilities

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,300

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 119

Point: Plant assets are also called fixed assets; property, plant and equipment; or long-lived assets.

Point: Furniture and fixtures are referred to as F&F, which are classified as noncurrent assets.

Point: Many financial ratios are distorted if accounts are not classified correctly.

Point: Only assets and liabilities are classified as current or noncurrent.

receivable, goods for sale (called merchandise or inventory), and prepaid expenses. The individual prepaid expenses of a company are usually small in amount compared to many other assets and are often combined and shown as a single item. The prepaid expenses likely include items such as prepaid insurance, prepaid rent, office supplies, and store supplies. Prepaid expenses are usually listed last because they will not be converted to cash (instead, they are used).

Long-Term Investments A second major balance sheet classification is long-term (or noncurrent) investments. Notes receivable and investments in stocks and bonds are long- term assets 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 investment because it is not used in operations.

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. The order listing for plant assets is usually from most liquid to least liquid such as equipment and machinery to buildings and land.

Intangible Assets Intangible assets are long-term resources that benefit business opera- tions, usually lack physical form, and have uncertain benefits. Examples are patents, trade- marks, copyrights, franchises, and goodwill. Their value comes from the privileges or rights granted to or held by the owner. K2 Sports, reported intangible assets of $228 million, which is nearly 20 percent of its total assets. Its intangibles included trademarks, patents, and licensing agreements.

Current Liabilities Current liabilities are obligations due to be paid or settled within one year or the operating cycle, whichever is longer. They are usually settled by paying out current assets such as cash. Current liabilities often include accounts payable, notes payable, wages payable, taxes payable, interest 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 revenues are current liabilities when they will be settled by delivering products or services within one year or the operating cycle, whichever is longer. Current liabili- ties are reported in the order of those to be settled first.

Long-Term Liabilities Long-term liabilities are obligations 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. The equity section for a corporation is divided into two main subsections, common stock and retained earnings.

17. Classify the following assets as (1) current assets, (2) plant assets, or (3) intangible assets: (a) land used in operations, (b) office supplies, (c) receivables from customers due in 10 months, (d ) insurance protection for the next 9 months, (e) trucks used to provide services to customers, (f ) trademarks.

18. Cite at least two examples of assets classified as investments on the balance sheet. 19. Explain the operating cycle for a service company.

Quick Check Answers — p. 133

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120 Chapter 3 Adjusting Accounts and Preparing Financial Statements

We explained that accounting under U.S. GAAP is similar, but not identical, to that under IFRS. This sec- tion discusses differences in adjusting accounts, preparing financial statements, and reporting assets and liabilities on a balance sheet.

Adjusting Accounts Both U.S. GAAP and IFRS include broad and similar guidance for adjust- ing accounts. Although some variations exist in revenue and expense recognition and other principles, all of the adjustments in this chapter are accounted for identically under the two systems. In later chap- ters we describe how certain assets and liabilities can result in different adjusted amounts using fair value measurements.

Preparing Financial Statements Both U.S. GAAP and IFRS prepare the same four basic finan- cial statements following the same process discussed in this chapter. Chapter 2 explained how both U.S. GAAP and IFRS require current items to be separated from noncurrent items on the balance sheet (yield- ing a classified balance sheet). U.S. GAAP balance sheets report current items first. Assets are listed from most liquid to least liquid, where liquid refers to the ease of converting an asset to cash. Liabilities are listed from nearest to maturity to furthest from maturity, maturity refers to the nearness of paying off the liability. IFRS balance sheets normally present noncurrent items first (and equity before liabilities), but this is not a requirement. Other differences with financial statements exist, which we identify in later chapters. Piaggio provides the following example of IFRS reporting for its assets, liabilities, and equity within the balance sheet:

GLOBAL VIEW

PIAGGIO Balance Sheet (in thousands of Euro)

December 31, 2011

Assets Equity and Liabilities Noncurrent assets Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446,218

Intangible assets . . . . . . . . . . . . . . . 649,420 Noncurrent liabilities

Property, plant and equipment. . . . 274,871 Financial liabilities falling due after one year. . . . . . 329,200

Other noncurrent assets . . . . . . . 86,185 Other long-term liabilities . . . . . . . . . . . . . . . . . . . 100,489

Total noncurrent assets . . . . . . . 1,010,476 Total noncurrent liabilities . . . . . . . . . . . . . . . . . 429,689

Current assets Current liabilities

Trade receivables . . . . . . . . . . . . . . 65,560 Financial liabilities falling due within one year . . . . . 170,261

Other receivables . . . . . . . . . . . . . 28,028 Trade payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,263

Short-term tax receivables . . . . . . 27,245 Tax payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,920

Inventories . . . . . . . . . . . . . . . . . . 236,988 Other short-term payables . . . . . . . . . . . . . . . . . . 64,718

Cash and cash equivalents . . . . . . 151,887 Current portion of other long-term provisions . . . 13,115

Total current assets .. . . . . . . . . . 509,708 Total current liabilities . . . . . . . . . . . . . . . . . . . . 644,277

Total assets . . . . . . . . . . . . . . . . . . 1,520,184 Total equity and liabilities . . . . . . . . . . . . . . . . . . . . 1,520,184

IFRS: New revenue recognition rules proposed by the FASB and the IASB re- duce variation between U.S. GAAP and IFRS when accounting for revenue.

Point: IASB and FASB are working to improve financial statements. One pro- posal would reorganize the balance sheet to show assets and liabilities classified as operating, investing, or financing.

PIAGGIO

Closing Process The closing process is identical under U.S. GAAP and IFRS. Although unique accounts can arise under either system, the closing process remains the same.

IFRS Revenue and expense recognition are key to recording accounting adjustments. IFRS tends to be more principles-based relative to U.S. GAAP, which is viewed as more rules-based. A principles-based system depends heavily on control procedures to reduce the potential for fraud or misconduct. Failure in judgment led to improper accounting adjustments at Fannie Mae, Xerox, WorldCom, and others. A KPMG survey of accounting and finance employees found that more than 10% of them had witnessed falsification or ma- nipulation of accounting data within the past year. Internal controls and governance processes are directed at curtailing such behavior. Yet, a 2011 KPMG fraud survey found that one in seven frauds was uncovered by chance, which emphasizes our need to improve internal controls and governance. ■

O pp

or tu

ni ty

Rationalization

Financial Pressure

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 121

Profit Margin and Current Ratio Decision Analysis

A2 Compute profit margin and describe its use in analyzing company performance.

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.

The Limited’s average profit margin is 5.9% during this 5-year period. This favorably compares to the average industry profit margin of 1.2%. However, Limited’s profit margin has rebounded in the most recent two years—from 2.4% in 2009 to 5.2% and 8.4% for the recent recovery periods (see margin graph). Future success depends on Limited maintaining its market share and increasing its profit margin.

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, due date, and collateral requirements. It can also affect a manager’s decisions about using cash to pay debts when they come due. The current ratio is one measure of a company’s ability to pay its short- term obligations. It is defined in Exhibit 3.24 as current assets divided by current liabilities.

EXHIBIT 3.23 Limited Brands’ Profit Margin

$ in millions 2011 2010 2009 2008 2007

Net income . . . . . . . . . . . . . . . . . $ 805 $ 448 $ 220 $ 718 $ 676

Net sales . . . . . . . . . . . . . . . . . . . $9,613 $8,632 $9,043 $10,134 $10,671

Profit margin . . . . . . . . . . . . . . 8.4% 5.2% 2.4% 7.1% 6.3%

Industry profit margin . . . . . . . . . 2.1% 0.9% 0.3% 1.1% 1.6%

$0 20102011 2009 2008 2007

$1,000

0.0%

2.5%

5.0%

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000 $10,000

RatioMillions

$11,000

7.5%

Limited: Net Income ($) Profit Margin (%)Net Sales ($)

EXHIBIT 3.22 Profit MarginProfit margin 5

Net income Net sales

This ratio is interpreted as reflecting the percent of profit in each dollar of sales. To illustrate how we compute and use profit margin, let’s look at the results of Limited Brands, Inc., in Exhibit 3.23 for its fiscal years 2007 through 2011.

A3 Compute the current ratio and describe what it reveals about a company’s financial condition.

EXHIBIT 3.24 Current RatioCurrent ratio 5

Current assets Current liabilities

Using financial information from Limited Brands, Inc., we compute its current ratio for the recent five- year period. The results are in Exhibit 3.25.

EXHIBIT 3.25 Limited Brands’ Current Ratio

$ in millions 2012 2011 2010 2009 2008 2007

Current assets . . . . . . . . . . . . . . . . $2,368 $2,592 $3,250 $2,867 $2,919 $2,771

Current liabilities . . . . . . . . . . . . . $1,526 $1,504 $1,322 $1,255 $1,374 $1,709

Current ratio . . . . . . . . . . . . . . 1.6 1.7 2.5 2.3 2.1 1.6

Industry current ratio . . . . . . . . . 1.6 1.7 1.9 2.0 2.1 2.3

Limited: Current Liabilities ($) Current RatioCurrent Assets ($)

$0 2011 200920102012 2008 2007

$500 1.5

Millions Ratio

$1,000

$1,500

$2,000

$2,500

$3,500

$3,000

2.0

2.5

Limited Brands’ current ratio averaged 2.0 for its fiscal years 2007 through 2012. The current ratio for each of these years suggests that the company’s short-term obligations can be covered with its short-term assets. However, if its ratio would approach 1.0, Limited would expect to face challenges in covering li- abilities. If the ratio were less than 1.0, current liabilities would exceed current assets, and the company’s

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122 Chapter 3 Adjusting Accounts and Preparing Financial Statements

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.

Effect on Effect on Amount in Effect on Effect on Total Total

Entry the Entry Net Income Total Assets Liabilities Equity

The following information relates to Fanning’s Electronics on December 31, 2013. 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, 2013, falls on a Monday, but the employees will not be paid their wages until Friday, January 4, 2014.

b. Eighteen months earlier, on July 1, 2012, the company purchased equipment that cost $20,000. Its use- ful life is predicted to be five years, at which time the equipment is expected to be worthless (zero salvage value).

c. On October 1, 2013, 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, 2013, 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, 2013, the company completed a $7,000 service that has not been billed and not re- corded as of December 31, 2013.

Required

1. Prepare any necessary adjusting entries on December 31, 2013, 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. Deter- mine 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 2013 income statement and the December 31, 2013, balance sheet. Use up (down) arrows to indicate an increase (decrease) in the Effect columns.

DEMONSTRATION PROBLEM 1

Analyst You are analyzing the financial condition of a company to assess its ability to meet upcoming loan payments. You compute its current ratio as 1.2. You also find that a major portion of accounts receivable is due from one client who has not made any payments in the past 12 months. Removing this receivable from current assets lowers the current ratio to 0.7. What do you conclude? ■ [Answer—p. 132]

Decision Maker

ability to pay short-term obligations could be in doubt. Limited Brand’s liquidity, as evidenced by its current ratio, declines in 2011 and 2012, after growing steadily from 2008–2010.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 123

(a) Dec. 31 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750

Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,750

To accrue wages for the last day of the year ($8,750 3 1y5).

(b) Dec. 31 Depreciation Expense — Equipment . . . . . . . . . . . . . . . . 4,000

Accumulated Depreciation — Equipment . . . . . . . . 4,000

To record depreciation expense for the year ($20,000y5 years 5 $4,000 per year).

(c) Dec. 31 Unearned Services Revenue . . . . . . . . . . . . . . . . . . . . . . 100,000

Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

To recognize services revenue earned ($120,000 3 20y24).

(d ) Dec. 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 600

To adjust for expired portion of insurance ($1,800 3 4y12).

(e) Dec. 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Services Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

To record services revenue earned.

2. T-accounts for adjusting journal entries a through e.

Accounts Receivable

(e) 7,000

Insurance Expense

(d ) 600

Prepaid Insurance

Unadj. Bal. 1,800

(d ) 600

Adj. Bal. 1,200

Unearned Services Revenue

Unadj. Bal. 120,000

(c) 100,000

Adj. Bal. 20,000

Services Revenue

(c) 100,000

(e) 7,000

Adj. Bal. 107,000

(a) 1,750

Wages Expense

(a) 1,750

Wages Payable

(b) 4,000

Depreciation Expense — Equipment

(b) 4,000

Accumulated Depreciation — Equipment

3. Financial statement effects of adjusting journal entries.

Effect on Effect on Amount in Effect on Effect on Total Total

Entry the Entry Net Income Total Assets Liabilities 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 ↑

SOLUTION TO DEMONSTRATION PROBLEM 1 1. Adjusting journal entries.

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124 Chapter 3 Adjusting Accounts and Preparing Financial Statements

1. Prepare the annual income statement from the adjusted trial balance 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 . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 250

Depreciation expense—Equipment . . . . . . . . . . 5,970

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,320

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,180

Use the following adjusted trial balance to answer questions 1–3.

DEMONSTRATION PROBLEM 2

CHOI COMPANY Adjusted Trial Balance

December 31

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . 400

Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 830

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,200

Accumulated depreciation—Equipment . . . . . . . . . $ 29,100

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880

Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

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 . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Depreciation expense—Equipment . . . . . . . . . . . . 5,970

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $281,880 $281,880

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 125

3. Prepare a balance sheet from the adjusted trial balance of Choi Company.

Answer:

CHOI COMPANY Balance Sheet December 31

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,050

Accounts receivable . . . . . . . . . . . . . . . . . 400

Prepaid insurance . . . . . . . . . . . . . . . . . . . 830

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . $217,200

Less accumulated depreciation . . . . . . . . 29,100 188,100

Total assets . . . . . . . . . . . . . . . . . . . . . . . . $192,460

Liabilities

Wages payable . . . . . . . . . . . . . . . . . . . . . . $ 880

Interest payable . . . . . . . . . . . . . . . . . . . . . 3,600

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 an alternative in accounting for prepaid expenses and unearned 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 must transfer the cost of the unused portions from expense accounts to prepaid expense (asset) accounts. This alternative method is acceptable. The financial statements are identical under either method, but the adjusting entries

P6 Explain the alternatives in accounting for prepaids.

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

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126 Chapter 3 Adjusting Accounts and Preparing Financial Statements

At the end of its accounting period on December 31, insurance protection for one month has expired. This means $100 ($2,400y24) 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.

When these entries are posted to the accounts in the ledger, we can see that these two methods give iden- tical results. The December 31 adjusted account balances in Exhibit 3A.3 show Prepaid Insurance of $2,300 and Insurance Expense of $100 for both methods.

Payment Recorded Payment Recorded as Asset as Expense

Dec. 31 Insurance Expense . . . . . . . . . . . . 100

Prepaid Insurance . . . . . . . . . 100

Dec. 31 Prepaid Insurance . . . . . . . . . . . . . 2,300

Insurance Expense . . . . . . . . 2,300

EXHIBIT 3A.2 Adjusting Entry for Prepaid Expenses for the Two Alternatives

RECORDING PREPAYMENT OF REVENUES IN REVENUE ACCOUNTS As with prepaid expenses, 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 must transfer the unearned portions from revenue accounts to unearned revenue (liability) accounts. This alter- native method is acceptable. The adjusting entries are different for these two alternatives, but the financial statements are identical. To illustrate the accounting 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.

Payment Recorded as Asset

Prepaid Insurance 128

Dec. 6 2,400 Dec. 31 100

Balance 2,300

Insurance Expense 637

Dec. 31 100

Prepaid Insurance 128

Dec. 31 2,300

Payment Recorded as Expense

Insurance Expense 637

Dec. 6 2,400 Dec. 31 2,300

Balance 100

EXHIBIT 3A.3 Account Balances under Two Alternatives for Recording Prepaid Expenses

EXHIBIT 3A.4 Alternative Initial Entries for Unearned Revenues

Receipt Recorded Receipt Recorded as Liability as Revenue

Dec. 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Unearned Consulting Revenue . . . . . . . . . 3,000

Dec. 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Consulting Revenue . . . . . . . . . . . . . . . . . 3,000

are different. To illustrate the differences between these two methods, let’s look at FastForward’s cash payment of December 6 for 24 months of insurance coverage beginning on December 1. FastForward re- corded that payment with a debit to an asset account, but it could have recorded a debit to an expense ac- count. These alternatives are shown in Exhibit 3A.1.

EXHIBIT 3A.1 Alternative Initial Entries for Prepaid Expenses

Payment Recorded Payment Recorded as Asset as Expense

Dec. 6 Prepaid Insurance . . . . . . . . . 2,400

Cash . . . . . . . . . . . . . . . 2,400

Dec. 6 Insurance Expense . . . . . . . . 2,400

Cash . . . . . . . . . . . . . . . 2,400

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 127

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 adjusting entry is as shown in Exhibit 3A.5.

After adjusting entries are posted, the two alternatives give identical results. The December 31 adjusted account balances in Exhibit 3A.6 show unearned consulting revenue of $2,750 and consulting revenue of $250 for both methods.

EXHIBIT 3A.5 Adjusting Entry for Unearned Revenues for the Two Alternatives

Receipt Recorded Receipt Recorded as Liability as Revenue

Dec. 31 Unearned Consulting Revenue . . . . . . . . . . . . . 250

Consulting Revenue . . . . . . . . . . . . . . . . . 250

Dec. 31 Consulting Revenue . . . . . . . . . . . . . . . . . . . . . 2,750

Unearned Consulting Revenue . . . . . . . . . 2,750

EXHIBIT 3A.6 Account Balances under Two Alternatives for Recording Unearned Revenues

Unearned Consulting Revenue 236

Dec. 31 2,750

Receipt Recorded as Revenue

Consulting Revenue 403

Dec. 31 2,750 Dec. 26 3,000

Balance 250

Unearned Consulting Revenue 236

Dec. 31 250 Dec. 26 3,000

Balance 2,750

Receipt Recorded as Liability

Consulting Revenue 403

Dec. 31 250

APPENDIX

Work Sheet as a Tool 3B Information preparers use various analyses and internal documents when organizing information for inter- nal and external decision makers. Internal documents are often called working papers. One widely used working paper is the work sheet, which is a useful tool for preparers in working with accounting informa- tion. It is usually not available to external decision makers.

Benefits of a Work Sheet (Spreadsheet) A work sheet is not a required report, yet using a manual or electronic work sheet has several potential benefits. Specifically, a work sheet:

● Aids the preparation of financial statements. ● Reduces the possibility of errors when working with many accounts and adjustments. ● Links accounts and adjustments to their impacts in financial statements. ● Assists in planning and organizing an audit of financial statements—as it can be used to reflect any

adjustments necessary. ● Helps in preparing interim (monthly and quarterly) financial statements when the journalizing and post-

ing of adjusting entries are postponed until the year-end. ● Shows the effects of proposed or “what if” transactions.

Use of a Work Sheet (Spreadsheet) When a work sheet is used to prepare financial state- ments, it is constructed at the end of a period before the adjusting process. The complete work sheet in- cludes 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

Point: Since a work sheet is not a required report or an accounting record, its format is flexible and can be modified by its user to fit his/her preferences.

P7 Prepare a work sheet and explain its usefulness.

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128 Chapter 3 Adjusting Accounts and Preparing Financial Statements

use the information from FastForward. Preparing the work sheet has five important steps. Each step, 1 through 5, is color-coded and explained with reference to Exhibit 3B.1.

Step 1. Enter Unadjusted Trial Balance

The first step in preparing a work sheet is to list the title of every account and its account number that is ex- pected to appear on its financial statements. This includes all accounts in the ledger plus any new ones from adjusting entries. Most adjusting entries — including expenses from salaries, supplies, depreciation, and insurance — are predictable and recurring. The unadjusted balance for each account is then entered in the ap- propriate Debit or Credit column of the unadjusted trial balance columns. The totals of these two columns must be equal. Exhibit 3B.1 shows FastForward’s work sheet after completing this first step. Sometimes blank lines are left on the work sheet based on past experience to indicate where lines will be needed for adjustments to certain accounts. Exhibit 3B.1 shows Consulting Revenue as one example. An alternative is to squeeze ad- justments on one line or to combine the effects of two or more adjustments in one amount. In the unusual case when an account is not predicted, we can add a new line for such an account following the Totals line.

Step 2. Enter Adjustments

The second step in preparing a work sheet is to enter adjustments in the Adjustments columns. The adjust- ments shown are the same ones shown in Exhibit 3.13. An identifying letter links the debit and credit of each adjusting entry. This is called keying the adjustments. After preparing a work sheet, adjusting entries must still be entered in the journal and posted to the ledger. The Adjustments columns provide the infor- mation for those entries.

Step 3. Prepare Adjusted Trial Balance

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 the equality of debits and credits.

Step 4. Sort Adjusted Trial Balance Amounts to Financial Statements

This step involves sorting account balances from the adjusted trial balance to their proper financial state- ment columns. Expenses go to the Income Statement Debit column and revenues to the Income Statement Credit column. Assets and Dividends go to the Balance Sheet Debit column. Liabilities, Retained Earn- ings, and Common Stock go to the Balance Sheet Credit column.

Step 5. Total Statement Columns, Compute Income or Loss, and Balance Columns

Each financial statement column (from Step 4) is totaled. The difference between the 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. 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 implies that it is to be added to retained earnings. If a loss occurs, it is added to the Debit column. This implies 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 income 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 been made. The error can either be mathematical or involve sorting one or more amounts to incorrect columns.

Work Sheet Applications and Analysis A work sheet does not substitute for financial state- ments. It is a tool we can use at the end of an accounting period to help organize data and 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. Similarly, 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 show the effects of these proposed transactions. These financial statement columns yield pro forma financial statements because they show the statements as if the proposed transactions occurred.

Point: To avoid omitting the transfer of an account balance, start with the first line (cash) and continue in account order.

2

3

4

5

1

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 129

EXHIBIT 3B.1 Work Sheet

(b) 1,050 (a) 100

(c) 375

(e) 210

(d) 250 (f) 1,800

3,785

(f) 1,800

(d) 250

(c) 375 (e) 210 (a) 100

(b) 1,050

2

3,785

375 6,200

210 2,750

30,000 0

7,850

300

47,685

4,350 1,800 8,670 2,300

26,000

200

375 1,610

100 1,000 1,050

230 47,685

3

7,850

300 375 1,610

100 1,000 1,050

230

4

4,350 1,800 8,670 2,300

26,000

200

375 6,200

210 2,750

30,000 0

Account

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

Unadjusted

Trial Balance

Adjusted

Trial Balance

Dr.

Adjustments

Cr. Dr. Cr.

Income

Statement

Dr. Cr.

Balance Sheet

Dr. Cr.Dr. Cr.

101 106 126 128 167 168 201 209 236 307 318 319 403

406 612 622 637 640 652 690

No.

1

FASTFORWARD

Work Sheet

For Month Ended December 31, 2013

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

4,350 0

9,720 2,400

26,000

200

0 1,400

0 1,000

0 230

45,300

0 6,200

0 3,000

30,000 0

5,800

300

45,300 Net income Totals

4,365 3,785

8,150

8,150

8,150

43,320

43,320

39,535 3,785

43,320 5

List all accounts from the ledger and those expected

to arise from adjusting entries.

Enter all amounts available from ledger accounts. Column

totals must be equal.

A work sheet collects and summarizes information used to prepare adjusting

entries, financial statements, and closing entries.

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. The purpose of reversing entries is to simplify a company’s recordkeeping. 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, 2014, 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.

Point: As a general rule, adjusting entries that create new asset or liability accounts are likely candidates for reversing.

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130 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Accounting without Reversing Entries The path down the left side of Exhibit 3C.1 is de- scribed in the chapter. To summarize here, 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 be- cause the debt has been settled. The disadvantage of this approach is the slightly more complex entry re- quired on January 9. Paying the accrued liability means that this entry differs from the routine entries made on all other paydays. To construct the proper entry on January 9, we must recall the effect of the December 31 adjusting entry. Reversing entries overcome this disadvantage.

Point: Firms that use reversing entries hope that this simplification will reduce errors.

Salaries Expense

Accrue salaries expense on December 31, 2013

No reversing entry recorded on January 1, 2014

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 2013

Dec. 12 700 700(7) 26 31

700 1,400 1,610

(16) 210(e)

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 210210

Expl. Debit BalanceCredit

Salaries Expense $490 Salaries Payable $ 0

Reversing entry recorded on January 1, 2014

— OR —

*Circled numbers in the Balance column indicate abnormal balances.

Salaries Expense 490 Salaries Payable 210

Cash 700 Salaries Expense

Salaries Payable

Date 2014

Jan. 9 490 490

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 210210

Expl. Debit BalanceCredit

NO ENTRY

Salaries Expense

Salaries Payable

Date 2014

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 2014

210210

2014

Jan. 9 0210

Expl. Debit BalanceCredit

Salaries Expense 700 Cash 700

Salaries Expense*

Salaries Payable

Date 2014

Jan. 1 Jan. 9 700 490

(e)

Expl. Debit

210

BalanceCredit

Date 2013

Dec. 31 210210 2014

Jan. 1 0210

Expl. Debit BalanceCredit

Salaries Expense*

Salaries Payable

Date 2014

(e)

Expl. Debit BalanceCredit

Date 2013

Dec. 31 2014

Jan. 1

210210

210 0

Expl. Debit BalanceCredit

Salaries Payable 210 Salaries Expense 210

Jan. 1 210

210

210

Pay the accrued and current salaries on January 9, the first payday in 2014

EXHIBIT 3C.1 Reversing Entries for an Accrued Expense

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 131

C1 Explain the importance of periodic reporting and the time period assumption. The value of information is often linked to its timeliness. To provide timely information, accounting systems prepare periodic reports at regular intervals. The time period as- sumption presumes that an organization’s activities can be divided into specific time periods for periodic reporting.

C2 Explain accrual accounting and how it improves financial statements. Accrual accounting recognizes revenue when earned and expenses when incurred—not necessarily when cash in- flows and outflows occur. This information is valuable in assessing a company’s financial position and performance.

C3 Identify steps in the accounting cycle. The accounting cycle consists of 10 steps: (1) analyze transactions, (2) journalize, (3) post, (4) prepare an unadjusted trial balance, (5) adjust accounts, (6) prepare an adjusted trial balance, (7) prepare statements, (8) close, (9) prepare a post-closing trial balance, and (10) prepare (optional) reversing entries.

C4 Explain and prepare a classified balance sheet. Classified bal-ance sheets report assets and liabilities in two categories: current and noncurrent. Noncurrent assets often include long-term invest- ments, plant assets, and intangible assets. A corporation separates eq- uity into common stock and retained earnings.

A1 Explain how accounting adjustments link to financial statements. Accounting adjustments bring an asset or liability account balance to its correct amount. They also update related ex- pense or revenue accounts. Every adjusting entry affects one or more income statement accounts and one or more balance sheet accounts. An adjusting entry never affects cash.

A2 Compute profit margin and describe its use in analyzing company performance. Profit margin is defined as the re- porting period’s net income divided by its net sales. Profit margin reflects on a company’s earnings activities by showing how much income is in each dollar of sales.

A3 Compute the current ratio and describe what it reveals about a company’s financial condition. A company’s current ratio is defined as current assets divided by current liabilities. We use it to evaluate a company’s ability to pay its current liabilities out of current assets.

Summary P1 Prepare and explain adjusting entries. Prepaid expenses refer to items paid for in advance of receiving their benefits. Prepaid expenses are assets. Adjusting entries for prepaids involve increasing (debiting) expenses and decreasing (crediting) assets. Unearned (or prepaid ) revenues refer to cash received in advance of providing products and services. Unearned revenues are liabilities. Adjusting entries for unearned revenues involve increasing (credit- ing) revenues and decreasing (debiting) unearned revenues. Accrued expenses refer to costs incurred in a period that are both unpaid and unrecorded. Adjusting entries for recording accrued expenses in- volve in creasing (debiting) expenses and increasing (crediting) lia- bilities. Accrued revenues refer to revenues earned in a period that are both unrecorded and not yet received in cash. Adjusting entries for recording accrued revenues involve increasing (debiting) assets and increasing (crediting) revenues.

P2 Explain and prepare an adjusted trial balance. An adjusted trial balance is a list of accounts and balances prepared after recording and posting adjusting entries. Financial statements are of- ten prepared from the adjusted trial balance.

P3 Prepare financial statements from an adjusted trial bal-ance. Revenue and expense balances are reported on the in- come statement. Asset, liability, and equity balances are reported on the balance sheet. We usually prepare statements in the following order: income statement, statement of retained earnings, balance sheet, and statement of cash flows.

P4 Describe and prepare closing entries. Closing entries in-volve four steps: (1) close credit balances in revenue (and gain) accounts to Income Summary, (2) close debit balances in expense (and loss) accounts to Income Summary, (3) close Income Summary to the retained earnings, and (4) close dividends account to retained earnings.

P5 Explain and prepare a post-closing trial balance. A post-closing trial balance is a list of permanent accounts and their balances after all closing entries have been journalized and posted. Its purpose is to verify that (1) total debits equal total credits for perma- nent accounts and (2) all temporary accounts have zero balances.

P6A Explain the alternatives in accounting for prepaids. Charging all prepaid expenses to expense accounts when they are

P8 Prepare reversing entries and explain their purpose. Accounting with Reversing Entries The right side of Exhibit 3C.1 shows how a reversing entry on January 1 overcomes the disadvantage of the January 9 entry when not using reversing entries. A reversing entry is the exact opposite of an adjusting entry. For FastForward, the Salaries Payable liabil- ity account is debited for $210, meaning that this account now has a zero balance after the entry is posted. The Salaries Payable account temporarily understates the liability, but this is not a problem since 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 is straightforward. This entry 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. Notice 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 ac- count 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. This means that both approaches yield identical results.

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132 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Investor Prepaid expenses are items paid for in advance of receiv- ing their benefits. They are assets and are expensed as they are used up. The publishing company’s treatment of the signing bonus is acceptable provided future book sales can at least match the $500,000 expense. 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).

Entrepreneur Depreciation is a process of cost allocation, not asset valuation. Knowing the depreciation schedule is not especially useful in your estimation of what the building and equipment are cur- rently worth. Your own assessment of the age, quality, and usefulness of the building and equipment is more important.

Loan Officer Your concern in lending to this store arises from analysis of current-year sales. While increased revenues and income are fine, your concern is with collectibility of these promotional sales. If the owner sold products to customers with poor records of

paying bills, then collectibility of these sales is low. Your analysis must assess this possibility and recognize any expected losses.

Financial Officer Omitting accrued expenses and recognizing revenue early can mislead financial statement users. One action is to request a second meeting with the president so you can explain that accruing expenses when incurred and recognizing revenue when earned are required practices. If the president persists, you might dis- cuss the situation with legal counsel and any auditors involved. Your ethical action might cost you this job, but the potential pitfalls for falsification of statements, reputation and personal integrity loss, and other costs are too great.

Analyst A current ratio of 1.2 suggests that current assets are suf- ficient to cover current liabilities, but it implies a minimal buffer in case of errors in measuring current assets or current liabilities. Re- moving the past due receivable reduces the current ratio to 0.7. Your assessment is that the company will have some difficulty meeting its loan payments.

Guidance Answers to Decision Maker and Decision Ethics

purchased is acceptable. When this is done, adjusting entries must transfer any unexpired amounts from expense accounts to asset ac- counts. Crediting all unearned revenues to revenue accounts when cash is received is also acceptable. In this case, the adjusting entries must transfer any unearned amounts from revenue accounts to un- earned revenue accounts.

P7B Prepare a work sheet and explain its usefulness. A work sheet can be a useful tool in preparing and analyzing financial statements. It is helpful at the end of a period in preparing adjusting

entries, an adjusted trial balance, and financial statements. A work sheet usually contains five pairs of columns: Unadjusted Trial Balance, Adjustments, Adjusted Trial Balance, Income Statement, and Balance Sheet & Statement of Equity.

P8C Prepare reversing entries and explain their purpose. Reversing entries are an optional step. They are applied to accrued expenses and revenues. The purpose of reversing entries is to simplify subsequent journal entries. Financial statements are unaffected by the choice to use or not use reversing entries.

1. An annual reporting (or accounting) period covers one year and refers to the preparation of annual financial statements. The an- nual reporting period is not always a calendar year that ends on December 31. An organization can adopt a fiscal year consist- ing of any consecutive 12 months or 52 weeks.

2. Interim financial statements (covering less than one year) are prepared to provide timely information to decision makers.

3. The revenue recognition principle and the expense recogni- tion (matching) principle lead most directly to the adjusting process.

4. No. Cash basis accounting is not consistent with the matching principle because it reports revenue when received, not neces- sarily when earned, and expenses when paid, not necessarily in the period when the expenses were incurred as a result of the revenues earned.

5. No expense is reported in 2014. Under cash basis accounting, the entire $4,800 is reported as an expense in April 2013 when the premium is paid.

6. If the accrued revenues adjustment of $200 is not made, then both revenues and net income are understated by $200 on the current year’s income statement, and both assets and equity are understated by $200 on the balance sheet.

7. A contra account is an account that is subtracted from the balance of a related account. Use of a contra account provides more information than simply reporting a net amount.

8. An accrued expense is a cost incurred in a period that is both unpaid and unrecorded prior to adjusting entries. One example is salaries earned but not yet paid at period-end.

9. An unearned revenue arises when a firm receives cash (or other assets) from a customer before providing the ser vices or prod- ucts to the customer. A magazine subscription paid in advance is one example; season ticket sales is another.

10. Salaries Payable . . . . . . . . . . . . . . . . . . . 1,000 Salaries Expense . . . . . . . . . . . . . . . . . . . 6,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Paid salary including accrual from December. 11. The probable adjusting entries of Jordan Air are: Insurance Expense . . . . . . . . . . . . . . . . . . 300 Prepaid Insurance . . . . . . . . . . . . . . . 300 To record insurance expired. Salaries Expense . . . . . . . . . . . . . . . . . . . . 1,400 Salaries Payable . . . . . . . . . . . . . . . . 1,400 To record accrued salaries.

Guidance Answers to Quick Checks

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 133

12. Revenue accounts and expense accounts. 13. Statement of retained earnings. 14. The major steps in preparing closing entries are to close

(1) credit balances in revenue accounts to Income Summary, (2) debit balances in expense accounts to Income Summary, (3) Income Summary to retained earnings, and (4) any divi- dends account to retained earnings.

15. Revenue (and gain) and expense (and loss) accounts are called temporary because they are opened and closed each period. The Income Summary and Dividends accounts are also temporary.

16. Permanent accounts make up the post-closing trial balance, which consist of asset, liability, and equity accounts.

17. Current assets: (b), (c), (d). Plant assets: (a), (e). Item ( f ) is an intangible asset.

18. Investment in common stock, investment in bonds, and land held for future expansion.

19. For a service company, the operating cycle is the usual time between (1) paying employees who do the services and (2) re- ceiving cash from customers for services provided.

Accounting cycle (p. 116)

Accounting periods (p. 98)

Accrual basis accounting (p. 99)

Accrued expenses (p. 105)

Accrued revenues (p. 107)

Adjusted trial balance (p. 110)

Adjusting entry (p. 101)

Annual financial statements (p. 98)

Book value (p. 104)

Cash basis accounting (p. 99)

Classified balance sheet (p. 117)

Closing entries (p. 112)

Closing process (p. 112)

Contra account (p. 103)

Current assets (p. 118)

Current liabilities (p. 119)

Current ratio (p. 121)

Depreciation (p. 103)

Expense recognition (or matching) principle (p. 100)

Fiscal year (p. 99)

Income Summary (p. 113)

Intangible assets (p. 119)

Interim financial statements (p. 98)

Long-term investments (p. 119)

Long-term liabilities (p. 119)

Natural business year (p. 99)

Operating cycle (p. 117)

Permanent accounts (p. 112)

Plant assets (p. 103)

Post-closing trial balance (p. 114)

Prepaid expenses (p. 101)

Profit margin (p. 121)

Pro forma financial statements (p. 128)

Reversing entries (p. 129)

Straight-line depreciation method (p. 103)

Temporary accounts (p. 112)

Time period assumption (p. 98)

Unadjusted trial balance (p. 110)

Unclassified balance sheet (p. 117)

Unearned revenues (p. 104)

Working papers (p. 127)

Work sheet (p. 127)

Key Terms

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 159 mhhe.com/wildFINMAN5e

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, 2013, a two-year insurance policy was purchased

for $24,000 with coverage to begin immediately. What is the amount of insurance expense that appears on the company’s income statement for the year ended December 31, 2013?

a. $4,000 b. $8,000

c. $12,000 d. $20,000 e. $24,000 4. On November 1, 2013, Stockton Co. receives $3,600 cash from

Hans Co. for consulting services to be provided evenly over the period November 1, 2013, to April 30, 2014—at which time Stockton credited $3,600 to Unearned Consulting Fees. The adjusting entry on December 31, 2013 (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. If a company had $15,000 in net income for the year, and its sales

were $300,000 for the same year, what is its profit margin? a. 20% b. 2,000% c. $285,000 d. $315,000 e. 5%

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134 Chapter 3 Adjusting Accounts and Preparing Financial Statements

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 cor- responds to its natural business year instead of the calendar year?

4. What is a prepaid expense and where is it reported in the finan- cial statements?

5. What type of assets require adjusting entries to record depreciation?

6. What contra account is used when recording and reporting the effects of depreciation? Why is it used?

7. Assume Piaggio has unearned revenue. What is unearned revenue and where is it re- ported in financial statements?

8. What is an accrued revenue? Give an example. 9.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?

10. Review the balance sheet of Polaris in Appendix A. Identify one asset account that re- quires adjustment before annual financial statements can be prepared. What would be the effect on the income statement if this asset account were not adjusted? (Number not required, but comment on over- or understating of net income.)

11. Review the balance sheet of Arctic Cat in Appen dix A. Identify the amount for property and equipment. What adjusting entry is necessary (no numbers re- quired) for this account when preparing financial statements?

12. Refer to KTM’s balance sheet in Appendix A. If it made an adjustment for unpaid wages at year- end, where would the accrued wages be reported on its balance sheet?

13. What are the steps in recording closing entries? 14. What accounts are affected by closing entries? What accounts

are not affected? 15. What two purposes are accomplished by recording closing

entries? 16. What is the purpose of the Income Summary account? 17. Explain whether an error has occurred if a post-closing

trial balance includes a Depreciation Expense account. 18.B What tasks are aided by a work sheet? 19.B Why are the debit and credit entries in the Adjustments

columns of the work sheet identified with letters? 20. What is a company’s operating cycle? 21. What classes of assets and liabilities are shown on a typical

classified balance sheet? 22. How is unearned revenue classified on the balance sheet? 23. What are the characteristics of plant assets? 24.C How do reversing entries simplify recordkeeping? 25.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?

26. Refer to the most recent balance sheet for Polaris in Appendix A. What five main noncur- rent asset categories are used on its classified balance sheet?

27. Refer to KTM’s most recent balance sheet in Appen dix A. Identify and list its 7 current assets.

28. Refer to Arctic Cat’s most recent balance sheet in Appen dix A. Identify the three accounts listed as current liabilities.

29. Refer to Piaggio’s financial statements in Appen dix A. What journal entry was likely re- corded as of December 31, 2011, to close its Income Summary account?

Discussion Questions

A(B,C) Superscript letter A(B,C) denotes assignments based on Appendix 3A(3B,3C).

Icon denotes assignments that involve decision making.

PIAGGIO

Polaris

Polaris

KTM

KTM Arctic Cat

Arctic Cat

PIAGGIO

a. On July 1, 2013, Lamis 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, 2013. Prepare the jour- nal entry to reflect expiration of the insurance as of December 31, 2013.

b. Shandi Company has a Supplies account balance of $5,000 on January 1, 2013. During 2013, it pur- chased $2,000 of supplies. As of December 31, 2013, a supplies inventory 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, 2013.

QUICK STUDY

QS 3-1 Adjusting prepaid expenses

P1

6. Based on the following information from Repicor Company’s balance sheet, what is Repicor Company’s current ratio?

a. 2.10 b. 1.50 c. 1.00 d. 0.95 e. 0.67

Current assets . . . . $ 75,000 Current liabilities . . . . . 50,000

Investments . . . . . . 30,000 Long-term liabilities . . . 60,000

Plant assets . . . . . . 300,000 Common stock . . . . . . 295,000

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 135

QS 3-2 Adjusting for depreciation

P1

a. Bargains Company purchases $20,000 of equipment on January 1, 2013. 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, 2013.

b. Welch Company purchases $10,000 of land on January 1, 2013. The land is expected to last indefi- nitely. What depreciation adjustment, if any, should be made with respect to the Land account as of December 31, 2013?

QS 3-3 Identifying accounting adjustments

P1

Classify the following adjusting entries as involving prepaid expenses (PE), unearned revenues (UR), accrued expenses (AE), or accrued revenues (AR).

a. To record expiration of prepaid insurance. b. To record revenue earned but not yet billed (nor recorded). c. To record wages expense incurred but not yet paid (nor recorded). d. To record annual depreciation expense. e. To record revenue earned that was previously received as cash in advance.

QS 3-7 Recording and analyzing adjusting entries

A1

Adjusting entries affect at least one balance sheet account and at least one income statement account. For the following entries, identify the account to be debited and the account to be credited. 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.

a. Tao Co. receives $10,000 cash in advance for 4 months of legal services on October 1, 2013, and records it by debiting Cash and crediting Unearned Revenue both for $10,000. It is now December 31, 2013, and Tao has provided legal services as planned. What adjusting entry should Tao make to ac- count for the work performed from October 1 through December 31, 2013?

b. A. 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, 2013. It sends Contest News to each of these subscribers every month from July through December. Assuming no changes in subscribers, prepare the journal entry that Caden must make as of December 31, 2013, to adjust the Subscription Revenue account and the Unearned Subscription Revenue account.

QS 3-5 Adjusting for unearned revenues

A1 P1

QS 3-4 Accruing salaries

A1 P1

Jasmine Culpepper 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.) Culpepper adjusts her books monthly, if needed, to show salaries earned but unpaid at month-end. The student works the last week of July — Friday is August 1. If the student earns $100 per day, what adjusting entry must Culpepper make on July 31 to correctly record accrued salaries expense for July?

In its first year of operations, Roma Co. earned $45,000 in revenues and received $37,000 cash from these customers. The company incurred expenses of $25,500 but had not paid $5,250 of them at year-end. The company also prepaid $6,750 cash for expenses that would be incurred the next year. Calculate the first year’s net income under both the cash basis and the accrual basis of accounting.

QS 3-6 Computing accrual and cash income C2 A1

QS 3-8 Preparing adjusting entries

P1

During the year, Sereno Co. 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, (2) adjust the Unearned Services Revenue account to recognize earned revenue, and (3) record services revenue earned for which cash will be received the following period. For each of these adjusting entries (1), (2), and (3), indicate the account from a through i to be debited and the account to be credited. a. Prepaid Salaries d. Unearned Services Revenue g. Accounts Receivable b. Cash e. Salaries Expense h. Accounts Payable c. Salaries Payable f. Services Revenue i. Equipment

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136 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Given this information, which of the following is likely included among its adjusting entries? a. A $400 debit to Insurance Expense and an $800 debit to Interest Payable. b. A $400 debit to Insurance Expense and an $800 debit to Interest Expense. c. A $400 credit to Prepaid Insurance and an $800 debit to Interest Payable.

QS 3-9 Interpreting adjusting entries

C2 P2

The following information is taken from Brooke Company’s unadjusted and adjusted trial balances.

Unadjusted Adjusted

Debit Credit Debit Credit

Prepaid insurance . . . . . . . . . $4,100 $3,700

Interest payable . . . . . . . . . . $ 0 $800

QS 3-12A

Preparing adjusting entries

P6

Calvin Consulting initially records prepaid and unearned items in income statement accounts. Given this company’s accounting practices, which of the following applies to the preparation of adjusting entries at the end of its first accounting period? a. Unearned fees (on which cash was received in advance earlier in the period) are recorded with a debit

to Consulting Fees Earned and a credit to Unearned Consulting Fees. b. Unpaid salaries are recorded with a debit to Prepaid Salaries and a credit to Salaries Expense. c. The cost of unused office supplies is recorded with a debit to Supplies Expense and a credit to Office

Supplies. d. Earned but unbilled (and unrecorded) consulting fees are recorded with a debit to Unearned Consult-

ing Fees and a credit to Consulting Fees Earned.

QS 3-14 Prepaid (deferred) expenses adjustments

P1

For each separate case below, follow the 3-step process for adjusting the prepaid asset account: 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. 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 re-

view of insurance policies and payments 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 and payments 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 2 years of rent for

facilities being occupied that day. The company debited Prepaid Rent and credited Cash for $24,000.

QS 3-10 Determining effects of adjusting entries

A1

In making adjusting entries at the end of its accounting period, Chao Consulting failed to record $3,200 of insurance coverage that had expired. This $3,200 cost had been initially debited to the Prepaid Insurance account. The company also failed to record accrued salaries expense of $2,000. As a result of these two oversights, the financial statements for the reporting period will [choose one] (1) understate assets by $3,200; (2) understate expenses by $5,200; (3) understate net income by $2,000; or (4) overstate liabilities by $2,000.

QS 3-11 Analyzing profit margin

A2

Deklin 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 3-13 International accounting standards

P3

Answer each of the following questions related to international accounting standards. a. Do financial statements prepared under IFRS normally present assets from least liquid to most liquid

or vice-versa? b. Do financial statements prepared under IFRS normally present liabilities from furthest from maturity

to nearest to maturity or vice-versa?

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 137

QS 3-15 Prepaid (deferred) expenses adjustments

P1

For each separate case below, follow the 3-step process for adjusting the supplies asset account: 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. 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 3-16 Accumulated depreciation adjustments

P1

For each separate case below, follow the 3-step process for adjusting the accumulated depreciation account: 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. 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 ex- pense 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 5 years, and is expected to have zero value at the end of the 5 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 7 years, and is expected to be valued at $4,000 at the end of the 7 years.

QS 3-17 Unearned (deferred) revenues adjustments

P1

For each separate case below, follow the 3-step process for adjusting the unearned revenue liability account: 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. 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 twelve months rent in ad- vance and occupancy began November 1.

b. Unearned Services Revenue. The company charges $75 per month to spray a house for insects. 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 treat- ments 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 3-18 Accrued expenses adjustments

P1

For each separate case below, follow the 3-step process for adjusting the accrued expense account: 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. 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. 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.

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138 Chapter 3 Adjusting Accounts and Preparing Financial Statements

QS 3-19 Accrued revenues adjustments

P1

For each separate case below, follow the 3-step process for adjusting the accrued revenue account: 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. Assume no other adjusting entries are made during the year. a. Accounts Receivable. At year-end, the Krug 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 collects fees when jobs are complete. The work for one

customer, whose job was bid at $1,300, has been completed, but the customer has not yet been billed.

QS 3-20 Identifying the accounting cycle

C3

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.

f. Preparing the financial statements. g. Preparing the unadjusted trial balance. h. Journalizing transactions and events. i. Preparing the post-closing trial balance.

For each of the following items, select the letter that identifies the balance sheet category where the item typically would appear.

1. Land not currently used in operations 2. Notes payable (due in five years) 3. Accounts receivable 4. Trademarks

5. Accounts payable 6. Store equipment 7. Wages payable 8. Cash

QS 3-21 Classifying balance sheet items

C4

The following are common categories on a classified balance sheet. A. Current assets B. Long-term investments C. Plant assets

D. Intangible assets E. Current liabilities F. Long-term liabilities

QS 3-22 Identifying current accounts and computing the current ratio

A3

Compute Chavez Company’s current ratio using the following information.

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

QS 3-23 Prepare closing entries from the ledger P4

The ledger of Mai Company includes the following accounts with normal balances: Common Stock $9,000; Dividends $800; Services Revenue $13,000; Wages Expense $8,400; and Rent Expense $1,600. Prepare the necessary closing entries from the available information at December 31.

QS 3-24 Identify post-closing accounts P5

Identify the accounts listed in QS 3-23 that would be included in a post-closing trial balance.

QS 3-26C

Reversing entries

P8

On December 31, 2012, Yates Co. prepared an adjusting entry for $12,000 of earned but unrecorded management fees. On January 16, 2013, Yates received $26,700 cash in management fees, which included the accrued fees earned in 2012. Assuming the company uses reversing entries, prepare the January 1, 2013, reversing entry and the January 16, 2013, cash receipt entry.

The ledger of Claudell Company includes the following unadjusted normal balances: Prepaid Rent $1,000, Serv ices Revenue $55,600, and Wages Expense $5,000. Adjusting entries are required for (a) prepaid rent expired, $200; (b) accrued services revenue $900; and (c) accrued wages expense $700. Enter these unad- justed balances and the necessary adjustments on a work sheet and complete the work sheet for these accounts. Note: Also include the following accounts: Accounts Receivable, Wages Payable, and Rent Expense.

QS 3-25B

Preparing a partial work sheet

P7

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 139

Exercise 3-2 Preparing adjusting entries

P1

For each of the following separate cases, prepare adjusting entries required of financial statements for the year ended (date of ) December 31, 2013. (Assume that prepaid expenses are initially recorded in asset accounts and that fees collected in advance of work are initially recorded as liabilities.) a. One-third of the work related to $15,000 cash received in advance is performed this period. b. Wages of $8,000 are earned by workers but not paid as of December 31, 2013. c. Depreciation on the company’s equipment for 2013 is $18,531. d. The Office Supplies account had a $240 debit balance on December 31, 2012. During 2013, $5,239 of

office supplies are purchased. A physical count of supplies at December 31, 2013, shows $487 of sup- plies available.

e. The Prepaid Insurance account had a $4,000 balance on December 31, 2012. An analysis of insurance policies shows that $1,200 of unexpired insurance benefits remain at December 31, 2013.

f. The company has earned (but not recorded) $1,050 of interest from investments in CDs for the year ended December 31, 2013. The interest revenue will be received on January 10, 2014.

g. The company has a bank loan and has incurred (but not recorded) interest expense of $2,500 for the year ended December 31, 2013. The company must pay the interest on January 2, 2014.

Check (e) Dr. Insurance Expense, $2,800; (f ) Cr. Interest Revenue, $1,050

EXERCISES

Exercise 3-1 Preparing adjusting entries

P1

Prepare adjusting journal entries for the year ended (date of) December 31, 2013, for each of these separate situations. Assume that prepaid expenses are initially recorded in asset accounts. Also assume that fees col- lected in advance of work are initially recorded as liabilities. a. Depreciation on the company’s equipment for 2013 is computed to be $18,000. b. The Prepaid Insurance account had a $6,000 debit balance at December 31, 2013, 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 Office Supplies account had a $700 debit balance on December 31, 2012; and $3,480 of office supplies were purchased during the year. The December 31, 2013, physical count showed $298 of sup- plies available.

d. Two-thirds of the work related to $15,000 of cash received in advance was performed this period. e. The Prepaid Insurance account had a $6,800 debit balance at December 31, 2013, before adjusting for

the costs of any expired coverage. An analysis of insurance policies showed that $5,800 of coverage had expired.

f. Wage expenses of $3,200 have been incurred but are not paid as of December 31, 2013.

Check (c) Dr. Office Supplies Expense, $3,882; (e) Dr. Insurance Expense, $5,800

Exercise 3-4 Adjusting and paying accrued expenses

A1

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 and the subsequent entry during May to record the payment of the accrued expenses. a. On April 1, the company retained an attorney for a flat monthly fee of $3,500. Payment for April legal

services was made by the company on May 12. b. A $900,000 note payable requires 10% annual interest, or $9,000 to be paid at the 20th day of each

month. The interest was last paid on April 20 and the next payment is due on May 20. As of April 30, $3,000 of interest expense has accrued.

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 Tuesday of this year, 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 3-3 Adjusting and paying accrued wages

C1 P1

Pablo Management has five part-time employees, each of whom earns $250 per day. They are normally paid on Fridays for work completed Monday through Friday of the same week. Assume that December 28, 2013, was a Friday, and that they were paid in full on that day. The next week, the five employees worked only four days because New Year’s Day was an unpaid holiday. (a) Assuming that December 31, 2013, was a Monday, prepare the adjusting entry that would be recorded at the close of that day. (b) Assuming that January 4, 2014, was a Friday, prepare the journal entry that would be made to record payment of the employees’ wages.

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140 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Exercise 3-5 Determining cost flows through accounts

C1 A1

Determine the missing amounts in each of these four separate situations a through d.

a b c d

Supplies available — prior year-end . . . . . . . . . . . . . . . . $ 400 $1,200 $1,260 ?

Supplies purchased during the current year . . . . . . . . . 2,800 6,500 ? $3,000

Supplies available — current year-end . . . . . . . . . . . . . . 650 ? 1,350 700

Supplies expense for the current year . . . . . . . . . . . . . ? 1,200 8,400 4,588

Exercise 3-6 Analyzing and preparing adjusting entries

A1 P3

Following are two income statements for Alexis Co. for the year ended December 31. The left column is prepared before any adjusting entries are recorded, and the right column includes the effects of adjusting entries. The company records cash receipts and payments related to unearned and prepaid items in balance sheet accounts. Analyze the statements and prepare the eight adjusting entries that likely were recorded. (Note: 30% of the $7,000 adjustment for Fees Earned has been earned but not billed, and the other 70% has been earned by performing services that were paid for in advance.)

ALEXIS CO. Income Statements

For Year Ended December 31

Unadjusted Adjusted

Revenues

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000 $25,000

Commissions earned . . . . . . . . . . . . . . . . . . . . . . . . 36,500 36,500

Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,500 61,500

Expenses

Depreciation expense—Computers . . . . . . . . . . . . 0 1,600

Depreciation expense—Office furniture . . . . . . . . . 0 1,850

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500 15,750

Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . 0 1,400

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800 3,800

Office supplies expense . . . . . . . . . . . . . . . . . . . . . . 0 580

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 2,500

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,245 1,335

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,045 28,815

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,455 $32,685

Use the following information to compute profit margin for each separate company a through e.

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. 80,142 435,500 c. 111,281 257,000

Which of the five companies is the most profitable according to the profit margin ratio? Interpret that com- pany’s profit margin ratio.

Exercise 3-7 Computing and interpreting profit margin

A2

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. 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

remodeling 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.

Exercise 3-8A

Adjusting for prepaids recorded as expenses and unearned revenues recorded as revenues

P6

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 141

Check (f ) Cr. Insurance Expense, $1,200; (g) Dr. Remodeling Fees Earned, $11,130

f. An analysis of the 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.

Costanza Company experienced the following events and transactions during July.

July 1 Received $3,000 cash in advance of performing work for Vivian Solana. 6 Received $7,500 cash in advance of performing work for Iris Haru. 12 Completed the job for Solana. 18 Received $8,500 cash in advance of performing work for Amina Jordan. 27 Completed the job for Haru. 31 None of the work for Jordan has been performed.

a. Prepare journal entries (including any adjusting entries as of the end of the month) to record these events using the procedure of initially crediting the Unearned Fees account when payment is received from a customer in advance of performing services.

b. Prepare journal entries (including any adjusting entries as of the end of the month) to record these events using the procedure of initially crediting the Fees Earned account when payment is received from a customer in advance of performing services.

c. Under each method, determine the amount of earned fees reported on the income statement for July and the amount of unearned fees reported on the balance sheet as of July 31.

Exercise 3-9A

Recording and reporting revenues received in advance

P6

Check (c) Fees Earned—using entries from part b, $10,500

Tangible and other assets . . . . . . . . . . . . . € 255 Intangible assets . . . . . . . . . . . . . . . € 154

Total equity . . . . . . . . . . . . . . . . . . . . . . . . 2,322 Total current liabilities . . . . . . . . . . 345

Receivables and other assets . . . . . . . . . . 1,767 Inventories . . . . . . . . . . . . . . . . . . . 30

Total noncurrent liabilities . . . . . . . . . . . . 3,379 Total liabilities . . . . . . . . . . . . . . . . . 3,724

Cash and cash equivalents . . . . . . . . . . . . 383 Other current assets . . . . . . . . . . . 28

Total current assets . . . . . . . . . . . . . . . . . . 2,208 Total noncurrent assets . . . . . . . . . 3,838

Other noncurrent assets . . . . . . . . . . . . . . 3,429

adidas AG reports the following balance sheet accounts for the year ended December 31, 2011 (euros in mil- lions). Prepare the balance sheet for this company as of December 31, 2011, following usual IFRS practices.

Exercise 3-10 Preparing a balance sheet following IFRS

P3

Exercise 3-11 Preparing financial statements

C3 P3

Use the following adjusted trial balance of Wilson Trucking Company to prepare the (1) income statement and (2) statement of retained earnings, for the year ended December 31, 2013. The retained earnings ac- count balance is $145,000 at December 31, 2012.

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 . . . . . . . . . . . . . . . . . 53,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . 145,000

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

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142 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Exercise 3-12 Preparing a classified balance sheet C4

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, 2013.

Check Total assets, $249,500

Exercise 3-14 Computing and analyzing the current ratio

A3

Calculate the current ratio in each of the following separate cases (round the ratio to two decimals). Identify the company case with the strongest liquidity position. (These cases represent competing companies in the same industry.)

Current Assets Current Liabilities

Case 1 . . . . . . . . $ 79,040 $ 32,000

Case 2 . . . . . . . . 104,880 76,000

Case 3 . . . . . . . . 45,080 49,000

Case 4 . . . . . . . . 85,680 81,600

Case 5 . . . . . . . . 61,000 100,000

Use the information in the adjusted trial balance reported in Exercise 3-11 to compute the current ratio as of the balance sheet date (round the ratio to two decimals). Interpret the current ratio for the Wilson Truck- ing Company. (Assume that the industry average for the current ratio is 1.5.)

Exercise 3-13 Computing the current ratio

A3

Exercise 3-15A

Preparing reversing entries

P8

The following two events occurred for Trey Co. on October 31, 2013, the end of its fiscal year. a. Trey rents a building from its owner for $2,800 per month. By a prearrangement, the company delayed

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.

Following are Nintendo’s revenue and expense accounts for a recent calendar year (yen in millions). Pre- pare the company’s closing entries for its revenues and its expenses.

Net sales . . . . . . . . . . . . . . . . . ¥1,014,345

Cost of sales . . . . . . . . . . . . . . 626,379

Advertising expense . . . . . . . . 96,359

Other expense, net . . . . . . . . . 213,986

Exercise 3-16 Preparing closing entries

P4

Exercise 3-17 Completing a worksheet

P7

The following data are taken from the unadjusted trial balance of the Westcott Company at December 31, 2013. Each account carries a normal balance and the accounts are shown here in alphabetical order.

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

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 143

1. Use the data above to prepare a worksheet. Enter the accounts in proper order and enter their balances in the correct debit or credit column.

2. Use the following adjustment information to complete the worksheet. a. Depreciation on equipment, $3 b. Accrued salaries, $6 c. The $12 of unearned revenue has been earned d. Supplies available at December 31, 2013, $15 e. Expired insurance, $15

For each of the following entries, 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.

PROBLEM SET A

Problem 3-1A Identifying adjusting entries with explanations

P1

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

Arnez Co. follows the practice of recording prepaid expenses and unearned revenues in balance sheet ac- counts. The company’s annual accounting period ends on December 31, 2013. The following information concerns the adjusting entries to be recorded as of that date. a. The Office Supplies account started the year with a $4,000 balance. During 2013, 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, 2013, totaled $2,554.

Problem 3-2A Preparing adjusting and subsequent journal entries

C1 A1 P1

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144 Chapter 3 Adjusting Accounts and Preparing 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, 2013, follows. WTI initially records prepaid expenses and unearned rev- enues in balance sheet accounts. Descriptions of items a through h that require adjusting entries on December 31, 2013, follow.

Additional Information Items

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 2013. c. Annual depreciation on the equipment is $13,200. d. Annual depreciation on the professional library is $7,200. e. On November 1, WTI agreed to do a special six-month course (starting immediately) for a client. The

contract calls for a monthly fee of $2,500, and the client paid the first five months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited. The fee for the sixth month will be recorded when it is collected in 2014.

f. On October 15, WTI agreed to teach a four-month class (beginning immediately) for an individual for $3,000 tuition per month payable at the end of the class. The class started on October 15, but no payment has yet been received. (WTI’s accruals are applied to the nearest half-month; for example, October recognizes one-half month accrual.)

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.

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Problem 3-3A Preparing adjusting entries, adjusted trial balance, and financial statements

A1 P1 P2 P3

Check (1b) Dr. Insurance Expense, $7,120 (1d ) Dr. Depreciation Expense, $30,500

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.)

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, 2013, 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, 2014.

d. The company purchased a building on January 1, 2013. 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, 2013. 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, 2013. 2. Prepare journal entries to record the first subsequent cash transaction in 2014 for parts c and e.

Months of Policy Date of Purchase Coverage Cost

A April 1, 2011 24 $14,400

B April 1, 2012 36 12,960

C August 1, 2013 12 2,400

b. An analysis of the company’s insurance policies provided the following facts.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 145

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

2013 and prepare its balance sheet as of December 31, 2013.

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

WELLS TECHNICAL INSTITUTE Unadjusted Trial Balance

December 31, 2013

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 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 10,000 80,000

123,900 40,000

A six-column table for JKL Company follows. The first two columns contain the unadjusted trial balance for the company as of July 31, 2013. The last two columns contain the adjusted trial balance as of the same date.

Required

Analysis Component

1. Analyze the differences between the unadjusted and adjusted trial balances to determine the eight ad- justments that likely were made. Show the results of your analysis by inserting these adjustment amounts in the table’s two middle columns. Label each adjustment with a letter a through h and pro- vide a short description of it at the bottom of the table.

Preparation Component

2. Use the information in the adjusted trial balance to prepare the company’s (a) income statement and its statement of retained earnings for the year ended July 31, 2013 (Note: retained earnings at July 31, 2012, was $25,000, and the current-year dividends were $5,000), and (b) the balance sheet as of July 31, 2013.

Problem 3-4A Interpreting unadjusted and adjusted trial balances, and preparing financial statements

A1 P1 P2 P3

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Check (2) Net income, $4,960; Total assets, $124,960

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146 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Unadjusted Adjusted Trial Balance Adjustments Trial Balance

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 34,000 _________________ $ 34,000 Accounts receivable . . . . . . . . . . . 14,000 _________________ 22,000 Office supplies . . . . . . . . . . . . . . . . 16,000 _________________ 2,000 Prepaid insurance . . . . . . . . . . . . . 8,540 _________________ 2,960 Office equipment . . . . . . . . . . . . . 84,000 _________________ 84,000 Accum. depreciation — Office equip. . . . . . . . . . . . . . . . $ 14,000 _________________ $ 20,000 Accounts payable . . . . . . . . . . . . . 9,100 _________________ 10,000 Interest payable . . . . . . . . . . . . . . . 0 _________________ 1,000 Salaries payable . . . . . . . . . . . . . . . 0 _________________ 7,000 Unearned consulting fees . . . . . . . 18,000 _________________ 15,000 Long-term notes payable . . . . . . . 52,000 _________________ 52,000 Common stock . . . . . . . . . . . . . . . 15,000 _________________ 15,000 Retained earnings. . . . . . . . . . . . . . 25,000 _________________ 25,000 Dividends . . . . . . . . . . . . . . . . . . . 5,000 _________________ 5,000 Consulting fees earned . . . . . . . . . 123,240 _________________ 134,240 Depreciation expense — Office equip. . . . . . . . . . . . . . . . 0 _________________ 6,000 Salaries expense . . . . . . . . . . . . . . 67,000 _________________ 74,000 Interest expense . . . . . . . . . . . . . . 1,200 _________________ 2,200 Insurance expense . . . . . . . . . . . . 0 _________________ 5,580 Rent expense . . . . . . . . . . . . . . . . 14,500 _________________ 14,500 Office supplies expense . . . . . . . . 0 _________________ 14,000 Advertising expense . . . . . . . . . . . 12,100 _________________ 13,000 Totals . . . . . . . . . . . . . . . . . . . . . . . $256,340 $256,340

_________________ $279,240 $279,240

The adjusted trial balance for Chiara Company as of December 31, 2013, follows.Problem 3-5A Preparing financial statements from the adjusted trial balance and calculating profit margin

P3 A1 A2

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 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

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 147

Required

1. Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31, 2013; (b) the statement of retained earnings for the year ended December 31, 2013; and (c) the balance sheet as of December 31, 2013.

2. Calculate the profit margin for year 2013.

Check (1) Total assets, $600,000

Problem 3-6A Determining balance sheet classifications

C4

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

D. Intangible assets E. Current liabilities

12. Accumulated depreciation—Trucks 13. Cash 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

1. Long-term investment in stock 2. Depreciation expense—Building 3. Prepaid rent 4. Interest receivable 5. Taxes payable 6. Automobiles 7. Notes payable (due in 3 years) 8. Accounts payable 9. Prepaid insurance 10. Common stock 11. Unearned services revenue

F. Long-term liabilities G. Equity

Problem 3-7A Applying the accounting cycle

P1 P2 P3 P4 P5

On April 1, 2013, Jiro Nozomi created a new travel agency, Adventure Travel. The following transactions occurred during the company’s first month.

April 1 Nozomi invested $30,000 cash and computer equipment worth $20,000 in the company in ex- change 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 on commissions from airlines on tickets obtained for

customers. 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 for dividends.

The company’s chart of accounts follows:

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101 Cash 405 Commissions Earned

106 Accounts Receivable 612 Depreciation Expense — Computer Equip.

124 Office Supplies 622 Salaries Expense

128 Prepaid Insurance 637 Insurance Expense

167 Computer Equipment 640 Rent Expense

168 Accumulated Depreciation — Computer Equip. 650 Office Supplies Expense

209 Salaries Payable 684 Repairs Expense

307 Common Stock 688 Telephone Expense

318 Retained Earnings 901 Income Summary

319 Dividends

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.

Check (3) Unadj. trial balance totals, $58,000

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148 Chapter 3 Adjusting Accounts and Preparing Financial Statements

(4a) Dr. Insurance Expense, $133

(5) Net income, $2,197; Total assets, $51,117

(7) P-C trial balance totals, $51,617

4. Use the following information to journalize and post adjusting entries for the month: a. Two-thirds (or $133) of one month’s insurance coverage has expired. 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, 2013. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

TYBALT CONSTRUCTION Adjusted Trial Balance

December 31, 2013

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 . . . . . . . . . . . . . . . . . . 7,500 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . 67,000 307 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

The adjusted trial balance for Tybalt Construction as of December 31, 2013, follows.Problem 3-8A Preparing closing entries, financial statements, and ratios

C4 A2 A3 P3 P4

O. Tybalt invested $5,000 cash in the business in exchange for more common stock during year 2013 (the December 31, 2012, credit balance of retained earnings was $121,400). Tybalt Construction is required to make a $7,000 payment on its long-term notes payable during 2014.

Required

1. Prepare the income statement and the statement of retained earnings for the calendar year 2013 and the classified balance sheet at December 31, 2013.

Check (1) Total assets (12/31/2013), $218,100; Net income, $4,300

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 149

2. Prepare the necessary closing entries at December 31, 2013. 3. Use the information in the financial statements to compute these ratios: (a) return on assets (total

assets at December 31, 2012, was $200,000), (b) debt ratio, (c) profit margin ratio (use total revenues as the denominator), and (d ) current ratio. Round ratios to three decimals for parts a and c , and to two decimals for parts b and d .

PROBLEM SET B

Problem 3-1B Identifying adjusting entries with explanations

P1

For each of the following entries, 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

Natsu Co. follows the practice of recording prepaid expenses and unearned revenues in balance sheet accounts. The company’s annual accounting period ends on October 31, 2013. The following information concerns the adjusting entries that need to be recorded as of that date. 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, 2013, totaled $800.

b. An analysis of the company’s insurance policies provided the following facts.

Problem 3-2B Preparing adjusting and subsequent journal entries

C1 A1 P1

Months of Policy Date of Purchase Coverage Cost

A April 1, 2012 24 $6,000 B April 1, 2013 36 7,200 C August 1, 2013 12 1,320

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 fiscal years.)

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150 Chapter 3 Adjusting Accounts and Preparing Financial Statements

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, 2013, 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, 2013.

d. The company purchased a building on November 1, 2010, 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. Since 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, 2013. 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, 2013. 2. Prepare journal entries to record the first subsequent cash transaction in November 2013 for parts c and e.

Check (1b) Dr. Insurance Expense, $4,730; (1d ) Dr. Depreciation Expense, $5,400.

Problem 3-3B Preparing adjusting entries, adjusted trial balance, and financial statements

A1 P1 P2 P3

Following is the unadjusted trial balance for Augustus Institute as of December 31, 2013, which initially records prepaid expenses and unearned revenues in balance sheet accounts. 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, 2013.

AUGUSTUS INSTITUTE Unadjusted Trial Balance

December 31, 2013

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 Common stock

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

0

$

0 0

0

$ 60,000 0

70,000 19,000 3,800

12,000

40,000

20,000

44,200

29,600

19,000 13,400

331,000

Debit

$331,000

$ 2,500

20,000 11,200

0 28,600 11,000

Retained earnings 60,500

129,200 68,000

Credit

Dividends

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 151

Additional Information Items

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 2013. 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 five-month course (starting immediately) for a

client. The contract calls for a $14,300 monthly fee, and the client paid the first two months’ fees in advance. When the cash was received, the Unearned Training Fees account was credited. The last two month’s fees will be recorded when collected in 2014.

f. On October 15, the Institute agreed to teach a four-month class (beginning immediately) to an  individual for $2,300 tuition per month payable at the end of the class. The class started on October 15, but no payment has yet been received. (The Institute’s accruals are applied to the nearest half-month; for example, October recognizes one-half month accrual.)

g. The Institute’s only employee is paid weekly. As of the end of the year, three days’ salaries have ac- crued 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 2013, and

prepare its balance sheet as of December 31, 2013.

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

Unadjusted Adjusted Trial Balance Adjustments Trial Balance

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 45,000 _________________ $ 45,000

Accounts receivable . . . . . . . . . . . 60,000 _________________ 66,660

Office supplies . . . . . . . . . . . . . . . . 40,000 _________________ 17,000

Prepaid insurance . . . . . . . . . . . . . 8,200 _________________ 3,600

Office equipment . . . . . . . . . . . . . 120,000 _________________ 120,000

Accumulated depreciation — Office equip. . . . . . . . . . . . . . . . $ 20,000 _________________ $ 30,000

Accounts payable . . . . . . . . . . . . . 26,000 _________________ 32,000

Interest payable . . . . . . . . . . . . . . . 0 _________________ 2,150

Salaries payable . . . . . . . . . . . . . . . 0 _________________ 16,000

Unearned consulting fees . . . . . . . 40,000 _________________ 27,800

Long-term notes payable . . . . . . . 75,000 _________________ 75,000

Common stock . . . . . . . . . . . . . . . 4,000 _________________ 4,000

Retained earnings. . . . . . . . . . . . . . 76,200 _________________ 76,200

Dividends . . . . . . . . . . . . . . . . . . . . 20,000 _________________ 20,000

Consulting fees earned . . . . . . . . . 234,600 _________________ 253,460

Depreciation expense — Office equip. . . . . . . . . . . . . . . . 0 _________________ 10,000

Salaries expense . . . . . . . . . . . . . . 112,000 _________________ 128,000

Interest expense . . . . . . . . . . . . . . 8,600 _________________ 10,750

Insurance expense . . . . . . . . . . . . 0 _________________ 4,600

Rent expense . . . . . . . . . . . . . . . . 20,000 _________________ 20,000

Office supplies expense . . . . . . . . 0 _________________ 23,000

Advertising expense . . . . . . . . . . . 42,000 _________________ 48,000

Totals . . . . . . . . . . . . . . . . . . . . . . . $475,800 $475,800 _________________

$516,610 $516,610

A six-column table for Yan Consulting Company follows. The first two columns contain the unadjusted trial balance for the company as of December 31, 2013, and the last two columns contain the adjusted trial balance as of the same date.

Problem 3-4B Interpreting unadjusted and adjusted trial balances, and preparing financial statements

A1 P1 P2 P3

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152 Chapter 3 Adjusting Accounts and Preparing Financial Statements

Required

Analysis Component

1. Analyze the differences between the unadjusted and adjusted trial balances to determine the eight adjustments that likely were made. Show the results of your analysis by inserting these adjustment amounts in the table’s two middle columns. Label each adjustment with a letter a through h and pro- vide a short description of it at the bottom of the table.

Preparation Component

2. Use the information in the adjusted trial balance to prepare this company’s (a) income statement and its statement of retained earnings for the year ended December 31, 2013 (Note: retained earnings at December 31, 2012, was $76,200, and the current-year dividends were $20,000), and (b) the balance sheet as of December 31, 2013.

Check (2) Net income, $9,110; Total assets, $222,260

Problem 3-5B Preparing financial statements from the adjusted trial balance and calculating profit margin

P3 A1 A2

The adjusted trial balance for Speedy Courier as of December 31, 2013, 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

1. Use the information in the adjusted trial balance to prepare (a) the income statement for the year ended December 31, 2013, (b) the statement of retained earnings for the year ended December 31, 2013, and (c) the balance sheet as of December 31, 2013.

2. Calculate the profit margin for year 2013.

Check (1) Total assets, $663,000

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 153

Problem 3-6B Determining balance sheet classifications

C4

1. Commissions earned 2. Interest receivable 3. Long-term investment in stock 4. Prepaid insurance 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 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

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 D. Intangible assets

E. Current liabilities F. Long-term liabilities G. Equity

Problem 3-7B Applying the accounting cycle

P1 P2 P3 P4 P5

On July 1, 2013, Lula Plume created a new self-storage business, Safe Storage Co. The following transac- tions 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 for dividends.

The company’s chart of accounts follows:

101 Cash 401 Storage Fees Earned

106 Accounts Receivable 606 Depreciation Expense—Buildings

124 Office Supplies 622 Salaries Expense

128 Prepaid Insurance 637 Insurance Expense

173 Buildings 640 Rent Expense

174 Accumulated Depreciation—Buildings 650 Office Supplies Expense

209 Salaries Payable 684 Repairs Expense

307 Common Stock 688 Telephone Expense

318 Retained Earnings 901 Income Summary

319 Dividends

Check (3) Unadj. trial balance totals, $189,800

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.

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154 Chapter 3 Adjusting Accounts and Preparing Financial Statements

4. Use the following information to journalize and post adjusting entries for the month: a. Two-thirds of one month’s insurance coverage has expired. 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, 2013. 6. Prepare journal entries to close the temporary accounts and post these entries to the ledger. 7. Prepare a post-closing trial balance.

(5) Net income, $2,725; Total assets, $180,825

(7) P-C trial balance totals, $182,325

(4a) Dr. Insurance Expense, $400

Problem 3-8B Preparing closing entries, financial statements, and ratios

C4 A2 A3 P3 P4

The adjusted trial balance for Anara Co. as of December 31, 2013, follows.

ANARA COMPANY Adjusted Trial Balance

December 31, 2013

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 . . . . . . . . . . . . . . . . . . 750 251 Long-term notes payable . . . . . . . . . . . . . . . . . . . . 40,000 307 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

P. Anara invested $40,000 cash in the business in exchange for more common stock during year 2013 (the December 31, 2012, credit balance of retained earnings was $52,800). Anara Company is required to make a $8,400 payment on its long-term notes payable during 2014.

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 155

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 still begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.

SP 3 After the success of the company’s first two months, Adria Lopez continues to operate Success Systems. (Transactions for the first two months are described in the serial problem of Chapter 2.) The November 30, 2013, unadjusted trial balance of Success Systems (reflecting its transactions for October and November of 2013) follows.

SERIAL PROBLEM Success Systems

P1 P2 P3 P4 P5

Required

1. Prepare the income statement and the statement of retained earnings for the calendar year 2013 and the classified balance sheet at December 31, 2013.

2. Prepare the necessary closing entries at December 31, 2013. 3. Use the information in the financial statements to calculate these ratios: (a) return on assets (total as-

sets at December 31, 2012, were $160,000), (b) debt ratio, (c) profit margin ratio (use total revenues as the denominator), and (d ) current ratio. Round ratios to three decimals for parts a and c, and to two decimals for parts b and d.

Check (1) Total assets (12/31/2013), $164,700; Net income, $28,890

No. Account Title Debit Credit

101 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,052 106 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,000 318 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,940 676 Mileage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 677 Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 684 Repairs expense—Computer . . . . . . . . . . . . . . . . . . . . . . . . . 805

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,659 $108,659

Success Systems had the following transactions and events in December 2013.

Dec. 2 Paid $1,025 cash to Hillside Mall for Success Systems’ 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 Success Systems’ bid of $7,000 on a proposed project

has been accepted. Alex’s paid a $1,500 cash advance to Success Systems. 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.

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156 Chapter 3 Adjusting Accounts and Preparing Financial Statements

22 – 26 Took the week off for the holidays. 28 Received $3,000 cash from Gomez Co. on its receivable. 29 Reimbursed A. Lopez for business automobile mileage (600 miles at $0.32 per mile). 31 The business paid $1,500 cash for 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 has expired.

Required

1. Prepare journal entries to record each of the December transactions and events for Success Systems. 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, 2013. 4. Prepare an income statement for the three months ended December 31, 2013. 5. Prepare a statement of retained earnings for the three months ended December 31, 2013. 6. Prepare a balance sheet as of December 31, 2013. 7. Record and post the necessary closing entries for Success Systems. 8. Prepare a post-closing trial balance as of December 31, 2013.

Check (3) Adjusted trial balance totals, $109,034

(6) Total assets, $83,460

Beyond the Numbers

BTN 3-1 Refer to Polaris’s financial statements in Appendix A to answer the following. 1. Identify and write down the revenue recognition principle as explained in the chapter. 2. Review Polaris’s footnotes to discover how it applies the revenue recognition principle and when it

recognizes revenue. Report what you discover. 3. What is Polaris’s profit margin for fiscal years ended December 31, 2011 and 2010. 4. For the year ended December 31, 2011, what amount is credited to Income Summary to summarize its

revenues earned? 5. For the year ended December 31, 2011, what amount is debited to Income Summary to summarize its

expenses incurred? 6. For the year ended December 31, 2011, what is the balance of its Income Summary account before it

is closed?

Fast Forward

7. Access Polaris’s annual report (10-K) for fiscal years ending after December 31, 2011, at its Website (Polaris.com) or the SEC’s EDGAR database (www .sec.gov). Assess and compare the December 31, 2011, fiscal year profit margin to any subsequent year’s profit margin that you compute.

REPORTING IN ACTION C1 C2 A1 A2 P4

Check (3) Adjusted trial balance totals, $119,034

(6) Total assets, $93,248

Polaris

Check Post-closing trial balance totals, $94,898

BTN 3-2 Key figures for the recent two years of both Polaris and Arctic Cat follow.

Polaris Arctic Cat

($ thousands) Current Year Prior Year Current Year Prior Year

Net income . . . . . . . . . . . . . $ 227,575 $ 147,138 $ 13,007 $ 1,875

Net sales . . . . . . . . . . . . . . . 2,656,949 1,991,139 363,015 350,871

Current assets . . . . . . . . . . . 878,676 808,145 232,040 201,015

Current liabilities . . . . . . . . . 615,531 584,210 87,444 75,320

COMPARATIVE ANALYSIS A2 A3

Polaris Arctic Cat

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 157

ETHICS CHALLENGE C1 C2 A1

BTN 3-3 Jessica Boland works for Sea Biscuit Co. She and Farah Smith, her manager, are preparing adjusting entries for annual financial statements. Boland computes depreciation and records it as

Depreciation Expense — Equipment . . . . . . . . . . . . . . . 123,000

Accumulated Depreciation — Equipment . . . . . . . . . 123,000

Smith agrees with her computation but says the credit entry should be directly to the Equipment account. Smith argues that while accumulated depreciation is technically correct, “it is less hassle not to use a con- tra account and just credit the Equipment account directly. And besides, the balance sheet shows the same amount for total assets under either method.”

Required

1. How should depreciation be recorded? Do you support Boland or Smith? 2. Evaluate the strengths and weaknesses of Smith’s reasons for preferring her method. 3. Indicate whether the situation Boland faces is an ethical problem. Explain.

BTN 3-4 Assume that 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 retained earnings. (Hint: Think about what would happen if the scoreboard is not cleared before the start of a new game.)

COMMUNICATING IN PRACTICE P4

BTN 3-5 Access EDGAR online (www.sec.gov) and locate the 10-K report of The Gap, Inc., (ticker GPS) filed on March 26, 2012. Review its financial statements reported for the year ended January 28, 2012, to answer the following questions.

Required

1. What are Gap’s main brands? 2. What is Gap’s fiscal year-end? 3. What is Gap’s net sales for the period ended January 28, 2012? 4. What is Gap’s net income for the period ended January 28, 2012? 5. Compute Gap’s profit margin for the year ended January 28, 2012. 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 C1 A2

Required

1. Compute profit margins for (a) Polaris and (b) Arctic Cat for the two years of data shown. 2. Which company is more successful on the basis of profit margin? Explain. 3. Compute the current ratio for both years for both companies. 4. Which company has the better ability to pay short-term obligations according to the current ratio? 5. Analyze and comment on each company’s current ratios for the past two years. 6. How do Polaris’s and Arctic Cat’s current ratios compare to their industry (assumed) average ratio of 2.4?

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158 Chapter 3 Adjusting Accounts and Preparing Financial Statements

BTN 3-6 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 A1 P1

BTN 3-7 Review the opening feature of this chapter dealing with ash&dans and the entrepreneurial owners, Ashley Cook and Danielle Dankner.

Required

1. Assume that ash&dans sells a $300 gift certificate to a customer, collecting the $300 cash in advance. Prepare the journal entry for the (a) collection of the cash for delivery of the gift certificate to the cus- tomer and (b) revenue from the subsequent delivery of merchandise when the gift certificate is used.

2. How can keeping less inventory help to improve ash&dans’s profit margin? 3. Ashley Cook and Danielle Dankner understand that many companies carry considerable inventory,

and they are thinking of carrying additional inventory of merchandise for sale. Ashley and Danielle desire your advice on the pros and cons of carrying such inventory. Provide at least one reason for and one reason against carrying additional inventory.

ENTREPRENEURIAL DECISION A2

BTN 3-8 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

BTN 3-9 Piaggio (Piaggio.com) manufactures two-, three- and four-wheel vehicles and is Europe’s leading manufacturer of motorcycles and scooters. The following selected information is available from Piaggio’s financial statements.

GLOBAL DECISION A2 A3 C1 C2

PIAGGIO (Euro thousands) Current Year Prior Year

Current assets . . . . . . . . . . . 509,708 575,897

Current liabilities . . . . . . . . . 644,277 616,166

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Chapter 3 Adjusting Accounts and Preparing Financial Statements 159

1. b; the forgotten adjusting entry is: dr. Wages Expense, cr. Wages Payable.

2. c; Supplies used 5 $450 2 $125 5 $325 3. b; Insurance expense 5 $24,000 3 (8y24) 5 $8,000; adjusting entry

is: dr. Insurance Expense for $8,000, cr. Prepaid Insurance for $8,000.

4. a; Consulting fees earned 5 $3,600 3 (2y6) 5 $1,200; adjusting entry is: dr. Unearned Consulting Fee for $1,200, cr. Consulting Fees Earned for $1,200.

5. e; Profit margin 5 $15,000y$300,000 5 5% 6. b

ANSWERS TO MULTIPLE CHOICE QUIZ

Required

1. Locate the notes to its December 31, 2011, financial statements at the company’s Website, and read note 2.2 Accounting Principles—Recognition of Revenues, first paragraph only. When is revenue rec- ognized by Piaggio?

2. Refer to Piaggio’s financials in Appendix A. What is Piaggio’s profit margin for the year ended December 31, 2011?

3. Compute Piaggio’s current ratio for both the current year and the prior year. 4. Comment on any change from the prior year to the current year for the current ratio.

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Learning Objectives

CONCEPTUAL

C1 Describe merchandising activities and identify income components for a merchandising company. (p. 162)

C2 Identify and explain the inventory asset and cost flows of a merchandising company. (p. 163)

ANALYTICAL

A1 Compute the acid-test ratio and explain its use to assess liquidity. (p. 178) A2 Compute the gross margin ratio and explain its use to assess profitability.

(p. 178)

PROCEDURAL

P1 Analyze and record transactions for merchandise purchases using a perpetual system. (p. 164)

P2 Analyze and record transactions for merchandise sales using a perpetual system. (p. 169)

P3 Prepare adjustments and close accounts for a merchandising company. (p. 172) P4 Define and prepare multiple-step and single-step income statements. (p. 174) P5 Appendix 4A—Record and compare merchandising transactions using both

periodic and perpetual inventory systems. (p. 183)

A Look at This Chapter

This chapter emphasizes merchandising activities. We explain how reporting merchandising activities differs from reporting service activities. We also analyze and record merchandise purchases and sales transactions, and explain the adjustments and closing process for merchandisers.

A Look Back

Chapter 3 focused on the final steps of the accounting process. We explained the importance of proper revenue and expense recognition and described the adjusting and closing processes. We also prepared financial statements.

Accounting for Merchandising Operations 4

A Look Ahead

Chapter 5 extends our analysis of merchandising activities and focuses on the valuation of inventory. Topics include the items in inventory, costs assigned, costing methods used, and inventory estimation techniques.

160

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Faithful Business

ATLANTA—“I have a learning disability,” explains Chelsea Eubank. “I went to LD schools and attend Beacon College, the only accredited LD college in America. It will always be with me.” However, Chelsea uses her LD as an opportunity. “It [LD] has made me take risks and focus on what my gifts are.” Explains Chelsea, “I always tell them that everyone has a talent and ev- eryone has a disability. They just need to figure out what their talent is!” For Chelsea, her “goal is to create a clothing line that gives to charity and to become a role model for students with challenges.” That goal has led her to launch Faithful Fish (FaithfulFish.com). Our mission, explains Chelsea, is to de- velop a “clothing line that expresses the customers positive val- ues and lifestyle.” She adds, “We are offering something that is not in the marketplace.” Still, her start-up was a struggle. “We had to go through our business plan and then . . . give a summary of the company,” explains Chelsea. She recalls how the business required a mer- chandising accounting system to account for purchases and sales transactions and to effectively track merchandise. Inven- tory was especially important to account for and monitor.

Chelsea admits, “I don’t really know what I am doing, so I have made mistakes.” To succeed, Chelsea made smart business decisions. She set up an accounting system to capture and communicate costs and sales information. Tracking merchandising activities was necessary to set prices and to manage discounts, allowances, and returns of both sales and purchases. A perpetual inventory system enabled her to stock the right kind and amount of mer- chandise and to avoid the costs of out-of-stock and excess in- ventory. Chelsea stresses that one must “ask people for advice.” To help with the accounting for merchandise, Chelsea admits, “I have a financial manager.” Mastering accounting for merchandising is about more than profits and losses—it is a means to an end for Chelsea. “Faithful Fish gives a portion of all sales to charities.” Adds Chelsea, “I want Faithful Fish to get big enough that I will be able to give over $1,000,000 a year away!”

[Sources: Faithful Fish Website, January 2013; YHP, October 2009; FBEnow.com, August 2009; Entrepreneur Girl, January 2012; EmbracingBeauty.com, March 2011]

“I have a vision, a BIG vision, a HUGE vision!“ —CHELSEA EUBANK

Decision Insight

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Point: Fleming, SuperValu, and SYSCO are wholesalers. Aeropostale, Coach, Target, and Walmart are retailers.

EXHIBIT 4.1 Computing Income for a Merchandising Company versus a Service Company

EqualsMinusEqualsMinus Expenses

Net income

Net sales

Merchandiser

Expenses Net

income Revenues

Service Company

Minus Equals

Gross profit

Cost of goods sold

Chapter Preview

Buyers of merchandise expect many products, discount prices, inventory on demand, and high quality. This chapter introduces the accounting practices used by companies engaged in merchandising. We show how financial statements reflect

merchandising activities and explain the new financial statement items created by merchandising activities. We also analyze and record merchandise purchases and sales, and explain the adjustments and the closing process for these companies.

Accounting for Merchandising Operations

Merchandising Purchases

• Purchase discounts • Purchase returns

and allowances • Transportation costs

Merchandising Activities

• Reporting income • Reporting inventory • Operating cycles • Inventory systems

Merchandising Sales

• Sales of merchandise

• Sales discounts • Sales returns and

allowances

Accounting Cycle

• Adjusting entries • Preparing financial

statements • Closing entries

Financial Statement Formats

• Multiple-step income statement

• Single-step income statement

• Classified balance sheet

Previous chapters emphasized the accounting and reporting activities of service companies. A merchandising company’s activities differ from those of a service company. Merchandise consists of products, also called goods, that a company acquires to resell to customers. A merchandiser earns net income by buying and selling merchandise. Merchandisers are often identified as either wholesalers or retailers. A wholesaler is an intermediary that buys products from manufacturers or other wholesalers and sells them to retailers or other wholesalers. A retailer is an intermediary that buys products from manufacturers or wholesalers and sells them to consumers. Many retailers sell both products and services.

Reporting Income for a Merchandiser Net income for a merchandiser equals revenues from selling merchandise minus both the cost of merchandise sold to customers and the cost of other expenses for the period, see Exhibit 4.1. The

MERCHANDISING ACTIVITIES

usual accounting term for revenues from selling merchandise is sales, and the term used for the expense of buying and preparing the merchandise is cost of goods sold. (Some ser vice companies use the term sales instead of revenues; and cost of goods sold is also called cost of sales.) The income statement for Z-Mart in Exhibit 4.2 illustrates these key components of a merchandiser’s net income. The first two lines show that products are acquired at a cost of $230,400 and sold for $314,700. The third line shows an $84,300 gross profit, also called

C1 Describe merchandising activities and identify income components for a merchandising company.

162

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Chapter 4 Accounting for Merchandising Operations 163

EXHIBIT 4.2 Merchandiser’s Income Statement

Z-MART

Income Statement

For Year Ended December 31, 2013

Net sales . . . . . . . . . . . . . . . . . . . $314,700

Cost of goods sold . . . . . . . . . 230,400

Gross profit . . . . . . . . . . . . . . . 84,300

Expenses . . . . . . . . . . . . . . . . . . . 71,400

Net income . . . . . . . . . . . . . . . . . $ 12,900

Point: Mathematically, Exhibit 4.4 says BI 1 NP 5 MAS,

where BI is beginning inventory, NP is net purchases, and MAS is merchandise available for sale. Exhibit 4.4 also says

MAS 5 EI 1 COGS, which can be rewritten as MAS 2 EI 5 COGS or MAS 2 COGS 5 EI, where EI is ending inventory and COGS is cost of goods sold. In both equations above, if we know two of the three values, we can solve for the third.

EXHIBIT 4.4 Merchandiser’s Cost Flow for a Single Time Period

Beginning inventory

Net purchases

5 Merchandise available for sale

Cost of goods sold

Ending inventory

+

+

gross margin, which equals net sales less cost of goods sold. Additional expenses of $71,400 are reported, which leaves $12,900 in net income.

Reporting Inventory for a Merchandiser A merchandiser’s balance sheet includes 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. The cost of this asset includes the cost incurred to buy the goods, ship them to the store, and make them ready for sale.

Operating Cycle for a Merchandiser A merchandising company’s operating cycle begins by purchasing merchandise and ends by collecting cash from selling the merchandise. 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 merchants usually range from two to eight weeks. A grocer has more operating cycles in a year than, say, clothing or electronics retailers. Exhibit 4.3 illustrates an operating cycle for a merchandiser with credit sales. The cycle moves from (a) cash purchases of merchandise to (b) inven- tory for sale to (c) credit sales to (d ) accounts receiv- able to (e) cash. 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 Cost of goods sold is the cost of merchandise sold to customers during a period. It is often the largest single expense on a merchandiser’s income statement. Inventory refers to pro d ucts a company owns and expects to sell in its normal operations. Exhibit 4.4 shows that a company’s merchandise available for sale consists of what it begins with (beginning inventory) and what it

EXHIBIT 4.3 Merchandiser’s Operating Cycle

Cash

(b) Merchandise

inventory (d) Accounts

receivable

(a) Purch a s e s

(e ) C

a s h c

o lle

ct ion

(c) Credit sa les

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Date Num

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Term s

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C2 Identify and explain the inventory asset and cost flows of a merchandising company.

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164 Chapter 4 Accounting for Merchandising Operations

purchases (net purchases). The merchandise available is either sold (cost of goods sold) or kept for future sales (ending inventory). Two alternative inventory accounting systems can be used to collect information about cost of goods sold and cost of inventory: perpetual system or periodic system. The perpetual inventory system continually updates accounting records for merchandising transactions — specifically, for those records of inventory available for sale and inventory sold. The periodic inventory system updates the accounting records for merchandise transactions only at the end of a period. Techno- logical advances and competitive pressures have dramatically increased the use of the perpetual system. It gives managers immediate access to detailed information on sales and inventory levels, where they can strategically react to sales trends, cost changes, consumer tastes, and so forth, to increase gross profit. (Some companies 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.)

The following sections, consisting of the next 10 pages on purchasing, selling, and adjusting merchandise, use the perpetual system. Appendix 4A uses the periodic system (with the perpetual results on the side). An instructor can choose to cover either one or both inventory systems.

Point: Growth of superstores such as Costco and Sam’s is fueled by efficient use of perpetual inventory. Such large stores evolved only after scannable UPC codes to help control inventory were invented.

1. Describe a merchandiser’s cost of goods sold. 2. How do we compute gross profit for a merchandising company? 3. Explain why use of the perpetual inventory system has dramatically increased.

Quick Check Answers — p. 189

Nov. 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Purchased merchandise for cash.

Assets 5 Liabilities 1 Equity 11,200 21,200

The cost of merchandise purchased for resale is recorded in the Merchandise Inventory asset account. To illustrate, Z-Mart records a $1,200 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.

Point: The Merchandise Inventory account reflects the cost of goods available for resale. Costs recorded in Merchandise Inventory are sometimes called inventoriable costs.

Point: Lowes and Home Depot offer trade discounts to construction compa- nies and contractors. Trade discounts help create loyalty among customers.

The invoice for this merchandise is shown in Exhibit 4.5. The buyer usually receives the origi- nal invoice, and the seller keeps a copy. This source document serves as the purchase invoice of Z-Mart (buyer) and the sales invoice for Trex (seller). The amount recorded for merchandise inventory includes its purchase cost, shipping fees, taxes, and any other costs necessary to make it ready for sale. This section explains how we compute the recorded cost of merchandise purchases.

Trade Discounts When a manufacturer or wholesaler prepares a catalog of items it has for sale, it usually gives each item a list price, also called a catalog price. However, an item’s intended selling price equals list price minus a given percent called a trade discount. The amount of trade discount usually depends on whether a buyer is a wholesaler, retailer, or final consumer. A wholesaler buying in large quantities is often granted a larger discount than a retailer buying in smaller quantities. A buyer records the net amount of list price minus trade discount. For example, in the November 2 purchase of merchandise by Z-Mart, the merchandise was listed in the seller’s catalog at $2,000 and Z-Mart received a 40% trade discount. This meant that Z-Mart’s purchase price was $1,200, computed as $2,000 2 (40% 3 $2,000). ■

Decision Insight

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Chapter 4 Accounting for Merchandising Operations 165

EXHIBIT 4.5 Invoice

54 6

1

W9797 Cherry Rd. Antigo, WI 54409

See reverse for terms of sale and returns.

Invoice

Date Number

11/2/13 4657-2 2

P.O. Date Salesperson Terms Freight Ship

SubTotal 1,200

1,200

Shipping

Tax

Total

7

6 Freight terms Goods7 Total invoice amount8

1 32 54Seller Invoice date Purchaser Order date Credit termsKey:

INVOICE

CH015

SD099

Challenger X7

Speed Demon

1

1

490

710

490

710

10/30/13 #141 2/10, n/30 FOB Destination Via FedEx

Model No. Description Quantity Price Amount

8

Firm Name

SOLD TO

Attention of

Address

City

State Zip

Tom Novak, Purchasing Agent

10 Michigan Street

Z-Mart

Chicago

Illinois 60521

3

Purchase Discounts The purchase of goods on credit requires a clear statement of expected future payments and dates to avoid misunderstandings. Credit terms for a purchase include the amounts and timing of payments from a buyer to a seller. Credit terms usually reflect an industry’s practices. To illustrate, when sellers require payment within 10 days after the end of the month of the invoice date, the invoice will show credit terms as “ny10 EOM,” which stands for net 10 days after end of month (EOM). When sellers require payment within 30 days after the invoice date, the in- voice shows credit terms of “ny30,” which stands for net 30 days. Exhibit 4.6 portrays credit terms. The amount of time allowed before full payment is due is called the credit period. Sellers can grant a cash discount to encourage buyers to pay earlier. A buyer views a cash discount as a purchase discount. A seller views a cash discount as a sales discount. Any cash discounts are described in the credit terms on the invoice. For example, credit terms of “2y10, ny60” 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 applies only for the discount period.

Point: Since both the buyer and seller know the invoice date, this date is used in setting the discount and credit periods.

EXHIBIT 4.6 Credit Terms

Amount Due

Due: Invoice priceDue: Invoice price minus discount*

*Discount refers to a purchase discount for a buyer and a sales discount for a seller.

Discount* period

Credit period

Date of invoice

Credit Terms

Time

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166 Chapter 4 Accounting for Merchandising Operations

Entrepreneur You purchase a batch of products on terms of 3y10, ny90, but your company has limited cash and you must borrow funds at an 11% annual rate if you are to pay within the discount period. Is it to your advantage to take the purchase discount? Explain. ■ [Answer—p. 188]

Decision Maker

To illustrate how a buyer accounts for a purchase discount, assume that Z-Mart’s $1,200 pur- chase of merchandise is on credit with terms of 2y10, ny30. Its entry is

If Z-Mart pays the amount due on (or before) November 12, the entry is

(a) Nov. 2 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Purchased merchandise on credit, invoice dated Nov. 2, terms 2y10, ny30.

Assets 5 Liabilities 1 Equity 11,200 11,200

(b) Nov. 12 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 24

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,176

Paid for the $1,200 purchase of Nov. 2 less the discount of $24 (2% 3 $1,200).

Assets 5 Liabilities 1 Equity 224 21,200 21,176

A buyer’s failure to pay within a discount period can be expensive. To illustrate, if Z-Mart does not pay within the 10-day 2% discount period, it can delay payment by 20 more days. This de- lay costs Z-Mart $24, computed as 2% 3 $1,200. Most buyers take advantage of a purchase discount because of the usually high interest rate implied from not taking it.1 Also, good cash management means that no invoice is paid until the last day of the discount or credit period.

The Merchandise Inventory account after these entries reflects the net cost of merchandise purchased, and the Accounts Payable account shows a zero balance. Both ledger accounts, in T-account form, follow:

Point: These entries illustrate what is called the gross method of accounting for purchases with discount terms.

Nov. 2 1,200

Balance 1,176

Nov. 12 24

Merchandise Inventory

Nov. 12 1,200 Nov. 2 1,200

Balance 0

Accounts Payable

1 The implied annual interest rate formula is:

[365 days 4 (Credit period 2 Discount period)] 3 Cash discount rate.

For terms of 2y10, ny30, missing the 2% discount for an additional 20 days is equal to an annual interest rate of 36.5%, computed as [365 daysy(30 days 2 10 days)] 3 2% discount rate. Favorable purchase discounts are those with implied annual interest rates that exceed the purchaser’s annual rate for borrowing money.

Purchase Returns and Allowances Purchase returns refer to merchandise a buyer acquires but then returns to the seller. A purchase allowance is a reduction in the cost of defective or unacceptable merchandise that a buyer acquires. Buyers often keep defective but still marketable merchandise if the seller grants an acceptable allowance. When a buyer returns or takes an allowance on merchandise, the buyer issues a debit memorandum to inform the seller of a debit made to the seller’s account payable in the buyer’s records.

Point: The sender (maker) of a debit memorandum will debit the account pay- able of the memo’s receiver. The memo’s receiver will credit the sender’s account receivable.

Point: Appendix 4A repeats journal entries a through f using a periodic inventory system.

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Chapter 4 Accounting for Merchandising Operations 167

Purchase Allowances To illustrate purchase allowances, assume that on November 15, Z-Mart (buyer) issues a $300 debit memorandum for an allowance from Trex for defective mer- chandise. Z-Mart’s November 15 entry to update its Merchandise Inventory account to reflect the purchase allowance is

(c) Nov. 15 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 300

Allowance for defective merchandise.

Assets 5 Liabilities 1 Equity 2300 2300

Transportation Costs and Ownership Transfer The buyer and seller must agree on who is responsible for paying any freight costs and who bears the risk of loss during transit for merchandising transactions. This is essentially the same as asking at what point ownership transfers from the seller to the buyer. The point of transfer is called the FOB ( free on board ) point, which determines who pays transportation costs (and often other incidental costs of transit such as insurance). Exhibit 4.7 identifies two alternative points of transfer. (1) FOB shipping point, also called FOB factory, means the buyer accepts ownership when the goods depart the seller’s place of business. The buyer is then responsible for paying shipping costs and bearing the risk of damage or loss when goods are in transit. The goods are part of the buyer’s inventory when they are in transit since ownership has transferred to the buyer. 1-800-FLOWERS.COM, a floral and gift

June 1 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

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

Purchased merchandise, invoice dated June 1, terms 2/10, n/60.

June 3 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 100

Returned merchandise to seller.

June 11 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 18

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 882

Paid for $900 merchandise ($1,000 2 $100) less $18 discount (2% 3 $900).

Example: Assume Z-Mart pays $980 cash for $1,000 of merchandise pur- chased within its 2% discount period. Later, it returns $100 of the original $1,000 merchandise. The return entry is Cash . . . . . . . . . . . . . . . . . . . . . . 98

Merchandise Inventory . . . . 98

The buyer’s allowance for defective merchandise is usually offset against the buyer’s current account payable balance to the seller. When cash is refunded, the Cash account is debited in- stead of Accounts Payable.

Purchase Returns Returns are recorded at the net costs charged to buyers. To illustrate the accounting for returns, suppose Z-Mart purchases $1,000 of merchandise on June 1 with terms 2/10, n/60. Two days later, Z-Mart returns $100 of goods before paying the invoice. When Z-Mart later pays on June 11, it takes the 2% discount only on the $900 remaining bal- ance. When goods are returned, a buyer can take a purchase discount on only the remaining balance of the invoice. The resulting discount is $18 (2% 3 $900) and the cash payment is $882 ($900 2 $18). The following entries reflect this illustration.

Point: In the perpetual system, all purchases, purchase discounts, purchase returns, and cost of sales are recorded in the Merchandise Inventory account. This is different from the periodic system as explained in Appendix 4A.

Payables Manager As a new accounts payable manager, you are being trained by the outgoing man- ager. 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 also 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. When a supplier complains, we blame the computer system and the mailroom.” Do you continue this payment policy? ■ [Answer—p. 188]

Decision Ethics

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168 Chapter 4 Accounting for Merchandising Operations

merchandiser, and Bare Escentuals, a cosmetic manufacturer, both use 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 is responsible for paying shipping charges and bears the risk of damage or loss in transit. The seller does not record revenue from this sale until the  goods arrive at the destination because this transaction is not complete before that point. Kyocera, a manufacturer, uses FOB destination. Z-Mart’s $1,200 purchase on November 2 is on terms of FOB destination. This means Z-Mart is not responsible for paying transportation costs. When a buyer is responsible for paying trans- portation costs, the payment is made to a carrier or directly to the seller depending on the agree- ment. The cost principle requires that any necessary transportation costs of a buyer (often called transportation-in or freight-in) be included as part of the cost of purchased merchandise. To illustrate, Z-Mart’s entry to record a $75 freight charge from an independent carrier for mer- chandise purchased FOB shipping point is

Point: The party not responsible for shipping costs sometimes pays the car rier. In these cases, the party paying these costs either bills the party responsible or, more commonly, adjusts its account payable or account receivable with the other party. For example, a buyer paying a carrier when terms are FOB destination can decrease its account payable to the seller by the amount of shipping cost.

EXHIBIT 4.7 Ownership Transfer and Transportation Costs

Destination

Ownership Transfers

When Goods Passed to

FOB shipping point Carrier

Transportation Costs Paid by

Carrier Shipping point

Shipping Terms

Seller Buyer

FOB destination Buyer

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

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

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

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Paid freight costs on purchased merchandise.

Assets 5 Liabilities 1 Equity 175 275

The accounting system described here does not provide separate records (accounts) for total purchases, total purchase discounts, total purchase returns and allowances, and total transportation-in. Yet nearly all companies collect this information in supplementary records because managers need this information to evaluate and control each of these cost elements. Supplementary records, also called supplemental records, refer to information outside the usual general ledger accounts.

Point: Some companies have separate accounts for purchase 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.

EXHIBIT 4.8 Itemized Costs of Merchandise Purchases

Z-MART

Itemized Costs of Merchandise Purchases

For Year Ended December 31, 2013

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

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

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

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

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

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

A seller records the costs of shipping goods to customers in a Delivery Expense account when the seller is responsible for these costs. Delivery Expense, also called transportation-out or freight-out, is reported as a selling expense in the seller’s income statement. In summary, purchases are recorded as debits to Merchandise Inventory. Any later purchase dis- counts, returns, and allowances are credited (decreases) to Merchandise Inventory. Transportation- in is debited (added) to Merchandise Inventory. Z-Mart’s itemized costs of merchandise purchases for year 2013 are in Exhibit 4.8.

Point: With tracking numbers it is possible to know the exact time shipped goods arrive at their destination.

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Chapter 4 Accounting for Merchandising Operations 169

Sales of Merchandise Each sales transaction for a seller of merchandise involves two parts.

4. How long are the credit and discount periods when credit terms are 2y10, ny60? 5. Identify which items are subtracted from the list amount and not recorded when computing

purchase price: (a) freight-in; (b) trade discount; (c) purchase discount; (d ) purchase return. 6. What does FOB mean? What does FOB destination mean?

Quick Check Answers — p. 189

Merchandising companies also must account for sales, sales discounts, sales returns and allow- ances, and cost of goods sold. A merchandising company such as Z-Mart reflects these items in its gross profit computation, as shown in Exhibit 4.9. This section explains how this informa tion is derived from transactions.

ACCOUNTING FOR MERCHANDISE SALES

1. Revenue received in the form of an asset from the customer. 2. Cost recognized for the merchandise sold to the customer.

Accounting for a sales transaction under the perpetual system requires recording information about both parts. This means that each sales transaction for merchandisers, whether for cash or on credit, requires two entries: one for revenue and one for cost. To illustrate, Z-Mart sold $2,400 of merchandise on credit on November 3. The revenue part of this transaction is recorded as

(e) Nov. 3 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Sold merchandise on credit.

Assets 5 Liabilities 1 Equity 12,400 12,400

P2 Analyze and record transactions for merchandise sales using a perpetual system.

This entry reflects an increase in Z-Mart’s assets in the form of accounts receivable. It also shows the increase in revenue (Sales). If the sale is for cash, the debit is to Cash instead of Accounts Receivable. The cost part of each sales transaction ensures that the Merchandise Inventory account under a perpetual inventory system reflects the updated cost of the merchandise available for sale. For example, the cost of the merchandise Z-Mart sold on November 3 is $1,600, and the entry to record the cost part of this sales transaction is

(e) Nov. 3 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . 1,600

To record the cost of Nov. 3 sale.

Assets 5 Liabilities 1 Equity 21,600 21,600

EXHIBIT 4.9 Gross Profit Computation

Z-MART

Computation of Gross Profit

For Year Ended December 31, 2013

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

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170 Chapter 4 Accounting for Merchandising Operations

Sales Discounts Sales discounts on credit sales can benefit a seller by decreasing the delay in receiving cash and reducing future collection efforts. At the time of a credit sale, a seller does not know whether a customer will pay within the discount period and take advantage of a discount. This means the seller usually does not record a sales discount until a customer actually pays within the discount period. To illustrate, Z-Mart completes a credit sale for $1,000 on November 12 with terms of 2y10, ny60. The entry to record the revenue part of this sale is

This entry records the receivable and the revenue as if the customer will pay the full amount. The customer has two options, however. One option is to wait 60 days until January 11 and pay the full $1,000. In this case, Z-Mart records that payment as

The customer’s second option is to pay $980 within a 10-day period ending November 22. If the customer pays on (or before) November 22, Z-Mart records the payment as

Sales Discounts is a contra revenue account, meaning the Sales Discounts account is deducted from the Sales account when computing a company’s net sales (see Exhibit 4.9). Management monitors Sales Discounts to assess the effectiveness and cost of its discount policy.

Sales Returns and Allowances Sales returns refer to merchandise that customers return to the seller after a sale. Many compa- nies allow customers to return merchandise for a full refund. Sales allowances refer to reduc- tions in the selling price of merchandise sold to customers. This can occur with damaged or defective merchandise that a customer is willing to purchase with a decrease in selling price. Sales returns and allowances usually involve dissatisfied customers and the possibility of lost future sales, and managers monitor information about returns and allowances.

Sales Returns To illustrate, recall Z-Mart’s sale of merchandise on November 3 for $2,400 that had cost $1,600. Assume that the customer returns part of the merchandise on

Nov. 12 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Sold merchandise under terms of 2y10, ny60.

Assets 5 Liabilities 1 Equity 11,000 11,000

Jan. 11 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment for Nov. 12 sale.

Assets 5 Liabilities 1 Equity 11,000 21,000

Nov. 22 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 980

Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Received payment for Nov. 12 sale less discount.

Assets 5 Liabilities 1 Equity 1980 220

21,000

Point: Published income statements rarely disclose sales discounts, returns and allowances.

Point: Radio-frequency identification (RFID) tags attach to objects for tracking purposes. Such tags help find items in a store, monitor shipments, and help check on production progress.

Suppliers and Demands Large merchandising companies often bombard suppliers with demands. These include discounts for bar coding and technology support systems, and fines for shipping errors. Mer- chandisers’ goals are to reduce inventories, shorten lead times, and eliminate errors. Many colleges now offer programs in supply chain management and logistics to train future employees that can help merchan- disers meet such goals. ■

Decision Insight

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Chapter 4 Accounting for Merchandising Operations 171

( f ) Nov. 6 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 800

Customer returns merchandise of Nov. 3 sale.

Assets 5 Liabilities 1 Equity 2800 2800

If the merchandise returned to Z-Mart is not defective and can be resold to another customer, Z-Mart returns these goods to its inventory. The entry to restore the cost of such goods to the Merchandise Inventory account is

Nov. 6 Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 600

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . 600

Returned goods added to inventory.

Assets 5 Liabilities 1 Equity 1600 1600

Nov. 6 Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . 100

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . 100

To record sales allowance on Nov. 3 sale.

Assets 5 Liabilities 1 Equity 2100 2100

Point: The sender (maker) of a credit memorandum will credit the account of the receiver. The receiver of a credit memorandum will debit the sender’s account.

This entry changes if the goods returned are defective. In this case the returned inventory is re- corded at its estimated value, not its cost. To illustrate, if the goods (costing $600) returned to Z-Mart are defective and estimated to be worth $150, the following entry is made: Dr. Merchan- dise Inventory for $150, Dr. Loss from Defective Merchandise for $450, and Cr. Cost of Goods Sold for $600.

Point: Some sellers charge buyers a re-stocking fee for returns.

Sales Allowances To illustrate sales allowances, assume that $800 of the merchandise Z-Mart sold on November 3 is defective but the buyer decides to keep it because Z-Mart of- fers a $100 price reduction. Z-Mart records this allowance as follows:

The seller usually prepares a credit memorandum to confirm a buyer’s return or allowance. A seller’s credit memorandum informs a buyer of the seller’s credit to the buyer’s Account Re- ceivable (on the seller’s books).

7. Why are sales discounts and sales returns and allowances recorded in contra revenue accounts instead of directly in the Sales account?

8. Under what conditions are two entries necessary to record a sales return? 9. When merchandise is sold on credit and the seller notifies the buyer of a price allowance,

does the seller create and send a credit memorandum or a debit memorandum?

Quick Check Answers — p. 189

November 6, and the returned items sell for $800 and cost $600. The revenue part of this transaction must reflect the decrease in sales from the customer’s return of merchandise as follows:

Reversing Returns. On May 3, 2011, Green Mountain Coffee Roasters beat analysts’ earnings estimates by $0.10 per share for the 13-week period ended March 26, 2011. The next day the stock price rose $11.91 per share to close at $75.98 per share, an 18.5% increase over the prior day’s closing price. In the weeks that followed, some analysts raised questions about the quality of Green Mountain’s earnings because of its ac- counting for sales returns. They allege that a large part of that earnings increase was due to an accounting adjustment that reversed much of a reserve that was set up for sales returns in prior periods. ■

Decision Insight

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172 Chapter 4 Accounting for Merchandising Operations

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

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

To adjust for $250 shrinkage revealed by a physical count of inventory.

Assets 5 Liabilities 1 Equity 2250 2250

EXHIBIT 4.10 Merchandising Cost Flow in the Accounting Cycle

Beginning inventory

From supplier

Net purchases

Ending inventory

P er

io d

2 P

er io

d 1

To Balance Sheet

To Income Statement

To Balance Sheet

Beginning inventory

Net purchases

Ending inventory

Cost of goods sold

To Income Statement Cost of

goods sold

Merchandise available for sale

Merchandise available for sale

From supplier

Adjusting Entries for Merchandisers Each of the steps in the accounting cycle described in the prior chapter for a service company applies to a merchandiser. This section and the next two further explain three steps of the ac- counting cycle for a merchandiser — adjustments, statement preparation, and closing. Adjusting entries are generally the same for merchandising companies and service com- panies, including those for prepaid expenses (including depreciation), accrued expenses, unearned revenues, and accrued revenues. However, a merchandiser using a perpetual inventory system is usually required to make another adjustment to update the Merchandise Inventory account to reflect any loss of merchandise, including theft and deterioration. Shrinkage is the term used to refer to the loss of inventory and it is computed by comparing a physical count of inventory with recorded amounts. A physical count is usually performed at least once annually.

To illustrate, Z-Mart’s Merchandise Inventory account at the end of year 2013 has a balance of $21,250, but a physical count reveals that only $21,000 of inventory exists. The adjusting entry to record this $250 shrinkage is

Point: About two-thirds of shoplifting losses are thefts by employees.

P3 Prepare adjustments and close accounts for a merchandising company.

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.

COMPLETING THE ACCOUNTING CYCLE

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Chapter 4 Accounting for Merchandising Operations 173

Point: The Inventory account is not affected by the closing process under a perpetual system.

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 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000 To close credit balances in temporary accounts.

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 To close debit balances in temporary accounts.

Step 3: Close Income Summary to Retained Earnings.

The third closing entry is identical for a merchandising company and a service company. The $12,900 amount is net income reported on the income statement.

Step 4: Close Dividends Account to Retained Earnings.

The fourth closing entry is identical for a merchandising company and a service company. It closes the Dividends account and adjusts the Retained Earnings account to the amount shown on the balance sheet.

Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 12,900 To close the Income Summary account.

Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 To close the Dividends account.

Preparing Financial Statements The financial statements of a merchandiser, and their preparation, are similar to those for a service company described in Chapters 2 and 3. The income statement mainly differs by the inclusion of cost of goods sold and gross profit. Also, net sales is affected by discounts, returns, and allowances, and some additional expenses are possible such as delivery expense and loss from defective merchandise. The balance sheet mainly differs by the inclusion of merchandise inventory as part of current assets. The statement of retained earnings is un- changed. A work sheet can be used to help prepare these statements, and one is illustrated in Appendix 4B for Z-Mart.

Closing Entries for Merchandisers Closing entries are similar for service companies and merchandising companies using a per- petual system. The difference is that we must close some new temporary accounts that arise from merchandising activities. Z-Mart has several temporary accounts unique to merchandisers: Sales (of goods), Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Their existence in the ledger means that the first two closing entries for a merchandiser are slightly different from the ones described in the prior chapter for a service company. These differences are set in red boldface in the closing entries of Exhibit 4.11.

Summary of Merchandising Entries Exhibit 4.12 summarizes the key adjusting and closing entries of a merchandiser (using a perpetual inventory system) that are different from those of a service company described in prior chapters (the Demonstration Problem 2 illustrates these merchandising entries).

Point: Staples’s costs of shipping merchandise to its stores is included in its costs of inventories as required by the cost principle.

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174 Chapter 4 Accounting for Merchandising Operations

EXHIBIT 4.12 Summary of Merchandising Entries

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . # Purchases Paying within discount period. Accounts Payable . . . . . . . . . . . . . . . . . . . . # Merchandise Inventory . . . . . . . . . . . . # Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . #

Recording purchase 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 . . . . . . . . . . . . . . . . . . . . . . # Sales

Accounts Receivable . . . . . . . . . . . . . . #

Granting sales returns or Sales Returns and Allowances . . . . . . . . . . . # allowances. Cash or Accounts Receivable . . . . . . . #

Merchandise Inventory . . . . . . . . . . . . . . . . # Cost of Goods Sold . . . . . . . . . . . . . . #

Paying freight costs on sales; Delivery Expense . . . . . . . . . . . . . . . . . . . . # FOB destination. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . #

Merchandising Events Adjusting and Closing Entries

Adjusting due to shrinkage Cost of Goods Sold . . . . . . . . . . . . . . . . . . # Adjusting (occurs when recorded amount Merchandise Inventory . . . . . . . . . . . . # larger than physical inventory).

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” . . . . . . . . . . . . . . . . #

Generally accepted accounting principles do not require companies to use any one presentation format for financial statements so we see many different formats in practice. This section de- scribes two common income statement formats: multiple-step and single-step. The classified balance sheet of a merchandiser is also explained.

FINANCIAL STATEMENT FORMATS

10. When a merchandiser uses a perpetual inventory system, why is it sometimes necessary to adjust the Merchandise Inventory balance with an adjusting entry?

11. What temporary accounts do you expect to find in a merchandising business but not in a service business?

12. Describe the closing entries normally made by a merchandising company.

Quick Check Answers — p. 189

P4 Define and prepare multiple-step and single- step income statements.

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Chapter 4 Accounting for Merchandising Operations 175

Point: Z-Mart did not have any non- operating activities; however, Exhibit 4.13 includes some for illustrative purposes.

EXHIBIT 4.13 Multiple-Step Income Statement

Z-MART

Income Statement

For Year Ended December 31, 2013

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 revenue and gains (expenses and losses) . . . . . . . . . . 2,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,900

Gross profit computation

Nonoperating activities computation

Income from operations computation

Beginning inventory. . . . . . . . . . . . . . $ 19,000 Cost of goods purchased . . . . . . . . . . 232,400 Goods available for sale . . . . . . . . . . . 251,400 Less ending inventory . . . . . . . . . . . . 21,000 Cost of goods sold . . . . . . . . . . . . . . . $230,400

*Cost of goods sold consists of the following:

Multiple-Step Income Statement A multiple-step income statement format shows detailed computations of net sales and other costs and expenses, and reports subtotals for various classes of items. Exhibit 4.13 shows a multiple-step income statement for Z-Mart. The statement has three main parts: (1) gross profit, determined by net sales less cost of goods sold, (2) income from operations, determined by gross profit less operating expenses, and (3) net income, determined by income from operations adjusted for nonoperating items.

Operating expenses are classified into two sections. Selling expenses include the expenses of promoting sales by displaying and advertising merchandise, making sales, and delivering goods to customers. General and administrative expenses support a company’s overall operations and include expenses related to accounting, human resource management, and financial man- agement. 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 expense. Nonoperating activities consist of other expenses, revenues, losses, and gains that are unre- lated to a company’s operations. Other revenues and gains commonly include interest revenue,

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176 Chapter 4 Accounting for Merchandising Operations

Point: Many companies report interest expense and interest revenue in separate categories after operating income and before subtracting income tax expense. As one example, see Arctic Cat’s and KTM’s income statements in Appendix A.

Example: Sometimes interest revenue and interest expense are reported on the income statement as interest, net. To illustrate, if a company has $1,000 of in- terest expense and $600 of interest rev- enue, it might report $400 as interest, net.

dividend revenue, rent revenue, and gains from asset disposals. Other expenses and losses com- monly include interest expense, losses from asset disposals, and casualty losses. When a com- pany has no reportable nonoperating activities, its income from operations is simply labeled net income.

Single-Step Income Statement A single-step income statement is another widely used format and is shown in Exhibit 4.14 for Z-Mart. It lists cost of goods sold as another expense and shows only one subtotal for total expenses. Expenses are grouped into very few, if any, categories. Many companies use formats that combine features of both the single- and multiple-step statements. Provided that income statement items are shown sensibly, management can choose the format. (In later chapters, we describe some items, such as extraordinary gains and losses, that must be reported in certain locations on the income statement.) Similar presentation options are available for the statement of retained earnings and statement of cash flows.

EXHIBIT 4.15 Classified Balance Sheet (partial) of a Merchandiser

Z-MART

Balance Sheet (partial)

December 31, 2013

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 4.14 Single-Step Income Statement

Z-MART

Income Statement

For Year Ended December 31, 2013

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

Classified Balance Sheet The merchandiser’s classified balance sheet reports merchandise inventory as a current asset, usually after accounts receivable according to an asset’s nearness to liquidity. Inventory is usually less liquid than accounts receivable because inventory must first be sold before cash can be received; but it is more liquid than supplies and prepaid expenses. Exhibit 4.15 shows the current asset section of Z-Mart’s classified balance sheet (other sections are as shown in Chapter 3).

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Chapter 4 Accounting for Merchandising Operations 177

Balance Sheet Presentation Chapters 2 and 3 explained how both U.S. GAAP and IFRS re- quire current items to be separated from noncurrent items on the balance sheet (yielding a classified bal- ance sheet). As discussed, U.S. GAAP balance sheets report current items first. Assets are listed from most liquid to least liquid, whereas liabilities are listed from nearest to maturity to furthest from maturity. IFRS balance sheets normally present noncurrent items first (and equity before liabilities), but this is not a requirement. Piaggio provides an example of IFRS reporting for the balance sheet in Appendix A.

This section discusses similarities and differences between U.S. GAAP and IFRS in accounting and reporting for merchandise purchases and sales, and for the income statement.

Accounting for Merchandise Purchases and Sales Both U.S. GAAP and IFRS include broad and similar guidance for the accounting of merchandise purchases and sales. Specifically, all of the transactions presented and illustrated in this chapter are accounted for identically under the two systems. The closing process for merchandisers also is identical for U.S. GAAP and IFRS. In the next chapter we describe how inventory valuation can, in some cases, be different for the two systems.

Income Statement Presentation We explained that net income, profit, and earnings refer to the same (bottom line) item. However, IFRS tends to use the term profit more than any other term, whereas U.S. statements tend to use net income more than any other term. Both U.S. GAAP and IFRS income statements begin with the net sales or net revenues (top line) item. For merchandisers and manufacturers, this is followed by cost of goods sold. The presentation is similar for the remaining items with the following differences.

● U.S. GAAP offers little guidance about the presentation or order of expenses. IFRS requires separate disclosures for financing costs (interest expense), income tax expense, and some other special items.

● Both systems require separate disclosure of items when their size, nature, or frequency are important. ● IFRS permits expenses to be presented by their function or their nature. U.S. GAAP provides no direc-

tion but the SEC requires presentation by function. ● Neither U.S. GAAP nor IFRS define operating income, which results in latitude in reporting. ● IFRS permits alternative income measures on the income statement; U.S. GAAP does not.

Volkswagen Group provides the following example of income statement reporting. We see the separate disclosure of finance costs, taxes, and other items. We also see the unusual practice of using the minus symbol in an income statement.

GLOBAL VIEW

VOLKSWAGEN GROUP

Income Statement (in Euros million)

For Year Ended December 31, 2011

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,337

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2131,371

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,966

Distribution expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214,582

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,384

Other operating income (net of other expenses) . . . . . . . . . . . 2,271

Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,271

Finance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,047

Other financial results (including equity investments). . . . . . . . . 9,702

Profit before tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,926

Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,127

Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,799

Merchandising Shenanigans Accurate invoices are important to both sellers and buyers. Merchandis- ers rely on invoices to make certain they receive all monies for products provided—no more, no less. To achieve this, controls are set up. Still, failures arise. A survey reports that 9% of employees in sales and marketing witnessed false or misleading invoices sent to customers. Another 14% observed employees violating contract terms with customers (KPMG 2009). ■

Decision Insight

VOLKSWAGEN

PIAGGIO

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178 Chapter 4 Accounting for Merchandising Operations

Acid-Test and Gross Margin RatiosDecision Analysis

Acid-Test Ratio For many merchandisers, inventory makes up a large portion of current assets. Inventory must be sold and any resulting accounts receivable must be collected before cash is available. Chapter 3 explained that the current ratio, defined as current assets divided by current liabilities, is useful in assessing a company’s ability to pay current liabilities. Because it is sometimes unreasonable to assume that inventories are a source of payment for current liabilities, we look to other measures. One measure of a merchandiser’s ability to pay its current liabilities (referred to as its liquidity) is the acid- test ratio. 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. The acid-test ratio, also called quick ratio, is defined as quick assets (cash, short-term investments, and current receivables) divided by current liabilities — see Exhibit 4.16.

A1 Compute the acid-test ratio and explain its use to assess liquidity.

EXHIBIT 4.16 Acid-Test (Quick) Ratio Acid-test ratio 5

Cash and cash equivalents 1 Short-term investments 1 Current receivables

Current liabilities

Exhibit 4.17 shows both the acid-test and current ratios of retailer JCPenney for fiscal years 2008 through 2012—also see margin graph. JCPenney’s acid-test ratio reveals a general increase from 2008 through 2011 that exceeds the industry average, and then a marked decline in 2012. Further, JCPenney’s current ratio shows a marked decline in 2012 to 1.84, which suggests that its short-term obligations are less confidently covered with short-term assets compared with prior years.

20102011 2009 2008

0.0 201020112012 2009 2008

0.5

1.0

1.5

2.0

2.5

Acid-Test Ratio Current RatioJCPenney:

EXHIBIT 4.17 JCPenney’s Acid-Test and Current Ratios

($ millions) 2012 2011 2010 2009 2008

Total quick assets . . . . . . . . . . . . . $1,920 $2,956 $3,406 $2,704 $2,845

Total current assets . . . . . . . . . . . 5,081 $6,370 $6,652 $6,220 $6,751

Total current liabilities . . . . . . . . . 2,756 $2,647 $3,249 $2,794 $3,338

Acid-test ratio . . . . . . . . . . . . . . 0.70 1.12 1.05 0.97 0.85

Current ratio . . . . . . . . . . . . . . . 1.84 2.41 2.05 2.23 2.02

Industry acid-test ratio . . . . . . . . . 0.54 0.61 0.59 0.63 0.62

Industry current ratio . . . . . . . . . . 2.01 2.27 2.15 2.31 2.39

A2 Compute the gross margin ratio and explain its use to assess profitability.

Gross Margin Ratio The cost of goods sold makes up much of a merchandiser’s expenses. Without sufficient gross profit, a merchandiser will likely fail. Users often compute the gross margin ratio to help understand this relation. It differs from the profit margin ratio in that it excludes all costs except cost of goods sold. The gross margin ratio (also called gross profit ratio) is defined as gross margin (net sales minus cost of goods sold) divided by net sales — see Exhibit 4.18.

EXHIBIT 4.18 Gross Margin Ratio Gross margin ratio 5

Net sales 2 Cost of goods sold

Net sales

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 to conclude that a company is unlikely to face near-term liquidity problems. A value much less than 1.0 raises liquidity concerns unless a company can generate enough cash from inventory sales or if much of its liabilities are not due until late in the next period. Similarly, a value slightly larger than 1.0 can hide a liquidity problem if payables are due shortly and receivables are not collected until late in the next period. Analysis of JCPenney shows some need for concern regarding its liquidity as its acid-test ratio is less than one. However, retailers such as JCPenney pay many current liabilities from inventory sales and in all years, JCPenney’s acid-test ratios exceed the industry norm (and its inventory is fairly liquid).

Point: Successful use of a just-in-time inventory system can narrow the gap between the acid-test ratio and the current ratio.

Supplier A retailer requests to purchase supplies on credit from your company. You have no prior experi- ence 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—p. 188]

Decision Maker

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Exhibit 4.19 shows the gross margin ratio of JCPenney for fiscal years 2008 through 2012. For JCPenney, each $1 of sales in 2012 yielded about 36.0¢ in gross margin to cover all other expenses and still produce a net income. This 36.0¢ margin is down from 38.6¢ in 2008. This decrease is not a favorable develop- ment. Success for merchandisers such as JCPenney depends on adequate gross margin. For example, the 2.60¢ decrease in the gross margin ratio, computed as 36.0¢ 2 38.6¢, means that JCPenney has $448.76 million less in gross margin! (This is computed as net sales of $17,260 million multiplied by the 2.6% decrease in gross margin.) Management’s discussion in its annual report attributes this decline to “softer than expected selling environment and the resulting increased promotional activity and the costs associ- ated with implementing our new pricing strategy.”

EXHIBIT 4.19 JCPenney’s Gross Margin Ratio

($ millions) 2012 2011 2010 2009 2008

Gross margin . . . . . . . . . . . . . . . . $ 6,218 $ 6,960 $ 6,910 $ 6,915 $ 7,671

Net sales . . . . . . . . . . . . . . . . . . . $17,260 $17,759 $17,556 $18,486 $19,860

Gross margin ratio . . . . . . . . . 36.0% 39.2% 39.4% 37.4% 38.6%

Use the following adjusted trial balance and additional information to complete the requirements.

DEMONSTRATION PROBLEM 1

Point: The power of a ratio is often its ability to identify areas for more detailed analysis.

KC ANTIQUES

Adjusted Trial Balance

December 31, 2013

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 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 (70% is store, 30% is office) . . . . . . . . . 24,000

Store supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 5,750

Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . 31,400

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $449,850 $449,850

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—p. 189]

Decision Maker

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180 Chapter 4 Accounting for Merchandising Operations

KC Antiques’ supplementary records for 2013 reveal the following itemized costs for merchandising activities:

Invoice cost of merchandise purchases . . . . . . . . $150,000 Purchase discounts received . . . . . . . . . . . . . . . . . 2,500 Purchase 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 2013. 2. Prepare a 2013 multiple-step income statement. (Inventory at December 31, 2012, is $70,100.) 3. Prepare a single-step income statement for 2013. 4. Prepare closing entries for KC Antiques at December 31, 2013. 5. Compute the acid-test ratio and the gross margin ratio. Explain the meaning of each ratio and interpret

them for KC Antiques.

PLANNING THE SOLUTION ● Compute the total cost of merchandise purchases for 2013. ● 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 Sum-

mary 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 TO DEMONSTRATION PROBLEM 1 1.

Invoice cost of merchandise purchases . . . . . . . . $150,000 Less: Purchases discounts received . . . . . . . . . . . . 2,500 Purchase returns and allowances . . . . . . . . . 2,700 Add: Cost of transportation-in . . . . . . . . . . . . . . . 5,000 Total cost of merchandise purchases . . . . . . . . . . $149,800

2. Multiple-step income statement

KC ANTIQUES

Income Statement

For Year Ended December 31, 2013

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

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Chapter 4 Accounting for Merchandising Operations 181

4.

Dec. 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 343,250 To 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Store Supplies Expense . . . . . . . . . . . . . . . . . . . . . . 5,750 Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . 31,400 To close debit balances in temporary accounts. Dec. 31 Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 30,500 To close the Income Summary account. Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 To close the Dividends account.

5. Acid-test ratio 5 (Cash and equivalents 1 Short-term investments 1 Current receivables)y Current liabilities

5 (Cash 1 Accounts receivabley(Accounts payable 1 Salaries payable) 5 ($7,000 1 $13,000)y($9,000 1 $2,000) 5 $20,000y$11,000 5 1.82

Gross margin ratio 5 Gross profityNet sales 5 $172,350y$332,250 5 0.52 (or 52%)

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

[continued from previous page]

* Cost of goods sold can also be directly computed (applying concepts from Exhibit 4.4):

Merchandise inventory, December 31, 2012 . . . . . . . . . . . . . . $ 70,100

Total cost of merchandise purchases (from part 1) . . . . . . . . . . 149,800

Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219,900

Merchandise inventory, December 31, 2013 . . . . . . . . . . . . . . . 60,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,900

3. Single-step income statement

KC ANTIQUES

Income Statement

For Year Ended December 31, 2013

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

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182 Chapter 4 Accounting for Merchandising Operations

DEMONSTRATION PROBLEM 2 Prepare journal entries to record the following merchandising 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, ny45, in- voice dated May 4. The cost of the merchandise was $900.

May 6 Sanuk paid transportation charges of $30 on the May 4 purchase from BMX. May 8 BMX sold $1,000 of merchandise on account to Sanuk, terms FOB destination, ny30, invoice

dated May 8. The cost of the merchandise was $700. May 10 BMX paid transportation costs of $50 for delivery of merchandise sold to Sanuk on May 8. May 16 BMX issued Sanuk a $200 credit memorandum for merchandise returned. The merchandise was

purchased by Sanuk on account on May 8. The cost of the merchandise returned was $140. May 18 BMX received payment from Sanuk for purchase of May 8. May 21 BMX sold $2,400 of merchandise on account to Sanuk, terms FOB shipping point, 2y10,

nyEOM. BMX prepaid transportation costs of $100, which were added to the invoice. The cost of the merchandise was $1,440.

May 31 BMX received payment from Sanuk for purchase of May 21, less discount (2% 3 $2,400).

SOLUTION TO DEMONSTRATION PROBLEM 2

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 . . . . . . . . . . . 2,500

Sales . . . . . . . . . . . . . . . . . . . . . . 2,400 Accounts Payable—BMX . . . . . . 2,500

Accounts Receivable—Sanuk . . . . . . . 100

Cash . . . . . . . . . . . . . . . . . . . . . . 100

Cost of Goods Sold . . . . . . . . . . . . . . 1,440

Merchandise Inventory . . . . . . . . 1,440

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 2,452 Accounts Payable—BMX . . . . . . . . . . 2,500

Sales Discounts . . . . . . . . . . . . . . . . . 48 Merchandise Inventory . . . . . . . 48

Accounts Receivable—Sanuk . . . . . 2,500 Cash . . . . . . . . . . . . . . . . . . . . . . 2,452

KC Antiques has a healthy acid-test ratio of 1.82. This means it has more than $1.80 in liquid assets to satisfy each $1.00 in current liabilities. The gross margin of 0.52 shows that KC Antiques spends 48¢ ($1.00 2 $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.

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Chapter 4 Accounting for Merchandising Operations 183

APPENDIX

Periodic Inventory System 4A

P5 Record and compare merchandising transactions using both periodic and perpetual inventory systems.

(b) Periodic Perpetual

Accounts Payable . . . . . . . . . 1,200 Accounts Payable . . . . . . . . . . . . . 1,200

Purchase Discounts . . . . 24 Merchandise Inventory . . . . . 24

Cash . . . . . . . . . . . . . . . . 1,176 Cash . . . . . . . . . . . . . . . . . . . . 1,176

(a) Periodic Perpetual

Purchases . . . . . . . . . . . . . . . 1,200 Merchandise Inventory . . . . . . . . . 1,200

Accounts Payable . . . . . 1,200 Accounts Payable . . . . . . . . . . 1,200

(c) Periodic Perpetual

Accounts Payable . . . . . . . . . 300 Accounts Payable . . . . . . . . . . . . . . 300

Purchase Returns and Allowances . . . . . . . 300 Merchandise Inventory . . . . . 300

Purchase Discounts The periodic system uses a temporary Purchase Discounts account that accumu- lates discounts taken on purchase transactions during the period. If payment in (a) is delayed until after the discount period expires, the entry is to debit Accounts Payable and credit Cash for $1,200 each. How- ever, if Z-Mart pays the supplier for the previous purchase in (a) within the discount period, the required payment is $1,176 ($1,200 3 98%) and is recorded as

Purchase Returns and Allowances Z-Mart returned merchandise purchased on November 2 because of defects. In the periodic system, the temporary Purchase Returns and Allowances account accumulates the cost of all returns and allowances during a period. The recorded cost (including discounts) of the defective merchandise is $300, and Z-Mart records the November 15 return with this entry:

Transportation-In Z-Mart paid a $75 freight charge to transport merchandise to its store. In the periodic system, this cost is charged to a temporary Transportation-In account.

A periodic inventory system requires updating the inventory account only at the end of a period to re- flect the quantity and cost of both the goods available and the goods sold. Thus, during the period, the Merchandise Inventory balance remains unchanged. It reflects the beginning inventory balance until it is updated at the end of the period. During the period the 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 when a company prepares financial statements, it takes a physical count of inventory by counting the quantities and costs of merchandise available. The cost of goods sold is then computed by subtracting the ending inventory amount from the cost of merchandise available for sale.

Recording Merchandise Transactions Under a periodic system, purchases, purchase returns and allowances, purchase discounts, and transportation-in transactions are recorded in separate temporary accounts. At period-end, each of these temporary accounts is closed and the Merchandise Inventory ac- count is updated. To illustrate, journal entries under the periodic inventory system are shown for the most common transactions (codes a through f link these transactions to those in the chapter, and we drop expla- nations for simplicity). For comparison, perpetual system journal entries are shown to the right of each periodic entry, where differences are in green font.

Purchases The periodic system uses a temporary Purchases account that accumulates the cost of all purchase transactions during each period. Z-Mart’s November 2 entry to record the purchase of merchan- dise for $1,200 on credit with terms of 2y10, ny30 is

Point: Purchase Discounts and Pur- chase Returns and Allowances are both classified as contra-purchases accounts and have normal credit balances.

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184 Chapter 4 Accounting for Merchandising Operations

Sales Under the periodic system, the cost of goods sold is not recorded at the time of each sale. (We later show how to compute total cost of goods sold at the end of a period.) Z-Mart’s November 3 entry to record sales of $2,400 in merchandise on credit (when its cost is $1,600) is:

(d ) Periodic Perpetual

Transportation-In . . . . . . . . . 75 Merchandise Inventory . . . . . . . . . 75

Cash . . . . . . . . . . . . . . . 75 Cash . . . . . . . . . . . . . . . . . . . 75

( f ) Periodic Perpetual

Sales Returns and Sales Returns and Allowances . . . . . . . . . . . . . . 800 Allowances . . . . . . . . . . . . . . . . . . 800

Accounts Receivable . . . 800 Accounts Receivable . . . . . . 800

Merchandise Inventory . . . . . . . . . 600

Cost of Goods Sold . . . . . . . 600

Periodic Perpetual

Cash . . . . . . . . . . . . . . . . . . . 1,552 Cash . . . . . . . . . . . . . . . . . . . . . . . 1,552

Sales Discounts ($1,600 3 .03) 48 Sales Discounts ($1,600 3 .03) . . . 48

Accounts Receivable . . . 1,600 Accounts Receivable . . . . . . 1,600

(e) Periodic Perpetual

Accounts Receivable . . . . . . 2,400 Accounts Receivable . . . . . . . . . . 2,400

Sales . . . . . . . . . . . . . . . 2,400 Sales . . . . . . . . . . . . . . . . . . . 2,400

Cost of Goods Sold . . . . . . . . . . . 1,600

Merchandise Inventory . . . . 1,600

Sales Returns A customer returned part of the merchandise from the transaction in (e), where the returned items sell for $800 and cost $600. (Recall: The periodic system records only the revenue effect, not the cost effect, for sales transactions.) Z-Mart restores the merchandise to inventory and records the November 6 return as

Sales Discounts To illustrate sales discounts, assume that the remaining $1,600 of receivables (com- puted as $2,400 from e less $800 for f ) has credit terms of 3/10, n/90 and that customers all pay within the discount period. Z-Mart records this payment as

Adjusting and Closing Entries The periodic and perpetual inventory systems have slight differ- ences in adjusting and closing entries. The period-end Merchandise Inventory balance (unadjusted) is $19,000 under the periodic system and $21,250 under the perpetual system. Since the periodic system does not update the Merchandise Inventory balance during the period, the $19,000 amount is the begin- ning inventory. However, the $21,250 balance under the perpetual system is the recorded ending inventory before adjusting for any inventory shrinkage. A physical count of inventory taken at the end of the period reveals $21,000 of merchandise avail- able. The adjusting and closing entries for the two systems are shown in Exhibit 4A.1. The periodic system records the ending inventory of $21,000 in the Merchandise Inventory account (which includes

EXHIBIT 4A.1 Comparison of Adjusting and Closing Entries—Periodic and Perpetual

PERPETUAL

Adjusting Entry—Shrinkage

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . 250

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

PERIODIC

Adjusting Entry—Shrinkage

None

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Chapter 4 Accounting for Merchandising Operations 185

shrinkage) in the first closing entry and removes the $19,000 beginning inventory balance from the account in the second closing entry.2

By updating Merchandise Inventory and closing Purchases, Purchase Discounts, Purchase Returns and Allowances, and Transportation-In, the periodic system transfers the cost of goods sold amount to Income Summary. Review the periodic side of Exhibit 4A.1 and notice that the boldface items affect Income Summary as follows.

[continued from previous page]

PERIODIC

Closing Entries

(1) Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000

Merchandise Inventory . . . . . . . . . . . . . . . 21,000

Purchase Discounts . . . . . . . . . . . . . . . . . . 4,200

Purchase Returns and Allowances . . . . . 1,500

Income Summary . . . . . . . . . . . . . . . . . . 347,700

(2) Income Summary 334,800

Sales Discounts . . . . . . . . . . . . . . . . . . . 4,300

Sales Returns and Allowances . . . . . . . 2,000

Merchandise Inventory . . . . . . . . . . 19,000

Purchases . . . . . . . . . . . . . . . . . . . . . . 235,800

Transportation-In . . . . . . . . . . . . . . . 2,300

Depreciation Expense . . . . . . . . . . . . . . 3,700

Salaries Expense . . . . . . . . . . . . . . . . . . . 43,800

Insurance Expense . . . . . . . . . . . . . . . . 600

Rent Expense . . . . . . . . . . . . . . . . . . . . 9,000

Supplies Expense . . . . . . . . . . . . . . . . . . 3,000

Advertising Expense . . . . . . . . . . . . . . . 11,300

(3) Income Summary . . . . . . . . . . . . . . . . . . . . . 12,900

Retained Earnings . . . . . . . . . . . . . . . . . 12,900

(4) Retained Earnings . . . . . . . . . . . . . . . . . . . . . 4,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . 4,000

PERPETUAL

Closing Entries

(1) Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321,000

Income Summary . . . . . . . . . . . . . . . . . . 321,000

(2) 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

(3) Income Summary . . . . . . . . . . . . . . . . . . . . . 12,900

Retained Earnings . . . . . . . . . . . . . . . . . 12,900

(4) Retained Earnings . . . . . . . . . . . . . . . . . . . . . 4,000

Dividends . . . . . . . . . . . . . . . . . . . . . . . 4,000

2 This 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.

This $230,400 effect on Income Summary is the cost of goods sold amount. 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

Credit to Income Summary in the first closing entry includes amounts from:

Merchandise inventory (ending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

Purchase discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200

Purchase 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(230,400)

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186 Chapter 4 Accounting for Merchandising Operations

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 peri- odic system are similar to those for a service company described in prior chapters. The income state- ment mainly differs by the inclusion of cost of goods sold and gross profit—of course, net sales is affected by discounts, returns, and allowances. The cost of goods sold section under the periodic sys- tem follows

The balance sheet mainly differs by the inclusion of merchandise inventory in current assets — see Exhibit 4.15. The statement of retained earnings is unchanged. A work sheet can be used to help pre- pare these statements. The only differences under the periodic system from the work sheet illustrated in Appendix 4B using the perpetual system are highlighted as follows in blue boldface font.

Calculation of Cost of Goods Sold

For Year Ended December 31, 2013

Beginning inventory . . . . . . . . . . . . . . . . . . $ 19,000

Cost of goods purchased . . . . . . . . . . . . . 232,400

Cost of goods available for sale . . . . . . . . 251,400

Less ending inventory . . . . . . . . . . . . . . . . 21,000

Cost of goods sold . . . . . . . . . . . . . . . . . . $230,400

No. Account Dr.

Unadjusted Trial

Balance

Adjusted Trial

Balance Income

Statement Balance SheetAdjustments Dr. Dr. Dr. Dr.Cr. Cr. Cr. Cr. Cr.

101 106 119 126 128 167 168 201 209 307 318

413 414 415 505 506 507 508 612 622 637 640 652 655

8,200 11,200 19,000

3,800 900

34,200

2,000 4,300

235,800

2,300

43,000

9,000

11,300 389,000

16,000

10,000

321,000

1,500 4,200

389,000

(a) 600

(b) 3,000

8,100

(b) 3,000 (a) 600

(c) 3,700

(d) 800

8,100

16,000 800

10,000

321,000

1,500 4,200

393,500

8,200 11,200 19,000

800 300

34,200

2,000 4,300

235,800

2,300

600 9,000 3,000

11,300 393,500

2,000 4,300

235,800

2,300

600 9,000 3,000

11,300 334,800

12,900 347,700

321,000

1,500 4,200

347,700

347,700

8,200 11,200 21,000

800 300

34,200

79,700

79,700

16,000 800

10,000

66,800 12,900 79,700

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17a 17b 17c 17d 18 19 20 21 22 23 24 25 26

19,000 21,000

Cash Accounts receivable Merchandise Inventory Supplies Prepaid insurance Equipment Accumulated depr.—Equip. Accounts payable Salaries payable Common stock Retained earnings

Sales Sales returns and allowances Sales discounts Purchases Purchases returns & allowance Purchases discounts Transportation-in Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Advertising expense Totals Net income Totals

7,400 7,400

4,000 32,600

4,000 32,600 32,600

4,000

3,700

(c) 3,700 (d) 800

3,700 43,800

3,700 43,800

319 Dividends

27

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Chapter 4 Accounting for Merchandising Operations 187

13. What account is used (for journalizing entries) in a perpetual inventory system but not in a periodic system?

14. Which of the following accounts are temporary accounts under a periodic system? (a) Merchandise Inventory; (b) Purchases; (c) Transportation-In.

15. How is cost of goods sold computed under a periodic inventory system? 16. Do reported amounts of ending inventory and net income differ if the adjusting entry method

of recording the change in inventory is used instead of the closing entry method?

Quick Check Answers — p. 189

APPENDIX

Work Sheet—Perpetual System 4B Exhibit 4B.1 shows the work sheet for preparing financial statements of a merchandiser. It differs slightly from the work sheet layout in Chapter 3 — the differences are in red boldface. Also, the adjustments in the work sheet reflect the following: (a) Expiration of $600 of prepaid insurance. (b) Use of $3,000 of sup- plies. (c) Depreciation of $3,700 for equipment. (d ) Accrual of $800 of unpaid salaries. (e) Inventory shrinkage of $250. Once the adjusted amounts are extended into the financial statement columns, the in- formation is used to develop financial statements.

No. Account Dr.

Unadjusted Trial

Balance

Adjusted Trial

Balance Income

Statement Balance SheetAdjustments Dr. Dr. Dr. Dr.Cr. Cr. Cr. Cr. Cr.

101 106 119 126 128 167 168 201 209 307 318

413 414 415 502 612 622 637 640 652 655

8,200 11,200 21,250 3,800 900

34,200

2,000 4,300

230,150

43,000

9,000

11,300 383,300

16,000

10,000

321,000

383,300

(a) 600

(b) 3,000

8,350

(b) 3,000 (a) 600

(c) 3,700

(d) 800

8,350

16,000 800

10,000

321,000

387,800

8,200 11,200 21,000

800 300

34,200

2,000 4,300

230,400 3,700 43,800

600 9,000 3,000

11,300 387,800

2,000 4,300

230,400 3,700

43,800 600

9,000 3,000

11,300 308,100 12,900

321,000

321,000

321,000

321,000

8,200 11,200 21,000

800 300

34,200

79,700

79,700

16,000 800

10,000

66,800 12,900 79,700

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

Cash Accounts receivable Merchandise Inventory Supplies Prepaid insurance Equipment Accumulated depr.—Equip. Accounts payable Salaries payable Common stock Retained earnings

Sales Sales returns and allowances Sales discounts Cost of goods sold Depreciation expense—Equip. Salaries expense Insurance expense Rent expense Supplies expense Advertising expense Totals Net income Totals

7,400 7,400

4,000 32,600 32,600 32,600

Dividends 4,000 4,000

3,700

(c) 3,700 (d) 800

(e) 250

(e) 250

319

28

EXHIBIT 4B.1 Work Sheet for Merchandiser (using a perpetual system)

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188 Chapter 4 Accounting for Merchandising Operations

C1 Describe merchandising activities and identify income components for a merchandising company. Merchandisers buy products and resell them. Examples of merchan disers include Walmart, Home Depot, The Limited, and Barnes & Noble. A mer- chandiser’s costs on the income statement include an amount for cost of goods sold. Gross profit, or gross margin, equals sales minus cost of goods sold.

C2 Identify and explain the inventory asset and cost flows of a merchandising company. The current asset section of a merchandising company’s balance sheet includes merchandise inventory, which refers to the products a merchandiser sells and are available for sale at the balance sheet date. Cost of merchandise purchases flows into Merchandise Inventory and from there to Cost of Goods Sold on the income statement. Any remaining inventory is reported as a current asset on the balance sheet.

A1 Compute the acid-test ratio and explain its use to assess liquidity. The acid-test ratio is computed as quick assets (cash, short-term investments, and current receivables) divided by current liabilities. It indicates a company’s ability to pay its current liabilities with its existing quick assets. An acid-test ratio equal to or greater than 1.0 is often adequate.

A2 Compute the gross margin ratio and explain its use to assess profitability. The gross margin ratio is computed as gross margin (net sales minus cost of goods sold) divided by net sales. It indicates a company’s profitability before considering other expenses.

P1 Analyze and record transactions for merchandise pur-chases using a perpetual system. For a perpetual inventory system, purchases of inventory (net of trade discounts) are added to the Merchandise Inventory account. Purchase discounts and purchase returns and allowances are subtracted from Merchandise Inventory, and transportation-in costs are added to Merchandise Inventory.

P2 Analyze and record transactions for merchandise sales using a perpetual system. A merchandiser records sales at

Summary list price less any trade discounts. The cost of items sold is trans- ferred from Merchandise Inventory to Cost of Goods Sold. Refunds or credits given to customers for unsatisfactory merchandise are recorded in Sales Returns and Allowances, a contra account to Sales. If merchandise is returned and restored to inventory, the cost of this merchandise is removed from Cost of Goods Sold and transferred back to Merchandise Inventory. When cash discounts from the sales price are offered and customers pay within the discount period, the seller records Sales Discounts, a contra account to Sales.

P3 Prepare adjustments and close accounts for a merchandis-ing company. With a perpetual system, it is often necessary to make an adjustment for inventory shrinkage. This is computed by comparing a physical count of inventory with the Merchandise Inventory balance. Shrinkage is normally charged to Cost of Goods Sold. Temporary accounts closed to Income Summary for a merchandiser include Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold.

P4 Define and prepare multiple-step and single-step income statements. Multiple-step income statements include greater detail for sales and expenses than do single-step income statements. They also show details of net sales and report expenses in categories reflecting different activities.

P5A Record and compare merchandising transactions using both periodic and perpetual inventory systems. A perpetual inventory system continuously tracks the cost of goods available for sale and the cost of goods sold. A periodic system accumulates the cost of goods purchased during the period and does not compute the amount of inventory or the cost of goods sold until the end of a period. Trans actions involving the sale and purchase of merchandise are recorded and analyzed under both the periodic and perpetual inventory systems. Adjusting and closing entries for both inventory systems are illustrated and explained.

Entrepreneur For terms of 3y10, ny90, missing the 3% discount for an additional 80 days equals an implied annual interest rate of 13.69%, computed as (365 days 4 80 days) 3 3%. Since you can borrow funds at 11% (assuming no other processing costs), it is bet- ter to borrow and pay within the discount period. You save 2.69% (13.69% 2 11%) in interest costs by paying early.

Payables Manager Your decision is whether to comply with prior policy or to create a new policy and not abuse discounts offered by suppliers. Your first step should be to meet with your superior to find out if the late payment policy is the actual policy and, if so, its rationale. If it is the policy to pay late, you must apply your own sense of ethics. One point of view is that the late payment policy is unethical. A deliberate plan to make late payments means the com- pany lies when it pretends to make payment within the discount pe- riod. Another view is that the late payment policy is acceptable. In some markets, attempts to take discounts through late payments are

accepted as a continued phase of “price negotiation.” Also, your company’s suppliers can respond by billing your company for the discounts not accepted because of late payments. However, this is a dubious viewpoint, especially since the prior manager proposes that you dishonestly explain late payments as computer or mail problems and since some suppliers have complained.

Supplier A current ratio of 2.1 suggests sufficient current assets to cover current liabilities. An acid-test ratio of 0.5 suggests, how- ever, that quick assets can cover only about one-half of current liabil- ities. This implies that the retailer depends on money from sales of inventory to pay current liabilities. If sales of inventory decline or profit margins decrease, the likelihood that this retailer will default on its payments increases. Your decision is probably not to extend credit. If you do extend credit, you are likely to closely monitor the retailer’s financial condition. (It is better to hold unsold inventory than uncollectible receivables.)

Guidance Answers to Decision Maker and Decision Ethics

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Chapter 4 Accounting for Merchandising Operations 189

Acid-test ratio (p. 178)

Cash discount (p. 165)

Cost of goods sold (p. 162)

Credit memorandum (p. 171)

Credit period (p. 165)

Credit terms (p. 165)

Debit memorandum (p. 166)

Discount period (p. 165)

EOM (p. 165)

FOB (p. 167)

General and administrative expenses (p. 175)

Gross margin (p. 163)

Gross margin ratio (p. 178)

Gross profit (p. 162)

Inventory (p. 163)

List price (p. 164)

Merchandise (p. 162)

Merchandise inventory (p. 163)

Merchandiser (p. 162)

Multiple-step income statement (p. 175)

Periodic inventory system (p. 164)

Perpetual inventory system (p. 164)

Purchase discount (p. 165)

Retailer (p. 162)

Sales discount (p. 165)

Selling expenses (p. 175)

Shrinkage (p. 172)

Single-step income statement (p. 176)

Supplementary records (p. 168)

Trade discount (p. 164)

Wholesaler (p. 162)

Key Terms

Financial Officer Your company’s net profit margin is about equal to the industry average and suggests typical industry perfor- mance. However, gross margin reveals that your company is paying far more in cost of goods sold or receiving far less in sales price than competitors. Your attention must be directed to finding the problem

with cost of goods sold, sales, or both. One positive note is that your company’s expenses make up 19% of sales (36% 2 17%). This fa- vorably compares with competitors’ expenses that make up 28% of sales (44% 2 16%).

1. Cost of goods sold is the cost of merchandise purchased from a supplier that is sold to customers during a specific period.

2. Gross profit (or gross margin) is the difference between net sales and cost of goods sold.

3. Widespread use of computing and related technology has dramatically increased the use of the perpetual inventory system.

4. Under credit terms of 2y10, ny60, the credit period is 60 days and the discount period is 10 days.

5. (b) trade discount. 6. FOB means “free on board.” It is used in identifying the point

when ownership transfers from seller to buyer. FOB destination means that the seller transfers ownership of goods to the buyer when they arrive at the buyer’s place of business. It also means that the seller is responsible for paying shipping charges and bears the risk of damage or loss during shipment.

7. Recording sales discounts and sales returns and allowances separately from sales gives useful information to managers for internal monitoring and decision making.

8. When a customer returns merchandise and the seller restores the merchandise to inventory, two entries are necessary. One

entry records the decrease in revenue and credits the customer’s account. The second entry debits inventory and reduces cost of goods sold.

9. Credit memorandum—seller credits accounts receivable from buyer.

10. Merchandise Inventory may need adjusting to reflect shrinkage. 11. Sales (of goods), Sales Discounts, Sales Returns and Allow-

ances, and Cost of Goods Sold (and maybe Delivery Expense). 12. Four closing entries: (1) close credit balances in temporary ac-

counts to Income Summary, (2) close debit balances in tempo- rary accounts to Income Summary, (3) close Income Summary to retained earnings, and (4) close dividends account to retained earnings.

13. Cost of Goods Sold. 14. (b) Purchases and (c) Transportation-In. 15. Under a periodic inventory system, the cost of goods sold is

determined at the end of an accounting period by adding the net cost of goods purchased to the beginning inventory and sub- tracting the ending inventory.

16. Both methods report the same ending inventory and income.

Guidance Answers to Quick Checks

Additional Quiz Questions are available at the book’s Website.

Multiple Choice Quiz Answers on p. 207 mhhe.com/wildFINMAN5e

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 b. $550,000

c. $357,000 d. $193,000 e. $(193,000)

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190 Chapter 4 Accounting for Merchandising Operations

2. A company purchased $4,500 of merchandise on May 1 with terms of 2y10, ny30. On May 6, it returned $250 of that mer- chandise. 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 b. $4,250 c. $4,160 d. $4,165 e. $4,410 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 b. $375,300 c. $300,300 d. $339,700 e. $414,700

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 b. 0.750 c. 0.625 d. 1.333 e. 0.469 5. A company’s net sales are $675,000, its costs of goods sold are

$459,000, and its net income is $74,250. Its gross margin ratio equals

a. 32% b. 68% c. 47% d. 11% e. 34%

A(B) Superscript letter A (B) denotes assignments based on Appendix 4A (4B).

Icon denotes assignments that involve decision making.

1. What items appear in financial statements of merch andising 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. 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 purchase discount?

8. Why would a company’s manager be concerned about the quantity of its purchase returns if its suppliers allow unlimited returns?

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 the balance sheet and income statement for Polaris in Appendix A. What does the company title its inventory account? Does the com- pany present a detailed calculation of its cost of sales?

12. Refer to Arctic Cat’s income statement in Appendix A. What title does it use for cost of goods sold?

13. Refer to the income statement for Piaggio in Appendix A. What does Piaggio title its cost of goods sold account?

14. Refer to the income statement of KTM 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?

Discussion Questions

QUICK STUDY

QS 4-1 Applying merchandising terms

C1

Enter the letter for each term in the blank space beside the definition that it most closely matches. A. Sales discount E. FOB shipping point H. Purchase discount B. Credit period F. Gross profit I. Cash discount C. Discount period G. Merchandise inventory J. Trade discount D. FOB destination

Polaris

Arctic Cat

PIAGGIO

KTM

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Chapter 4 Accounting for Merchandising Operations 191

QS 4-3 Recording purchases— perpetual system

P1

Prepare journal entries to record each of the following purchases transactions of a merchandising company. Show supporting calculations and assume a perpetual inventory system.

Nov. 5 Purchased 600 units of product at a cost of $10 per unit. Terms of the sale are 2y10, ny60; the invoice is dated November 5.

Nov. 7 Returned 25 defective units from the November 5 purchase and received full credit. Nov. 15 Paid the amount due from the November 5 purchase, less the return on November 7.

QS 4-4 Recording sales— perpetual system

P2

Prepare journal entries to record each of the following sales transactions of a merchandising company. Show supporting calculations and assume a perpetual inventory system.

Apr. 1 Sold merchandise for $3,000, granting the customer terms of 2y10, EOM; invoice dated April 1. The cost of the merchandise is $1,800.

Apr. 4 The customer in the April 1 sale returned merchandise and received credit for $600. The mer- chandise, which had cost $360, is returned to inventory.

Apr. 11 Received payment for the amount due from the April 1 sale less the return on April 4.

a b c d

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 4-5 Computing and analyzing gross margin

A2

Compute net sales, gross profit, and the gross margin ratio for each separate case a through d. Interpret the gross margin ratio for case a.

QS 4-2 Identifying inventory costs

C2

The cost of merchandise inventory includes which of the following: a. Costs incurred to make the goods ready for sale. b. Costs incurred to ship the goods to the store(s). c. Costs incurred to buy the goods.

d. Both b and c. e. a, b, and c.

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.

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

QS 4-6 Accounting for shrinkage— perpetual system

P3

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).

1. Goods a company owns and expects to sell to its customers. 2. Time period that can pass before a customer’s payment is due. 3. Seller’s description of a cash discount granted to buyers in return for early payment. 4. Reduction below list or catalog price that is negotiated in setting the price of goods. 5. Ownership of goods is transferred when the seller delivers goods to the carrier. 6. Purchaser’s description of a cash discount received from a supplier of goods. 7. Reduction in a receivable or payable if it is paid within the discount period. 8. Difference between net sales and the cost of goods sold. 9. Time period in which a cash discount is available. 10. Ownership of goods is transferred when delivered to the buyer’s place of business.

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192 Chapter 4 Accounting for Merchandising Operations

QS 4-7 Closing entries P3

Refer to QS 4-6 and prepare journal entries to close the balances in temporary revenue and expense accounts. Remember to consider the entry for shrinkage that is made to solve QS 4-6.

QS 4-9 Contrasting liquidity ratios A1

Identify similarities and differences between the acid-test ratio and the current ratio. Compare and describe how the two ratios reflect a company’s ability to meet its current obligations.

QS 4-10 Multiple-step income statement

P4

The multiple-step income statement normally includes which of the following: a. Operating expenses are usually classified into (1) selling expenses and (2) general and administrative

expenses. b. Detailed computations of expenses, including subtotals for various expense categories. c. Detailed computations of net sales. d. Both a and c. e. a, b, and c.

QS 4-11A

Contrasting periodic and perpetual systems

P5

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. Markedly increased in frequency and popularity in business within the past decade. d. Records cost of goods sold each time a sales transaction occurs. e. Provides more timely information to managers.

QS 4-12A

Recording purchases— periodic system P5

Refer to QS 4-3 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

QS 4-13A

Recording purchases— periodic system P5

Refer to QS 4-4 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

Cash . . . . . . . . . . . . . . . . . . . . $1,490 Prepaid expenses . . . . . . . . . . . . . $ 700

Accounts receivable . . . . . . . . 2,800 Accounts payable . . . . . . . . . . . . . 5,750

Inventory . . . . . . . . . . . . . . . . . 6,000 Other current liabilities . . . . . . . . 850

QS 4-8 Computing and interpreting acid-test ratio

A1

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.

Net income . . . . . . . . . . . . . . . . . . . . . . . . . € 670

Financial income . . . . . . . . . . . . . . . . . . . . . 31

Financial expenses . . . . . . . . . . . . . . . . . . . . 115

Operating profit . . . . . . . . . . . . . . . . . . . . . 1,011

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . 257

Income before taxes . . . . . . . . . . . . . . . . . . 927

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . 6,344

Royalty and commission income . . . . . . . . 93

Other operating income . . . . . . . . . . . . . . . 98

Other operating expenses . . . . . . . . . . . . . 5,524

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,344

Income statement information for adidas Group, a German footwear, apparel, and accessories manufacturer, for the year ended December 31, 2011, follows. The company applies IFRS, as adopted by the European Union, and reports its results in millions of Euros. Prepare its calendar year 2011 (1) multiple-step income statement and (2) single-step income statement.

QS 4-14 IFRS income statement presentation

P4

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Chapter 4 Accounting for Merchandising Operations 193

QS 4-15 International accounting standards

C1

Answer each of the following questions related to international accounting standards. a. Explain how the accounting for merchandise purchases and sales is different between accounting un-

der IFRS versus U.S. GAAP. b. Income statements prepared under IFRS usually report an item titled finance costs. What do finance

costs refer to? c. U.S. GAAP prohibits alternative measures of income reported on the income statement. Does IFRS

permit such alternative measures on the income statement?

QS 4-16 Recording discounts taken—perpetual P1

On August 1, Gilmore Company purchased merchandise from Hendren with an invoice price of $60,000 and credit terms of 2y10, ny30. Gilmore Company paid Hendren on August 11. Prepare any required journal entry(ies) for Gilmore Company (the purchaser) on: (a) August 1, and (b) August 11. Assume Gilmore uses the perpetual inventory method.

QS 4-17 Recording discounts missed—perpetual P1

On September 15, Krug Company purchased merchandise inventory from Makarov with an invoice price of $35,000 and credit terms of 2y10, ny30. Krug Company paid Makarov on September 28. Prepare any required journal entry(ies) for Krug Company (the purchaser) on: (a) September 15, and (b) September 28. Assume Krug uses the perpetual inventory method.

Exercise 4-2 Recording entries for merchandise purchases

P1

Prepare journal entries to record the following transactions for a retail store. Assume a perpetual inventory system.

Apr. 2 Purchased merchandise from Lyon Company under the following terms: $4,600 price, invoice dated April 2, credit terms of 2y15, ny60, and FOB shipping point.

3 Paid $300 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

merchandise. 18 Purchased merchandise from Frist Corp. under the following terms: $8,500 price, invoice dated

April 18, credit terms of 2y10, ny30, and FOB destination. 21 After negotiations, received from Frist a $1,100 allowance on the April 18 purchase. 28 Sent check to Frist paying for the April 18 purchase, net of the discount and allowance. Check April 28, Cr. Cash $7,252

QS 4-18 Merchandise equations and flows

C2

Use the following information (in random order) from a service company and from a merchandiser to compute net income. For the merchandiser, also compute gross profit, the goods available for sale, and the cost of goods sold. Hint: Not all information may be necessary.

Krug Service Company Kleiner Merchandising Company

Expenses. . . . . . . . . . . . . . . . $ 8,500 Accumulated depreciation . . . . . . . . . . $ 700 Revenues . . . . . . . . . . . . . . . 14,000 Beginning inventory . . . . . . . . . . . . . . . 5,000 Dividends . . . . . . . . . . . . . . . 1,600 Common stock . . . . . . . . . . . . . . . . . . 50 Cash . . . . . . . . . . . . . . . . . . . 700 Retained earnings. . . . . . . . . . . . . . . . . 900 Prepaid rent . . . . . . . . . . . . 800 Ending inventory . . . . . . . . . . . . . . . . . 1,700 Accounts payable . . . . . . . . . 200 Operating expenses . . . . . . . . . . . . . . . 1,450 Common stock . . . . . . . . . . 500 Purchases . . . . . . . . . . . . . . . . . . . . . . . 3,900 Retained earnings. . . . . . . . . 2,500 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500 Equipment . . . . . . . . . . . . . . 1,300 Dividends . . . . . . . . . . . . . . . . . . . . . . . 1,600

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. inventory made available for sale. b. cash collections from customers. c. credit sales to customers. d. purchases of merchandise. e. accounts receivable accounted for.

EXERCISES

Exercise 4-1 Operating cycle for merchandiser

C2

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194 Chapter 4 Accounting for Merchandising Operations

Exercise 4-7 Analyzing and recording merchandise transactions— both buyer and seller

P1 P2

On May 11, Sydney Co. accepts delivery of $40,000 of merchandise it purchases for resale from Troy Corporation. With the merchandise is an invoice dated May 11, with terms of 3y10, ny90, FOB shipping point. The goods cost Troy $30,000. When the goods are delivered, Sydney pays $345 to Express Shipping for delivery charges on the merchandise. On May 12, Sydney returns $1,400 of goods to Troy, who receives them one day later and restores them to inventory. The returned goods had cost Troy $800. On May 20, Sydney mails a check to Troy Corporation for the amount owed. Troy receives it the following day. (Both Sydney and Troy use a perpetual inventory system.) 1. Prepare journal entries that Sydney Co. records for these transactions. 2. Prepare journal entries that Troy Corporation records for these transactions.

Check (1) May 20, Cr. Cash $37,442

Exercise 4-8 Recording effects of merchandising activities

P1 P2

The following supplementary records summarize Tosca Company’s merchandising activities for year 2013. Set up T-accounts for Merchandise Inventory and Cost of Goods Sold. Then record the summarized activi- ties in those T-accounts and compute account balances.

Check Year-End Merchandise Inventory Dec. 31, $20,000

Cost of merchandise sold to customers in sales transactions . . . . . . . . . . . . . . . . . . . $196,000 Merchandise inventory, December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Invoice cost of merchandise purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,500 Shrinkage determined on December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 Cost of transportation-in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,900 Cost of merchandise returned by customers and restored to inventory . . . . . . . . . . 2,100 Purchase discounts received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Purchase returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Exercise 4-3 Analyzing and recording merchandise transactions — both buyer and seller

P1 P2

Santa Fe Company purchased merchandise for resale from Mesa Company with an invoice price of $24,000 and credit terms of 3y10, ny60. The merchandise had cost Mesa $16,000. Santa Fe paid within the discount period. Assume that both buyer and seller use a perpetual inventory system. 1. Prepare entries that the buyer should record for (a) the purchase and (b) the cash payment. 2. Prepare entries that the seller should record for (a) the sale and (b) the cash collection. 3. Assume that the buyer borrowed enough cash to pay the balance on the last day of the discount period

at an annual interest rate of 8% and paid it back on the last day of the credit period. Compute how much the buyer saved by following this strategy. (Assume a 365-day year and round dollar amounts to the nearest cent, including computation of interest per day.)Check (3) $465 savings

Exercise 4-5 Recording purchase returns and allowances P1

Refer to Exercise 4-4 and prepare the appropriate journal entries for Baker Co. to record the May 5 pur- chase and each of the three separate transactions a through c. Baker is a retailer that uses a perpetual inventory system and purchases these units for resale.

Exercise 4-6 Sales returns and allowances

C1

Business decision makers desire information on sales returns and allowances. (1) Explain why a company’s manager wants the accounting system to record customers’ returns of unsatisfactory goods in the Sales Returns and Allowances account instead of the Sales account. (2) Explain whether this information would be useful for external decision makers.

Allied Parts was organized on May 1, 2013, and made its first purchase of merchandise on May 3. The purchase was for 2,000 units at a price of $10 per unit. On May 5, Allied Parts sold 1,500 of the units for $14 per unit to Baker Co. Terms of the sale were 2y10, ny60. Prepare entries for Allied Parts to record the May 5 sale and each of the following separate transactions a through c using a perpetual inventory system. a. On May 7, Baker returns 200 units because they did not fit the customer’s needs. Allied Parts restores

the units to its inventory. b. On May 8, Baker discovers that 300 units are damaged but are still of some use and, therefore, keeps

the units. Allied Parts sends Baker a credit memorandum for $600 to compensate for the damage. c. On May 15, Baker discovers that 100 units are the wrong color. Baker keeps 60 of these units because

Allied Parts sends a $120 credit memorandum to compensate. Baker returns the remaining 40 units to Allied Parts. Allied Parts restores the 40 returned units to its inventory.

Exercise 4-4 Recording sales returns and allowances P2

Check (c) Dr. Merchandise Inventory $400

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Chapter 4 Accounting for Merchandising Operations 195

Exercise 4-10 Computing revenues, expenses, and income

C1 C2

Using your accounting knowledge, 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 $ ?

Exercise 4-11 Interpreting a physical count error as inventory shrinkage

A1

A retail company recently completed a physical count of ending merchandise inventory to use in prepar- ing adjusting entries. In determining the cost of the counted inventory, company employees failed to consider that $3,000 of incoming goods had been shipped by a supplier on December 31 under an FOB shipping point agreement. These goods had been recorded in Merchandise Inventory as a purchase, but they were not included in the physical count because they were in transit. Explain how this overlooked fact affects the company’s financial statements and the following ratios: return on assets, debt ratio, cur- rent ratio, and acid-test ratio.

Exercise 4-12 Physical count error and profits

A2

Refer to the information in Exercise 4-11 and explain how the error in the physical count affects the com- pany’s gross margin ratio and its profit margin ratio.

Exercise 4-9 Preparing adjusting and closing entries for a merchandiser

P3

The following list includes selected permanent accounts and all of the temporary accounts from the Decem- ber 31, 2013, 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.

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

Cost of goods sold . . . . . . . . . . . . . . . . 212,000

Sales salaries expense . . . . . . . . . . . . . . 48,000

Utilities expense . . . . . . . . . . . . . . . . . . 15,000

Selling expenses . . . . . . . . . . . . . . . . . . 36,000

Administrative expenses . . . . . . . . . . . . 105,000

Additional Information

Accrued sales salaries amount to $1,700. Prepaid selling expenses of $3,000 have expired. A physical count of year-end merchandise inventory shows $28,450 of goods still available.

Check Entry to close Income Summary: Cr. Retained Earnings $84,250

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196 Chapter 4 Accounting for Merchandising Operations

Exercise 4-18A

Buyer and seller transactions— periodic system P5

Refer to Exercise 4-7 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used by both the buyer and the seller.

Exercise 4-19A

Recording purchases— periodic system P5

Refer to Exercise 4-14 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

Journalize the following merchandising transactions for Chilton Systems assuming it uses a perpetual inventory system. 1. On November 1, Chilton Systems purchases merchandise for $1,500 on credit with terms of 2y5,

ny30, FOB shipping point; invoice dated November 1. 2. On November 5, Chilton Systems pays cash for the November 1 purchase. 3. On November 7, Chilton Systems discovers and returns $200 of defective merchandise purchased on

November 1 for a cash refund. 4. On November 10, Chilton Systems pays $90 cash for transportation costs with the November 1 purchase. 5. On November 13, Chilton Systems sells merchandise for $1,600 on credit. The cost of the merchan-

dise is $800. 6. On November 16, the customer returns merchandise from the November 13 transaction. The returned

items would sell for $300 and cost $130; the items were not damaged and were returned to inventory.

Exercise 4-14 Preparing journal entries— perpetual system

P1 P2

A company reports the following sales related information: Sales (gross) of $200,000; Sales discounts of $4,000; Sales returns and allowances of $16,000; Sales salaries expense of $10,000. Prepare the net sales portion only of this company’s multiple-step income statement.

Exercise 4-15 Multiple-step income statement

P4

Refer to Exercise 4-2 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used.

Exercise 4-16A

Recording purchases— periodic system P5

Exercise 4-17A

Recording purchases and sales— periodic system P5

Refer to Exercise 4-3 and prepare journal entries to record each of the merchandising transactions assuming that the periodic inventory system is used by both the buyer and the seller. (Skip the part 3 requirement.)

Case X Case Y Case Z

Cash . . . . . . . . . . . . . . . . . . . . . . . . $2,000 $ 110 $1,000

Short-term investments . . . . . . . . 0 0 600

Current receivables . . . . . . . . . . . . 350 590 700

Inventory . . . . . . . . . . . . . . . . . . . . 2,650 2,300 4,100

Prepaid expenses . . . . . . . . . . . . . . 200 500 900

Total current assets . . . . . . . . . . . . $5,200 $3,500 $7,300

Current liabilities . . . . . . . . . . . . . . $2,200 $1,200 $3,750

Compute the current ratio and acid-test ratio for each of the following separate cases. (Round ratios to two decimals.) Which company case is in the best position to meet short-term obligations? Explain.

Exercise 4-13 Computing and analyzing acid-test and current ratios

A1

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Chapter 4 Accounting for Merchandising Operations 197

Problem 4-2A Preparing journal entries for merchandising activities— perpetual system

P1 P2

Prepare journal entries to record the following merchandising transactions of Sheng Company, which applies the perpetual inventory system. (Hint: It will help to identify each receivable and payable; for example, record the purchase on August 1 in Accounts Payable — Arotek.)

Aug. 1 Purchased merchandise from Arotek Company for $7,500 under credit terms of 1y10, ny30, FOB destination, invoice dated August 1.

4 At Arotek’s request, Sheng paid $200 cash for freight charges on the August 1 purchase, reduc- ing the amount owed to Arotek.

5 Sold merchandise to Laird Corp. for $5,200 under credit terms of 2y10, ny60, 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 1y10, ny45, FOB shipping point, invoice dated August 8. The invoice showed that at Sheng’s request, Waters paid the $140 shipping charges and added that amount to the bill. (Hint: Discounts are not applied to freight and shipping charges.)

9 Paid $125 cash for shipping charges related to the August 5 sale to Laird Corp. 10 Laird returned merchandise from the August 5 sale that had cost Sheng $400 and been sold for

$600. The merchandise was restored to inventory. 12 After negotiations with Waters Corporation concerning problems with the merchandise pur-

chased on August 8, Sheng received a credit memorandum from Waters granting a price reduction of $700.

Check Aug. 9, Dr. Delivery Expense, $125

Net profit . . . . . . . . . . . . € 2,440.9 Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . €1,025.8

Finance costs . . . . . . . . . . 19.6 Profit before tax expense . . . . . . . . . . . . . . . . . . . . . . . 3,466.7

Net sales . . . . . . . . . . . . . 20,343.1 Research and development expense . . . . . . . . . . . . . . 720.5

Gross profit . . . . . . . . . . . 14,491.6 Selling, general and administrative expense . . . . . . . . . 4,186.9

Other income . . . . . . . . . 193.7 Advertising and promotion expense . . . . . . . . . . . . . . 6,291.6

Cost of sales . . . . . . . . . . 5,851.5

L’Oréal reports the following income statement accounts for the year ended December 31, 2011 (euros in millions). Prepare the income statement for this company for the year ended December 31, 2011, following usual IFRS practices.

Exercise 4-20 Preparing an income statement following IFRS

P4

Prepare journal entries to record the following merchandising transactions of Blink Company, which applies the perpetual inventory system. (Hint: It will help to identify each receivable and payable; 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 1y15, ny30, FOB shipping point, invoice dated July 1.

2 Sold merchandise to Creek Co. for $900 under credit terms of 2y10, ny60, 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 2y15, ny60, FOB

destination, invoice dated July 9. 11 Received a $200 credit memorandum from Leight Co. for the return of part of the merchandise

purchased on July 9. 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 2y15, ny60, FOB

shipping point, invoice dated July 19. 21 Issued a $200 credit memorandum to Art Co. for an allowance on goods sold on July 19. 24 Paid Leight Co. the balance due after deducting the 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 2y10, ny60,

FOB shipping point, invoice dated July 31.

PROBLEM SET A

Problem 4-1A Preparing journal entries for merchandising activities— perpetual system

P1 P2

Check July 12, Dr. Cash $882 July 16, Cr. Cash $5,940

July 24, Cr. Cash $1,960 July 30, Dr. Cash $980

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198 Chapter 4 Accounting for Merchandising Operations

15 Received balance due from Laird 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 reduction

granted. 19 Sold merchandise to Tux Co. for $4,800 under credit terms of 1y10, ny30, FOB shipping point,

invoice 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. Sheng sent Tux a $500 credit memorandum to resolve the issue. 29 Received Tux’s cash payment for the amount due from the August 19 sale. 30 Paid Arotek Company the amount due from the August 1 purchase.

Aug. 18, Cr. Cash $4,793

Aug. 29, Dr. Cash $4,257

Check (2) Gross profit, $67,750; (3) Total expenses, $106,775; Net income, $975

Problem 4-3A Preparing adjusting entries and income statements; and computing gross margin, acid- test, and current ratios

A1 A2 P3 P4

The following unadjusted trial balance is prepared at fiscal year-end for Nelson Company.

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

Cash Merchandise inventory Store supplies Prepaid insurance Store equipment Accumulated depreciation—Store equipment Accounts payable Common stock Retained earnings Dividends Sales Sales discounts

Sales returns and allowances Cost of goods sold Depreciation expense—Store equipment

Salaries expense Insurance expense Rent expense Store supplies expense Advertising expense

Totals

1,000 12,500 5,800 2,400

42,900

2,000

2,200

2,200 38,400

0

35,000 0

15,000 0

9,800

169,200

$

$

NELSON COMPANY Unadjusted Trial Balance

January 31, 2013 Debit Credit

169,200

15,250 10,000 5,000

27,000

111,950

$

$

Rent expense and salaries expense are equally divided between selling activities and the general and administrative activities. Nelson Company uses a perpetual inventory system.

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, for the fiscal year is $1,400. 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 fiscal year 2013. 3. Prepare a single-step income statement for fiscal year 2013. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of January 31, 2013. (Round ratios

to two decimals.)

mhhe.com/wildFINMAN5e

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Chapter 4 Accounting for Merchandising Operations 199

Problem 4-4A Computing merchandising amounts and formatting income statements

C2 P4

Valley Company’s adjusted trial balance on August 31, 2013, its fiscal year-end, follows.

Debit Credit

Merchandise inventory . . . . . . . . . . . . . $ 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

Invoice cost of merchandise purchases . . . . . . . . $92,000

Purchase discounts received . . . . . . . . . . . . . . . . . 2,000

Purchase returns and allowances . . . . . . . . . . . . . 4,500

Costs of transportation-in . . . . . . . . . . . . . . . . . . 4,600

On August 31, 2012, merchandise inventory was $25,400. Supplementary records of merchandising ac- tivities for the year ended August 31, 2013, reveal the following itemized costs.

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 selling expenses and for

general and administrative expenses. 4. Prepare a single-step income statement that includes these expense categories: cost of goods sold,

selling expenses, and general and administrative expenses.

Check (2) $90,100;

(3) Gross profit, $136,850; Net income, $49,850;

(4) Total expenses, $161,500

Problem 4-5A Preparing closing entries and interpreting information about discounts and returns

C2 P3

Use the data for Valley Company in Problem 4-4A to complete the following requirements.

Required

1. Prepare closing entries as of August 31, 2013 (the perpetual inventory system is used).

Analysis Component

2. The company makes all purchases on credit, and its suppliers uniformly offer a 3% sales discount. Does it appear that the company’s cash management system is accomplishing the goal of taking all available discounts? Explain.

3. In prior years, the company experienced a 4% returns and allowance rate on its sales, which means approximately 4% of its gross sales were eventually returned outright or caused the company to grant allowances to customers. How do this year’s results compare to prior years’ results?

(3) Current-year rate, 5.3%

Check (1) $49,850 Dr. to close Income Summary

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200 Chapter 4 Accounting for Merchandising Operations

Problem 4-6AB

Preparing a work sheet for a merchandiser

P3

Refer to the data and information in Problem 4-3A.

Required

Prepare and complete the entire 10-column work sheet for Nelson Company. Follow the structure of Exhibit 4B.1 in Appendix 4B.

Check May 14, Dr. Cash $10,780 May 17, Cr. Cash $9,900

May 30, Dr. Cash $2,352

Prepare journal entries to record the following merchandising transactions of Yarvelle Company, which applies the perpetual inventory system. (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 1y15, ny30, FOB shipping point, invoice dated May 2.

4 Sold merchandise to Heather Co. for $11,000 under credit terms of 2y10, ny60, 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 2y15, ny60, FOB

destination, invoice dated May 10. 12 Received a $400 credit memorandum from Duke Co. for the return of part of the merchandise

purchased on May 10. 14 Received the balance due from Heather Co. for the invoice dated May 4, net of the discount. 17 Paid the balance due to Havel Co. within the discount period. 2