Accounting
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Chapter1_Accounting_VolumeI.pdf
chapter 1
Introduction to Accounting
Learning Goals
• Develop a general understanding of alternative forms of business entities.
• Differentiate between financial and managerial accounting.
• Acquire knowledge about the conceptual underpinnings of accounting.
• Learn the fundamental accounting equation and the impact of transactions.
• Discover alternative career paths within the accounting profession.
Copyright Barbara Chase/Corbis/AP Images
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CHAPTER 1Chapter Outline
Chapter Outline 1.1 Entity Concepts 1.2 The Language of Business
Disciplines of Accounting Financial Accounting
1.3 Key Concepts 1.4 The Financial Reporting Model
Sources of Capital Comprehensive Illustration Statement of Cash Flows: A Fourth Financial Statement
1.5 Usefulness of Accounting in Careers and Life 1.6 The Importance of Ethics
The stereotypical accountant is characterized as a boring number cruncher, charged with maintaining the books and accounts of a business. This image may be traced back to the 1843 book by Charles Dickens entitled A Christmas Carol. In that tale, Ebene- zer Scrooge is a penny-pinching miser who cares nothing for the people around him. His sole purpose is making money, and his trusted but suffering accountant is Bob Cratchit, who painstakingly tracks every penny. Mr. Scrooge eventually sees the light, but that’s another story.
Today’s accountant is also another story. The mundane aspects of accounting are now largely accomplished by sophisticated computer software. For small businesses, the soft- ware may reside on a simple personal computer. Larger businesses may use elaborate enterprise resource packages that integrate accounting with all other aspects of managing the business. Such complex business systems may be maintained internally by a specific business or be contracted for through a third-party “cloud computing” service provider.
The changed environment has redefined what it means to be an accountant. Although accountants certainly need to have comprehensive understanding of the fundamental practices, rules, and procedures constituting the foundation of accounting, they are often- times more focused on broader measurement, reporting, and managerial tasks. Less time is spent on data capture, and more time is devoted to analyzing information and helping with sound business decisions.
Furthermore, to understand and monitor results produced by sophisticated information systems, accountants need to be knowledgeable and vigilant. If their organizations solely rely on the data produced by their computers, decision making can be quickly handi- capped by erroneous output. The accountant must have a keen “forensic” eye to make sure that reported information is logical and correct. Indeed, the role of accounting has grown more complex, and with that, the value of the accountant has increased. A large proportion of business leaders start out as accountants.
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CHAPTER 1Section 1.1 Entity Concepts
1.1 Entity Concepts
Broadly speaking, accounting describes the concepts and techniques that are used to measure and report financial information. This information relates to a particular entity. There are many types of entities—business entities, governmental entities, and nonprofit entities. Each type has unique goals, objectives, and attributes, and those ele- ments influence the nature of accounting procedures and reports. This course will focus on business enterprises that come in a variety of forms.
Some businesses are sole proprietorships. This means they are owned by one person. Sole proprietorships can be started informally and are not technically separate legal enti- ties from the owner. Just about any business activity that you undertake without the help of others (or through a formally structured legal entity) can be regarded as a sole propri- etorship. Importantly, a sole proprietor must maintain clearly identifiable business records for such business activities. To judge business success, segregating personal affairs from business affairs is imperative. Thus, the sole proprietorship constitutes a separate entity for purposes of accountability. Throughout your studies, you will learn accounting prin- ciples and methods that are necessary and useful in tracking the business affairs of a sole proprietorship.
When more than one person is engaged in a business activity, the importance of account- ability over their comingled business efforts becomes even more critical. A popular busi- ness form is the partnership (or limited liability partnership). A partnership can come into existence accidentally. No formal action is required to create a simple partnership. A partnership is considered to exist when there is co-ownership of a business activity car- ried on with the objective of making a profit (unless specific actions are taken to avoid the formation of a partnership, such as legally incorporating). Most of the general accounting principles you will study also apply to partnerships. However, a later chapter will look closely at the unique benefits, risks, and accounting issues that are introduced for the partnership form of organization.
A more structured form of business entity is the corporation. A corporation is a legally created entity that is owned by one or more persons. A corporation is both a legal and eco- nomic entity, and it is probably apparent that it represents a unique area of accountability. The corporate form of organization has several key advantages, particularly the ability to attract investment capital from a broad group of investors. However, those investors depend heavily on accounting information about the entity that they have invested in, thus the need for financial reports for each specific entity.
This course will build your foundational knowledge of accounting, beginning with core accounting principles. Although most of the examples will be styled around the corporate form of organization, the basic principles generally relate to each form of entity. Future chapters will draw distinctions as appropriate for unique issues pertaining to alternative forms of business organization.
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CHAPTER 1Section 1.2 The Language of Business
1.2 The Language of Business
As noted, accounting is the collective concepts and techniques used to measure and report financial information about an entity. In essence, accounting is the language of business. Businesspeople are generally expected to possess at least rudimentary knowl- edge of this language. It is not essential that they know every nuance or specific rule, but they must be at least functionally literate in basic concepts. Indeed, it is very difficult to intelligently read and understand essential accounting reports without a firm grasp of accounting principles. No matter what career you pursue, you will come to appreciate the material you will learn in this course.
Disciplines of Accounting
At its core, accounting is a tool for providing information for decision making. Deci- sion makers include owner(s), managers, creditors, employees, government, and other interested parties. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity, and each may have different ideas about the information they seek. This leads to a natural division of specialties within the accounting field.
Some accountants focus on taxation. Tax returns must be prepared, according to estab- lished laws, rules, and regulations. Tax accountants are also heavily involved in planning and strategy. The tax ramifications of significant transactions must be carefully evalu- ated. Businesses must consider complex implications of doing business in multiple states and countries.
Other accountants focus on managerial accounting. Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire spe- cialized reports, budgets, product-costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be developed.
Another major area of accounting emphasis is financial accounting and auditing. Finan- cial accounting is targeted toward reporting financial information about a business to external users such as the owner(s) and creditors. These parties often lack direct access to underlying details about day-to-day operations of the business and depend on sum- marized (frequently audited) financial statements to form their opinions about whether to invest in or lend to the business. As a result, their ability to understand and have con- fidence in reports directly depends on the standardization of principles and practices used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare. Auditors provide independent oversight and assurance about the fairness and accuracy of reported financial accounting information. This introductory course is largely about financial accounting. It is the right place to begin your studies of accounting because understanding core financial account- ing principles is essential for business success. Furthermore, many tax and managerial accounting processes are derivatives of the financial accounting model.
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CHAPTER 1Section 1.3 Key Concepts
Financial Accounting
Financial accounting focuses on correctly measuring and reporting information about a business’s transactions and events. This information must be captured and summarized into reports that are used by persons interested in the entity. This task is far more complex than most people appreciate. It involves a talented blending of technical knowledge and applied judgment. Understanding financial accounting begins with an understanding of the overall structure of accounting and the fundamental reporting model that is common to all business entities.
As noted, standardization of reporting is a hallmark of financial accounting. Such stan- dardization derives from certain well-organized processes and organizations. In the United States, a private-sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB http:// www.ifrs.org/The-organisation/Pages/IFRS-Foundation-and-the-IASB.aspx and FASB http://www.fasb.org/home work cooperatively on many projects, and a single harmonious set of international financial reporting standards (IFRS) might eventually emerge. This effort to establish consistency in global financial reporting is motivated by the increase in global business. Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard-setting bodies are intended to be general purpose in orien- tation. This means that they are not prepared especially for owners, creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups.
1.3 Key Concepts
The development of GAAP has occurred over many decades, and serious attempts have been made to base individual rules on thoughtful conceptual guideposts. Foremost is the idea of decision usefulness. Financial accounting information is intended to facilitate decisions about investing and lending. At a macrolevel, accounting information is the basis upon which capital is allocated in a free market economy. Investors like to invest where profits are best, and creditors like to loan when they foresee that they are apt to be repaid. The best businesses and business opportunities attract capital via signals about their performance, and those signals emanate from the financial reporting model. Without this flow of information and capital, a modern economy would stutter.
To be useful for decision making, accounting information should be relevant and reliable. Relevance means the degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and per- formance. Information is also seen as relevant if it possesses predictive value. Reliability relates mostly to truthfulness but also contemplates freedom from bias (neutral).
Accounting information should also possess the qualities of comparability and consistency. Comparability generally relates to the ability to make relative assessments of companies. Investors and creditors all have limited resources and will clearly seek to place their funds with companies offering the best returns commensurate with understandable
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CHAPTER 1Section 1.3 Key Concepts
risk levels. This necessarily entails the need to compare companies. Accounting should facilitate such comparisons. This does not mean that all companies must use identical accounting techniques. Accounting disclosures, however, should possess sufficient detail so that careful users can discern differences in firms that are based on economic differ- ences rather than accounting choice. Consistency is a concept that relates to performance assessments over time. Basically, if a firm’s economic activity is consistent from period to period, its accounting measures should also be consistent. Differences in measured out- comes from period to period should be indicative of deviations in business results.
Despite accounting’s appearance as concrete and absolute, this is not quite true. Account- ing information is often based on arbitrary allocations, assumptions, and individual judg- ment. Although rooted in mathematics, it nevertheless remains a social science. This con- cept is often misunderstood, resulting in perhaps excessive fixation on reported results for a single period of time. For example, how much profit is earned in a particular month or quarter when a cell phone is sold for less than cost, but the purchaser is also required to subscribe to a profitable 2-year service plan? There are no absolute answers to such ques- tions; instead accountants routinely embrace estimates and assumptions in the develop- ment of periodic financial reports.
It is also important to note that it has not been accounting’s historic role to value a busi- ness. Accounting information may be useful in supporting this objective, but it is not a primary objective. As such, many transactions and events are reported based on their historical cost. For example, land is typically recorded and carried in the accounting records at its purchase price. The historical cost principle is based on the concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions.
An often-debated alternative to historical cost is the fair value (in contrast to historical cost), or fair market value (FMV), approach. Under this technique, assets and liabilities would be periodically revalued based on assessments of current worth, or FMV. Although problematic to implement, proponents of this view argue that it provides more relevant information for decision making. The competing viewpoint holds that FMV accounting is entirely too subjective to form a reliable basis for reporting. Currently, selected finan- cial instruments may be valued at fair value. Otherwise, most U.S. companies fairly well adhere to historical cost measurement principles. Some global firms deploy more exten- sive fair value reporting, and it is possible that fair value accounting will gain more trac- tion in years to come. The accountant of the future may be called on to develop added skills in valuation methods. This observation is consistent with the ever-changing role of the accounting profession.
There are many other guiding principles that you will be exposed to throughout this course. Table 1.1 provides a very high-level view of additional selected concepts and prin- ciples that drive accounting practice and judgment.
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CHAPTER 1Section 1.4 The Financial Reporting Model
Table 1.1: Selected concepts and principles
Basic Concepts, Principles, and Assumptions
Materiality Accountants are only concerned with decisions about how to account for matters that would bear on a decision-making process about the entity.
Monetary unit Accountants describe the amounts reported on financial statements in measures of money rather than some other basis (e.g., land in acres).
Going concern In the absence of evidence to the contrary, accountants assume that the business will continue to operate into the future.
Periodicity Accountants assume that business activity can be divided into measurement intervals, such as months, quarters, and years.
Economic entity Accountants present information along the lines of distinct economic units.
Full disclosure Accountants hold to the principle that all relevant information is adequately described and presented within financial statements and related notes.
Stable currency Accountants presume that the currency used to measure financial statement elements is not significantly changed over time because of inflationary effects.
1.4 The Financial Reporting Model
Despite major advances in accounting technology and significant growth in the control-ling rule set (there are well in excess of 20,000 specific accounting rules), the intrinsic model has changed little in more than 500 years. The model traces its roots to the Renais- sance era. A monk named Luca Pacioli developed a method for tracking the success or fail- ure of ocean-going trading ventures. Capitalists of that era pooled their money to invest in ships that circled significant parts of the globe to trade goods. These returning ships then sold the collected wares. What was lacking was a way to track the costs and benefits of these efforts. Friar Pacioli met the challenge by developing a mathematical model that is still central to even the most sophisticated accounting systems of the modern age.
Central to the model is the concept that a business entity can be described as a collection of assets and corresponding claims against those assets. Some claims belong to creditors of the business, and the residual claims belong to the owner(s). This gives rise to the fol- lowing accounting equation:
Assets Liabilities Owner’s Equity
Depending on your life’s experiences, this may or may not seem intuitive. If you own your home or car (an asset) but bought it with a loan on which you still owe some amount, you can probably relate. For example, assume that you bought a house for $200,000 but still owe $125,000 on the loan. Your fundamental accounting equation would be
$200,000 (your asset) $125,000 (your liability) $75,000 (your equity)
You would report that you have equity in your home of $75,000. This is the amount you would get to keep if you sold the home for $200,000.
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CHAPTER 1Section 1.4 The Financial Reporting Model
In general, assets are the economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, build- ings, equipment, and even intangible assets such as patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner. As previously noted, many assets are measured and reported at their historical cost in the accounting records.
Liabilities are the amounts owed to others. Such obligations arise from loans, extensions of credit, and other obligations that occur in the normal course of business.
Owner’s equity is the owner “interest” in the business. Because it is equivalent to assets minus liabilities, it also referred to as the net assets of a particular business. For a sole proprietorship, the equity would typically consist of a single owner’s capital account. With a partnership, a separate capital account is maintained for each investor. A corpo- ration’s ownership is represented by divisible units called shares of capital stock. These shares are easily transferable, with the current holder(s) of the stock being the owner(s). The total owner’s equity (i.e., stockholders’ equity) of a corporation usually consists of several amounts. This generally corresponds to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends. (Dividends are distributions to shareholders as a return on their investment.) These undistributed earnings are customarily termed the retained earnings of the business.
Knowledge of the fundamental accounting equation is key to understanding one of the most basic financial statements: the balance sheet. A balance sheet reveals the assets, liabilities, and equity of a business at a particular time. Examine Exhibit 1.1, the balance sheet for Clearview Window Washers. Note that the balance sheet’s date is as of a particu- lar time, as indicated by the specific date attached to the statement.
Exhibit 1.1: Balance sheet for Clearview Window Washers
Notice that the balance sheet reveals a listing of assets totaling $288,500. The business owes various creditors a total of $61,500, leaving $227,000 of residual equity attributable to the shareholders of the business. The fundamental accounting equation for Clearview Window Washers is
Assets Liabilities
Cash
Accounts receivable
Supplies
Land
Total assets
$ 54,000
135,000
4,500
95,000
–
$ 288,500
$ 4,500
57,000
$ 62,000
165,000
$ 61,500
227,000
$ 288,500
Accounts payable
Loan payable
Total liabilities
Stockholders’ equity
Capital stock
Retained earnings
Total liabilities and equity
Clearview Window Washers Balance Sheet
December 31, 20X3
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CHAPTER 1Section 1.4 The Financial Reporting Model
$288,500 (total assets) $61,500 (total liabilities) $227,000 (total stockholders’ equity)
The equity of $227,000 does not mean that the business is worth $227,000. Remember that many assets are not reported at current value. For example, although the land is reported at its cost of $95,000, it could worth more. Similarly, the business likely has unrecorded resources such as its brand name and customer base. In a contrary fashion, the business may face business risks or pending litigation that might restrict its value. Thus, account- ing statements are important in investment and credit decisions, but they are not the sole source of information for evaluating a business.
Sources of Capital
Clearview Window Washers reported total equity of $227,000. What was the source of that capital? One would generally conclude that it was invested by the company’s share- holders. However, there is another important source of capital to consider, and that is the earnings of the business. Hopefully, over time, a business will prove to be profitable for its owners. The shareholders might receive periodic dividends; however, much of the income will likely be left in the business and reinvested in additional business assets. Thus, equity arises from two principal sources: capital investments and retained earnings.
Before proceeding further, it is important to consider concepts of business income. Income can be thought of as the enhancement to the business as a result of providing goods and services to its customers. Mathematically, it is the result of subtracting expenses from revenues. Revenues are the gross inflows from customers, and expenses are the costs incurred in the process of producing those revenues. It is important to note that income and revenue are not synonymous. Very simply, income is revenues minus expenses. Some refer to revenue as the top line and income as the bottom line. You have already seen a balance sheet for Clearview Window Washers. Exhibit 1.2 is an income statement. Note, in particular, the date range shown on the income statement. It is important to identify carefully the period of time during which the revenues and expenses were generated.
Exhibit 1.2: Income statement for Clearview Window Washers
Perhaps it goes without saying that a business can also lose money. In other words, expenses can exceed revenues. When this happens, the business is said to have a net loss, and this will reduce retained earnings. Severe losses can erode owner investments and result in negative retained earnings, or accumulated deficit.
Revenues
Expenses
Net income
Services to customers $ 40,000
$ 7,000
3,000
10,000
$ 30,000
Clearview Window Washers Income Statement
For the Month Ending December 31, 20X3
Wages
Supplies
Total expenses
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CHAPTER 1Section 1.4 The Financial Reporting Model
When a business pays dividends to stockholders, such amounts are not reported as expenses. Granted, they are an outflow from the business, but they are reported sepa- rate from the income statement. Dividends are a distribution of income, not a reduction in income. Often, a statement of retained earnings is prepared. This statement builds a bridge between the retained earnings that existed at the beginning and end of a particular period. Exhibit 1.3 is an example of the statement of retained earnings for Clearview Window Washers.
Exhibit 1.3: Statement of retained earnings for Clearview Window Washers
If you take time to review the financial statements for a public company that you are familiar with (they are often found on a company’s website under “Investor Relations”), you might find an expanded statement of stockholders’ equity in lieu of the statement of retained earnings. The expanded statement explains not only the periodic change in retained earnings but also shows all other sources of changes in equity. Examples include issuing additional shares of stock, dividends paid in shares of stock, and other unique events. These topics will be covered in a later chapter. For now, let’s stick with the basic statement of retained earnings.
It is important to note that the income statement, statement of retained earnings, and bal- ance sheet mesh together in a self-balancing fashion. Exhibit 1.4 shows how income flows from the income statement into the statement of retained earnings. Additionally note how the ending retained earnings from the statement of retained earnings also appear in the balance sheet. This final tie-in causes the balance sheet to balance.
Assumed Beginning balance –
December 1, 20X3 Plus: Net income $ 140,000
30,000
Clearview Window Washers Statement of Retained Earnings
For the Month Ending December 31, 20X3
5,000
$ 165,000 Less: Dividends
Ending balance – December 31, 20X3
$ 170,000
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CHAPTER 1Section 1.4 The Financial Reporting Model
Exhibit 1.4: Flow of income
How the articulation of the income statement, statement of retained earnings, and balance sheet occurs may at first seem mysterious, but the following illustration for Clearview Window Washers will begin to clarify the logic of the self-balancing nature of the core financial statements.
Comprehensive Illustration
A primary objective of this chapter is to examine business transactions using the account- ing equation. You now have a basis for meeting this objective. Recognize that every busi- ness transaction has the potential to impact the assets, liabilities, and equity of a business. That impact will not undermine the self-balancing nature of the accounting equation. The reason should become apparent as you review the following example for Clearview Window Washers.
The following example includes a summary of transactions and events for Clearview for the month of December, followed by a spreadsheet showing how each transaction impacts the overall accounting equation. The beginning-of-month amounts are all assumed, and the ending balances were used to prepare the financial statements illustrated earlier. Table 1.2 lists December’s transactions.
Assets
Liabilities
Cash
Accounts receivable
Inventories
Land
Building
Equipment
Other assets
$ 192,000
128,000
120,000
300,000
100,000
50,000
10,000
$ 900,000
$ 34,000
166,000
700,000
$ 900,000
$ 220,000
480,000
Salaries payable
Accounts payable
Capital stock
Retained earnings
Quartz Corporation Balance Sheet
December 31, 20X9
Stockholders’ equity
Total assets
Total liabilities
Total stockholders’ equity
Total liabilities and equity
$ 200,000
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CHAPTER 1Section 1.4 The Financial Reporting Model
Table 1.2: December’s transactions for Clearview Window Washers
Description Amount Discussion of How Balance Is Maintained
Provided window-washing services for cash.
$10,000 Cash (an asset) and Revenues both increase; revenues increase income, which increases equity.
Provided services on account to customers.
$30,000 The asset, Accounts Receivable (representing amounts due from customers for work already rendered), is increased, which is matched with an increase in Revenues, which impacts Income and Equity.
Collected amounts due from customers for work previously rendered.
$20,000 Cash is increased and Accounts Receivable is decreased, resulting in no change in total assets.
Used supplies on hand $3,000 Supplies Expense increases (which impacts Income and Equity); Supplies Inventory decreases.
Bought additional supplies on account.
$ 2,500 Supplies increase, as does the Accounts Payable liability account.
Paid amounts due on outstanding Accounts Payable.
$ 6,000 Cash and Accounts Payable are both decreased.
Issued additional shares of stock. $12,000 Cash and the Capital Stock account are both increased by the same amount.
Purchased land for cash ($20,000) and incurred a $55,000 loan.
$75,000 Land (an asset) goes up by $75,000. This is offset by a $20,000 reduction in Cash. The balancing amount of $55,000 is reflected as an increase in the liability account Loan Payable.
Paid wages to employees. $ 7,000 Cash is decreased, as is Income/Equity via the recording of Wages Expense.
Paid dividends to shareholders. $ 5,000 Cash is decreased and the Dividends account is increased by the same amount (which causes a decrease in Retained Earnings and Equity).
You should carefully each transaction’s impact within the spreadsheet shown in Exhibit 1.5. This will not be immediately intuitive; you will need to think carefully and slowl- about each entry, noting in particular how (1) the transaction impacts the various ac- counts and (2) how the equality of the fundamental accounting equation is preserved.
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CHAPTER 1Section 1.4 The Financial Reporting Model
Exhibit 1.5: Spreadsheet for Clearview Window Washers for December
One challenge of accounting is to evaluate each transaction correctly and make sure that it is properly recorded into the accounts. If recording is not done correctly, the fundamen- tal accounting equation will be violated, and it will not be possible to prepare logically “balanced” financial statements. The ability to evaluate and record transactions becomes routine—with practice—much like learning to play a musical instrument. Don’t fret that it is at first a bit confusing. In addition, an actual business would not want to rely on the spreadsheet in Exhibit 1.5 as the heart of its accounting system. Such a system suffers from a number of limitations, which are described in Chapter 2. That chapter will introduce a much better way to record transactions and process them into correct financial statements.
Statement of Cash Flows: A Fourth Financial Statement
In addition to a balance sheet, income statement, and statement of retained earnings, some businesses will also prepare and present a statement of cash flows. This state- ment is intended to show how cash is generated and expended during a specific period of
Assets Liabilities
$ 50,000
+ 10,000
+ 20,000
– (6,000)
+ 12,000
– (20,000)
– (7,000)
– (5,000)
$ 54,000
$ 125,000
+ 30,000
– (20,000)
–
$ 135,000
Stockholders’ Equity
Cash Accounts Receivable
Supplies Land Accounts payable
Loan payable
Capital stock
(increase equity)
Dividends (decrease
equity)
Revenues (increase
income, thus equity)
Expenses (decrease
income, thus equity)
Assumed Beginning balances
Services for cash
Services on account
Collect account
Record use of supplies
Buy supplies on account
Pay on account
Additional investment
Pay wages
Dividends
Ending balance
$ 5,000
– (3,000)
+ 2,500
–
$ 4,500
$ 20,000
+ 75,000
–
$ 95,000
$ 8,000
+ 2,500
– (6,000)
–
$ 4,500
$ 2,000
+ 55,000
–
$ 57,000
$ 50,000
+ 12,000
–
$ 62,000
+ 5,000
$ 5,000
+ 10,000
+ 30,000
–
$ 40,000
+ 3,000
+ 7,000
–
$ 10,000
Description
Buy land with cash and loan
Retained Earnings $140,000
$30,000 Net Income
$288,500 Total Assets
$61,500 Total Liabilities
$227,000 Total Equity
$30,000 – $5,000 = $25,000 Increase in retained earnings
Plus beginning retained earnings $140,000
Ending retained earnings $165,000
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CHAPTER 1Section 1.5 Usefulness of Accounting in Careers and Life
time. Recall that some transactions, such as providing services to customers on account, can impact income without producing any immediate cash effects. Although assessing a business’s income is important, it is sometimes important to also monitor periodic cash flows. Thus, the statement of cash flows identifies cash that is generated by operations. In addition, a comprehensive cash flows statement provides additional disclosures about cash generated or consumed through investing and financing activities. Understanding a statement of cash flows is usually predicated on knowing a number of other accounting subjects. As such, coverage of this important statement is deferred until later. For now, simply begin to appreciate that cash flows and income are not necessarily synonymous, and financial statement users need to be keenly aware of both.
1.5 Usefulness of Accounting in Careers and Life
You have probably heard that accounting is a great subject to study, maybe because it is one of the better academic pathways to a good job. In addition, the skills you will learn will prove helpful in managing your personal finances and investments. These are lifelong skills that will continue to serve you for many years to come.
If you decide to become an accountant, you will find that there are many specialty areas. Many accountants specialize in public accounting, which involves providing audit, tax, and consulting services to the general public. To specialize in public accounting usually requires licensing. Individual states issue a license called a certified public accountant (CPA). Auditing involves the examination of transactions and systems that underlie an organi- zation’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically and include such diverse activities as information systems engineering and evaluating production methods.
Many accountants are privately employed by small and large businesses (i.e., industry accounting) and nonprofit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may serve as internal auditors, who look at controls and procedures in use by their employer. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations.
It probably goes without saying that many accountants also work in the governmental sector, whether at the local, state, or national level. Many accountants are employed at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commis- sion, and even the Federal Bureau of Investigation (Table 1.3).
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CHAPTER 1Section 1.6 The Importance of Ethics
Table 1.3: Examples of careers in accounting
Public-sector accounting Audit and assurance services Tax preparation and planning Business consulting and systems design
Private-sector accounting Staff accountant Controller Chief financial officer Tax manager Information technology manager Internal auditor
Federal government Internal Revenue Service General Accounting Office Securities and Exchange Commission Federal Bureau of Investigation
Nonprofit and state, local governmental sector Staff accountant Tax auditor Chief accounting officer/director Budget officer
1.6 The Importance of Ethics
Investors and creditors greatly rely on financial statements in making their investment and credit decisions. It is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion. To help ensure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, governmental oversight, and the ever-vigilant plaintiff’s attorney all serve a vital role in providing additional safeguards against the errant accountant. Those who are pre- paring to enter the accounting profession should do so with the intention of behaving with honor and integrity. Others will likely rely on accountants in some aspect of their personal or professional lives. They have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, they will be entrusting them with financial resources and confidential information.
Being ethical can sometimes be more challenging than you might presume. Accounting tasks naturally relate to money. This is especially true for public companies that have share prices prone to fluctuate based on reported income numbers. Sometimes millions of dollars are ultimately at stake based on what the accountants ultimately report. It is easy for accountants to fall into a trap of trying to cover what is seen as a tempo- rary shortfall in income by some type of accounting gimmick. These stories usually end badly because participants tend to get sucked into an ever-worsening pattern of financial deception. In retrospect, participants in these schemes usually report that they initially acted in haste and under pressure. Nevertheless, the consequences tend to be career end- ing and worse. You must prepare yourself for ethical challenges in advance, so be firm and ready to act in an appropriate manner at all times. Accountants are fiduciaries for others and must act accordingly.
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16
CHAPTER 1Concept Check
In closing, many students cannot envision themselves as accountants. That’s okay. There are two important things to remember. First, accountants often move on to significant business leadership roles. This is true because their accounting training and experience provide the foundation for understanding and being successful in business. Second, peo- ple in business often remark that they wish they had studied more and knew more about accounting. In business, they quickly discover that accounting knowledge is essential— indeed paramount. Accounting truly is the language of business.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of these issues by selecting the best answer. (The answers appear on p. 235.)
1. The principle of historical cost a. holds that acquisitions of goods and services should be entered in the accounting
records at acquisition cost. b. results in the development of subjective financial statements. c. is ideal for use in periods of high inflation. d. is not acceptable when constructing general-purpose financial statements.
2. Apex Company had owner’s equity of $32,000 on January 1, 20X2. During January, owner investments and withdrawals amounted to $15,000 and $9,000, respectively. In addition, the company generated revenues of $50,000 and expenses of $48,000. What was the amount of owner’s equity on January 31? a. $ 8,000 b. $36,000 c. $40,000 d. $58,000
3. John Davis recently withdrew $1,000 cash from the Davis Repair Shop, a sole pro- prietorship. This transaction would a. decrease both assets and liabilities. b. decrease both assets and owner’s equity. c. decrease assets and increase owner’s equity. d. increase both assets and owner’s equity.
4. A company’s ending accounts receivable balance and the period’s advertising expense would be found on which financial statements, respectively? a. Balance sheet and statement of owner’s equity b. Balance sheet and income statement c. Income statement and balance sheet d. Income statement and statement of owner’s equity
5. X Company had revenues, expenses, owner investments, and owner with-drawals of $45,000, $35,000, $4,000, and $1,000, respectively. What was the firm’s net income? a. $ 9,000 b. $10,000 c. $13,000 d. $14,000
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17
CHAPTER 1Key Terms
assets The economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangi- bles such as patents and other legal rights and claims.
auditing The examination of transactions and systems that underlie an organiza- tion’s financial reports, with the ulti- mate goal of providing an independent report on the appropriateness of financial statements.
balance sheet A basic financial statement, it reveals the assets, liabilities, and equity of a business at a particular time.
certified public accountant (CPA) A license issued by states that allows an accountant to specialize in public accounting.
comparability The ability to make relative assessments of companies.
consistency A concept that relates perfor- mance assessments over time.
corporation A legally created entity that is owned by one or more persons.
CPA See certified public accountant.
dividends Distributions to shareholders as a return on their investment.
expenses The costs incurred in the process of producing revenues.
FASB See Financial Accounting Standards Board.
fair value An assessment based on current worth.
financial accounting Targeted toward reporting financial information about a business to external users such as the owner(s) and creditors.
Financial Accounting Standards Board (FASB) A private-sector group primarily responsible for developing the rules that form the foundation of financial reporting.
GAAP See generally accepted accounting principles.
generally accepted accounting principles (GAAP) General-purpose standards intended to be equally useful for all user groups.
historical cost The concept that it is best to report certain financial statement ele- ments at amounts that are tied to objective and verifiable past transactions.
IASB See International Accounting Stan- dards Board.
IFRS See international financial reporting standards.
income The enhancement to the business as a result of providing goods and services to its customers; mathematically, it is the result of subtracting expenses from revenues.
income statement A statement that reports income for a particular time period.
internal auditors Those professionals who look at controls and procedures in use by their employer.
International Accounting Standards Board (IASB) The international counter- part to the FASB, the IASB and FASB work cooperatively on many projects.
Key Terms
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18
CHAPTER 1
Critical Thinking Questions
1. How does financial accounting differ from managerial accounting? 2. What are several limitations of accounting information? 3. How does bookkeeping differ from accounting? 4. Paul Martin is contemplating an investment in the Indiana Company. He has
secured the firm’s audited financial statements, which have been examined by a certified public accountant. How can Martin be satisfied that the statements do not present false and incorrect information to purposely mislead investors?
5. Discuss the use of historical cost in the accounting process. Why is historical cost used, and what is one of its chief limitations?
6. Consider the income statement, the statement of owner ’s equity, and the bal- ance sheet. Which of these statements cover(s) a period of time as opposed to a specific date?
Critical Thinking Questions
international financial reporting stan- dards (IFRS) The effort to establish consis- tency in global financial reporting.
liabilities The amounts owed to others, such as obligations to loans, extensions of credit, and others that occur in the normal course of business.
managerial accounting Information intended to serve the specific needs of management.
net assets Another term for owner’s equity.
owner’s equity The owner’s “interest” in the business, the equivalent to assets minus liabilities.
partnership A type of business considered to exist when there is co-ownership of a business activity carried on with the objec- tive of making a profit.
relevance The degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance.
reliability The degree that accounting information is truthful and free from bias, or neutral.
retained earnings Earnings of a business that are not distributed.
revenues The gross inflows from customers.
sole proprietorship A business owned by one person.
statement of cash flows A statement intended to show how cash is generated and expended during a specific period of time.
statement of retained earnings A state- ment that builds a bridge between the retained earnings that existed at the begin- ning and end of a particular period.
statement of stockholders’ equity An expanded statement that explains not only the periodic change in retained earnings but also shows all other sources of changes in equity.
tax services Provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alterna- tive actions.
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19
CHAPTER 1Exercises
Exercises
1. Basic concepts. Jean’s Marine Supply specializes in the sale of boating equipment and accessories. Identify the items that follow as an asset (A), liability (L), revenue (R), or expense (E) from the firm’s viewpoint. a. The inventory of boating supplies owned by the company b. Monthly rental charges paid for store space c. A loan owed to Citizens Bank d. New computer equipment purchased to handle daily record keeping e. Daily sales made to customers f. Amounts due from customers g. Land owned by the company to be used as a future store site h. Weekly salaries paid to salespeople
2. Basic computations. The following selected balances were extracted from the accounting records of Rossi Enterprises on December 31, 20X3:
Accounts Payable $ 3,200 Interest Expense $ 2,500
Accounts Receivable 14,800 Land 18,000
Auto Expense 1,900 Loan Payable 40,000
Building 30,000 Tax Expense 3,300
Cash 7,400 Utilities Expense 4,100
Fee Revenue 56,900 Wage Expense 37,500
a. Determine Rossi’s total assets as of December 31. b. Determine the company’s total liabilities as of December 31. c. Compute 20X3 net income or loss.
3. Impact of business transactions. The following items describe the impact of a busi- ness transaction or event on the components of the accounting equation. Present an example of a transaction or event that correctly matches the described impact. a. Increase an asset and increase a liability. b. Increase one asset and decrease another asset. c. Increase an asset and increase in owner’s equity from a transaction or event not
related to income-producing activities. d. Increase an asset and increase in owner’s equity from a transaction or event re-
lated to income-producing activities. e. Decrease an asset and decrease a liability. f. Decrease an asset and decrease in owner’s equity from a transaction or event not
related to income-producing activities.
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20
CHAPTER 1Exercises
4. Analysis of transactions. Set up the following headings across a piece of paper:
Assets Liabilities Owner’s Equity
Using “-” and “+,” indicate the effect of each of the following transactions on total
assets, liabilities, and owner’s equity:
a. Processed a $5,000 cash withdrawal for the owner. b. Recorded the receipt of May’s utility bill, to be paid in June. c. Provided services to customers on account. d. Paid the current month’s advertising charges. e. Purchased a $27,000 delivery truck by paying $5,000 down and securing a loan
for the remaining balance. f. Received $11,000 cash from the owner as an investment in the business. g. Returned a new computer and printer purchased earlier in the month on ac-
count. The bill had not as yet been paid. h. Paid the utility bill recorded previously in part (b).
5. Accounting equation; analysis of owner’s equity. Sportscar Repair revealed the following financial data on January 1 and December 31 of the current year.
Assets Liabilities
January 1 $45,000 $20,000
December 31 49,000 31,000
a. Compute the change in owner’s equity during the year by using the accounting equation.
b. Assume that there were no owner investments or withdrawals during the year. What is the probable cause of the change in owner’s equity from part (a)?
c. Assume that there were no owner investments during the year. If the owner withdrew $17,000, determine and compute the company’s net income or net loss. Be sure to label your answer.
d. If owner investments and withdrawals amounted to $13,000 and $2,000, respec- tively, determine whether the company operated profitably during the year. Show appropriate calculations.
6. Balance sheet preparation. The following data relate to Preston Company as of December 31, 20XX:
Building $44,000 Accounts Receivable $24,000
Cash 17,000 Loan Payable 30,000
J. Preston, Capital 65,000 Land 21,000
Accounts Payable ?
Prepare a balance sheet in good form as of December 31, 20XX.
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21
CHAPTER 1Exercises
7. Income statement concepts. Evaluate the following comments as being true or false. If the comment is false, briefly explain why.
a. An income statement reveals the net income or net loss of an entity for a period of time as opposed to a specific date.
b. Withdrawals are properly classified as an expense of doing business. c. If a company has $50,000 of revenues for March, it stands to reason that cash
receipts for March must total $50,000. d. If expenses exceed revenues, a net loss has been generated. e. A computer acquired late in the year for use in the business should be disclosed
on a firm’s income statement.
8. Financial statement relationships. The following information appeared on the financial statements of the Altoona Repair Company:
Income statement
Total expenses $ 64,900
Net income 7,200
Statement of owner’s equity
Beginning owner’s equity balance $ 113,200
Owner withdrawals 61,300
Ending owner’s equity balance 70,800
Balance sheet
Total liabilities $ 97,000
By picturing the content of and the interrelationships among the financial state- ments, determine the following:
a. Total revenues for the year b. Total owner investments c. Total assets
9. Financial statement presentation. The accounting records of Hickory Enterprises revealed the following selected information for the year ended December 31, 20X6.
Cash investments by the owner $ 59,000
Services rendered to customers 86,000
Cash withdrawals by the owner 12,000
Total year-end assets 177,800
Salaries, advertising, and utilities for the year totaled $68,500. The year-end asset total included a parcel of land that had cost the company $45,000. Hickory’s ac- countant used this amount for valuation purposes rather than the land’s current market value of $75,000 (as determined by a recent real estate appraisal).
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CHAPTER 1Problems
a. Determine the net income to be disclosed on the company’s income statement. b. Compute the increase or decrease in owner’s equity during 20X6. On which
financial statement would this information appear? c. Determine and justify the proper valuation for Hickory’s year-end assets.
Problems
1. Identification of transactions. The following tabulation summarizes several transactions of the Hartford Company:
Assets
Liabilities Owner’s Equity
Cash
Accounts Receivable
Computer Accounts
Payable (Investments 2 Withdrawals) (Revenues 2 Expenses)
$5,000 $13,000 $29,000 $17,000 $30,000
Balances
a. 2800 2800*
b. 1,900 21,900
c. 22,000 22,000
d. 23,000 10,000 7,000
e. 1,500 1,500*
f. 2,500 2,500
g. 900 2900*
$1,100 $12,600 $41,500 $24,900 $30,300
Transactions in the Owner ’s Equity column designated with an asterisk (*) were caused by the company’s income-producing activities. The $2,000 and $2,500 figures are unrelated to such activities.
Instructions Write a brief explanation of each transaction.
2. Basic transaction processing. On November 1 of the current year, Richard Parker established a sole proprietorship. The following transactions occurred during the month:
1: Received $19,000 from Parker as an investment in the business. 2: Paid $9,000 to acquire a used minivan.
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23
CHAPTER 1Problems
3: Purchased $1,800 of office furniture on account. 4: Rendered $2,100 of consulting services on account. 5: Paid $300 of repair expenses. 6: Received $800 from clients who were previously billed in item 4. 7: Paid $500 on account to the supplier of office furniture in item 3. 8: Received a $150 electric bill, to be paid next month. 9: Processed a $600 withdrawal for Parker.
10: Received $250 from clients for consulting services rendered. 11: Returned a $450 office desk to the supplier. The supplier agreed to reduce the
balance due.
Instructions a. Arrange the following asset, liability, and owner’s equity elements of the account-
ing equation: Cash, Accounts Receivable, Office Furniture, Van, Accounts Payable, Investments/Withdrawals, and Revenues/Expenses.
b. Record each transaction on a separate line. After all transactions have been recorded, compute the balance in each of the preceding items.
c. Answer the following questions for Parker.
(1) How much does the company owe to its creditors at month-end? On which financial statement(s) would this information be found?
(2) Did the company have a “good” month from an accounting viewpoint? Briefly explain.
3. Statement preparation. The following information is taken from the accounting records of Grimball Cardiology at the close of business on December 31, 20X1.
Accounts Payable $ 14,700 Surgery Revenue $175,000
Surgical Expenses 80,000 Cash 60,000
Surgical Equipment 37,000 Office Equipment 118,000
Salaries Expense 30,000 Rent Expense 15,000
Accounts Receivable 135,000 Loan Payable 10,300
Utilities Expense 5,000
All equipment was acquired just prior to year-end. Conversations with the prac- tice’s bookkeeper revealed the following data:
Rose Grimball, capital (January 1, 20X1) $300,000
19X1 owner investments 2,000
19X1 owner withdrawals 22,000
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CHAPTER 1Problems
Instructions a. Prepare the income statement for Grimball Cardiology in good form. b. Prepare a statement of owner’s equity in good form. c. Prepare Grimball’s balance sheet in good form.
4. Transaction analysis and statement preparation. The transactions that follow relate to Frisco Enterprises for March 20X1, the company’s first month of activity.
3/1: Received $20,000 cash from Joanne Burton, the owner, as an investment in the business.
3/4: Rendered $2,400 of services on account.
3/7: Acquired a small parcel of land by paying $6,000 cash.
3/12: Received $700 from a client, who was billed previously on March 4.
3/15: Paid $800 to the Journal Herald for advertising that ran during the first half of the month.
3/18: Acquired $9,000 of equipment from Park Central Outfitters by paying $7,000 down and agreeing to remit the balance owed within the next 2 weeks.
3/22: Received $300 cash from clients for services performed on this date.
3/24: Paid $1,500 on account to Park Central Outfitters in partial settlement of the balance due from the transaction on March 18.
3/28: Rented a car from United Car Rental for use on March 28. Total charges amounted to $75, with United billing Frisco for the amount due.
3/31: Paid $900 for March wages.
3/31: Processed a $600 cash withdrawal from the business for Joanne Burton.
Instructions a. Determine the impact of each of the preceding transactions on Frisco’s assets,
liabilities, and owner’s equity. Use the following format:
Assets Liabilities Owner’s Equity
Cash Accounts Receivable Land Equipment
Accounts Payable
() Investments () Revenues (2) Withdrawals (2) Expenses
Record each transaction on a separate line. Calculate balances only after the last transaction has been recorded.
b. Prepare an income statement, a statement of owner’s equity, and a balance sheet in good form.
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25
CHAPTER 1Problems
5. Financial statement preparation. On October 1, 20X6, Susan Thompson opened Thompson Decorating Services, a sole proprietorship. Susan began operations with $50,000 cash, 60% of which was acquired via an owner investment. The remain- ing amount was obtained from a bank loan. A review of the accounting records for October revealed the following:
• Asset purchases: Van, $16,000; office equipment, $4,000; and decorator (household) furnishings, $17,000. These amounts were paid in cash except for $2,100 that is still owed for the furnishings acquisition.
• Services performed: Total billings on account, $18,300. Clients have remitted a total of $14,200 in settlement of their balances due.
• Expenses incurred: Salaries, $8,700; advertising, $2,500; taxes, $150; postage, $1,800; utilities, $100; interest, $450; and miscellaneous, $200. These amounts had been paid by month-end with the exception of $700 of the advertising expenditures.
Further information revealed that Thompson withdrew $5,500 of cash from the business on October 31.
Instructions a. Prepare an income statement for the month ending October 31, 20X6. b. Prepare a statement of owner’s equity for the month ending October 31, 20X6. c. Prepare a balance sheet as of October 31, 20X6.
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CHAPTER 1Problems
6. Identification of income statement errors. The following income statement was prepared by Action Tree Service’s bookkeeper:
ACTION TREE SERVICE Income Statement
June 30, 20XX
Revenue
Services rendered 34,900
Accounts receivable 6,100 41,000
Owner investments 6,000
Total revenue $57,000
Less:
Salaries expense 15,600
Advertising expense 3,400
Down payment on truck 1,000
Utilities expense 900
Rent expense 1,200
Tree-trimming equipment 15,000
Loan payment (includes $600 interest)
1,900
Miscellaneous expense 12,000
Supplies used 800
Owner withdrawals 2,000
Total deductions 40,300
Net loss $16,700
Instructions Identify and explain the errors in Action’s income statement. Tell what should be done to correct the errors. (Note: A corrected income statement is not required.)
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