CHAPTER 1

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ACCOUNTING IN ACTION
OVERVIEW

You and every other member of society depend on information to function

efficiently and effectively. For example, people who invest in business enterprises use
economic information to guide their decisions about future financial possibilities.
Information about the effects of past actions is accumulated to serve as an aid in
making better decisions in the future.

As a financial information system, accounting is the process of identifying,

recording, and communicating the economic events of an organization. In this chapter,
we: (1) introduce the subject of accounting and GAAP (generally accepted accounting
principles), (2) discuss the basic accounting equation and the effects of transactions on
its elements, and (3) examine the composition of the four general purpose financial
statements required for business enterprises.

SUMMARY OF STUDY OBJECTIVES

1. Explain the meaning of accounting. Accounting is the process of identifying,

recording, and communicating the economic events of an organization (business
or nonbusiness) to interested users of the information.

2. Identify the users and uses of accounting. The major users and uses of
accounting are: (a) Management uses accounting information in planning,
controlling, and evaluating business operations. (b) Investors (owners) judge the
wisdom of buying, holding, or selling their financial interest on the basis of
accounting data. (c) Creditors (suppliers and bankers) evaluate the risks of
granting credit or lending money to particular businesses on the basis of the
accounting information obtained about those businesses. Other groups with an
indirect interest are taxing authorities, regulatory agencies, customers, labor
unions, and economic planners.

3. Understand why ethics is a fundamental business concept. Ethics are the

standards of conduct by which one's actionsboth personal and businessare
judged as right or wrong. If you cannot depend on the honesty of the individuals
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you deal with, effective communication and economic activity will be impossible
and information will have no credibility.

4. Explain the meaning of generally accepted accounting principles and the

cost principle. Generally accepted accounting principles are a common set of
standards used by accountants. One important principle is the cost principle,
which states that assets should be recorded at their cost.

5. Explain the meaning of the monetary unit assumption and the economic
entity assumption. The monetary unit assumption requires that only transaction
data capable of being expressed in terms of money be included in the accounting
records of the economic entity. The economic entity assumption states that
economic events can be identified with a particular unit of accountability.

6. State the basic accounting equation and explain the meaning of assets,
liabilities, and owner's equity. The basic accounting equation is:

ASSETS = LIABILITIES + OWNER'S EQUITY

Assets are resources owned by a business. Liabilities are creditorship claims on

total assets. Owner's equity is the ownership claim on total assets. It is often
referred to as residual equity.

7. Analyze the effect of business transactions on the basic accounting

equation. Each business transaction must have a dual effect on the accounting
equation. For example, if an individual asset is increased, there must be a
corresponding (1) decrease in another asset, (2) increase in a specific liability, or
(3) increase in owner's equity.

8. Prepare an income statement, owner's equity statement, balance sheet, and

statement of cash flows. An income statement presents the revenues and
expenses of a company for a specified period of time. An owner's equity
statement summarizes the changes in owner's equity that have occurred during a
given period of time. A balance sheet reports the assets, liabilities, and owner's
equity of a business at a specific date. A statement of cash flows summarizes
information concerning the cash inflows (receipts) and outflows (payments) for a
specific period of time.
 Accounting in Action 1-3
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TIPS ON CHAPTER TOPICS

TIP: Accounting is the language of business. Thus, the more you learn and
understand about accounting and its usefulness, the better you will be able to
succeed in any business endeavor, regardless of what your major field of study
and job title are.

TIP: Transactions are the economic events of an entity recorded by accountants.

Some events (happenings of consequence to an entity) are not measurable in
terms of money and thus do not get recorded in the accounting records. Hiring
employees, placing an order for supplies, greeting a customer and quoting prices
for products are examples of activities that do not by themselves constitute
transactions. When an event is identified as a transaction, it must be measured
(i.e., the appropriate dollar amount must be determined) before it can be
recorded.

TIP: When you encounter a transaction, always analyze it in terms of its effects on the
elements of the basic accounting equation (or balance sheet equation). For
your analysis to be complete, it must maintain balance in the basic accounting
equation. The basic accounting equation is as follows:

ASSETS = LIABILITIES + OWNER'S EQUITY

Assets are economic resources. Liabilities and owner's equity are sources of
resources; liabilities are creditor sources, and owner's equity represents owner
sources (owner investments and undistributed profits).

TIP: The balance of liabilities and the balance of owner's equity at a point in time
simply serve as scorecards of the total amounts of unspecified assets which
have come about from creditor sources (liabilities) and owner sources (owner's
equity). Thus, you can not determine the amount of cash (or any other specific
asset) held by an entity by looking at the balance of owner's equity or liabilities.
You must look at the listing of individual assets on the balance sheet to
determine the amount of cash owned.

TIP: The owner's equity of a business, particularly a proprietorship (a business with

one owner), is often called capital.

TIP: A revenue type transaction will always cause an increase in owner's equity. In
addition, it will cause either an increase in assets or a decrease in liabilities (the
former is the more common effect). An expense type transaction will always
cause a decrease in owner's equity. In addition, it will cause either a decrease in
assets or an increase in liabilities (the former is the more common effect).

TIP: The cost principle is often called the historical cost principle. Because of this
principle, we typically report the cost of assets held, not their market values.
Generally, the balance sheet does not purport to reflect market values.
1-4 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
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TIP: Like any other discipline, accounting has its own vocabulary. In order for you to
be able to understand what you read in subsequent chapters of this book, it is
imperative that you master the new terms explained in this chapter. If you are
not thoroughly familiar with the basic concepts used to explain more advanced
material, you will likely have an erroneous interpretation of that later material.
For each chapter in your text, make it a habit to study the glossary until you
master the new terms being introduced.

TIP: Accounting assumptions and principles are often referred to as accounting

concepts.

TIP: Generally, accounting is based on completed transactions. As a result, salaries

which have been earned by employees (whether paid or not) must be accounted
for presently, however, salaries to be earned by employees and paid by the entity
in future periods are not reflected in the entity's statements until the future period
in which they are incurred.

TIP: Read the Preface and How to Study Accounting. These precede Chapter 1 of
this self-study volume.

EXERCISE 1-1

Purpose: (S.O. 6, 7) This exercise will test your understanding of the components of
the basic accounting equation.

Instructions
A list of independent situations appears below. Answer each question posed.

1. The total assets of Mitzer Company at December 31, 1999 are $380,000 and its
total liabilities are $150,000 at that same date. Question: What is the amount of
Mitzer Company's total owner's equity at December 31, 1999?

Answer: _________________________________

2. The total assets of Heidi Company are $400,000 at December 31, 1999, and its
total owner's equity is $280,000 at the same date. Question: What is the amount
of Heidi Company's total liabilities at December 31, 1999?

Answer: _________________________________

3. The total liabilities of Aaron Company are $128,000 at December 31, 1999. Total
owner's equity for the company is $220,000 at that same date. Question: What is
the amount of total assets for the company at December 31, 1999?

Answer: __________________________________
 Accounting in Action 1-5
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4. The total liabilities of Malcohm Company are $80,000. The total assets of the
company are three times the amount of its total liabilities. Question: What is the
amount of Malcohm Company's total owner's equity?

Answer: __________________________________

5. At January 1, 1999, Molly Company had total assets of $600,000 and total
liabilities of $340,000. During the calendar year of 1999, total assets increased
$80,000, and total liabilities decreased $30,000. Question 1: What was the
change in owner's equity during 1999?

Answer 1: ________________________________

Question 2: What was the amount of owner's equity at December 31, 1999?

Answer 2: ________________________________

6. At January 1, 1999, Blackford Company had total assets of $500,000 and total
owner's equity of $280,000. During 1999, total assets decreased $40,000, and
total liabilities decreased $22,000. Question 1: What was the amount of total
liabilities at January 1, 1999?

Answer 1: ________________________________

Question 2: What was the change during 1999 in total owner's equity?

Answer 2: ________________________________

Question 3: What was the total owner's equity at December 31, 1999?

Answer 3: ________________________________

SOLUTION TO EXERCISE 1-1

Approach: Write down the basic accounting equation:

ASSETS = LIABILITIES + OWNER'S EQUITY

or
A = L + OE

Fill in the amounts given and use your knowledge of algebra to solve for any unknown.
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Explanation:
1. Assets = Liabilities + Owner's Equity
$380,000 = $150,000 + OE
$380,000 - $150,000 = OE
$230,000 = OE
$230,000 = Owner's Equity

TIP: Recall that algebraic rules require the change in a number's sign when moved to
the other side of the equals sign. Thus, a positive $150,000 becomes a negative
$150,000 when moved from the right side of the equation to the left side of the
equation.

2. Assets = Liabilities + Owner's Equity

$400,000 = L + $280,000
$400,000 - $280,000 = L
$120,000 = L
$120,000 = Liabilities

3. Assets = Liabilities + Owner's Equity

A = $128,000 + $220,000
A = $348,000
Assets = $348,000

4. Assets = Liabilities + Owner's Equity

3 (L) = L + OE
3 ($80,000) = $80,000 + OE
$240,000 = $80,000 + OE
$240,000 - $80,000 = OE
$160,000 = OE
$160,000 = Owner's Equity

5. (1) A = L + OE
$80,000 = $30,000 + OE
$80,000 + $30,000 = OE
$110,000 = OE
Increase of $110,000 = Change in Owner's Equity

TIP: When the $30,000 is moved from the right side of the "=" to the left side of the
equation, its sign changes so it becomes a $30,000.

TIP: The basic accounting equation is applied at a specific point in time. When you
have the facts for the equation components at two different points in time for the
same entity (such as amounts as of the beginning of a year and amounts as of
the end of the year), you can modify the basic accounting equation to reflect that
total changes in assets equals total changes in liabilities plus total changes in
owner's equity. Using the symbol to designate change, the following equation
also holds true:
A = L + OE
 Accounting in Action 1-7
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(2) Assets = Liabilities + Owner's Equity

$600,000 = $340,000 + OE
$600,000 - $340,000 = OE at January 1, 1999
$260,000 = Owner's Equity at January 1, 1999

Owner's Equity at January 1, 1999 $260,000

Increase in Owner's Equity during 1999 (Answer 1) 110,000
Owner's Equity at December 31, 1999 $370,000

OR

Assets at January 1, 1999 $600,000

Increase in Assets during 1999 80,000
Total Assets at December 31, 1999 $680,000

Liabilities at January 1, 1999 $340,000

Decrease in Liabilities during 1999 (30,000)
Total Liabilities at December 31, 1999 $310,000

Assets = Liabilities + Owner's Equity

$680,000 = $310,000 + OE
$680,000 - $310,000 = OE
$370,000 = OE
$370,000 = Owner's Equity at December 31, 1999

6. (1) Assets = Liabilities + Owner's Equity

$500,000 = L + $280,000
$500,000 - $280,000 = L
$220,000 = L
$220,000 = Liabilities at January 1, 1999

(2) A = L + OE
$40,000 = $22,000 + OE
$40,000 + $22,000 = OE
$18,000 = OE
Decrease of $18,000 = Change in Owner's Equity during 1999

(3) Owner's Equity at January 1, 1999 $280,000

Decrease in Owner's Equity during 1999 (Answer 2) (18,000)
Owner's Equity at December 31, 1999 $262,000
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OR

Assets at January 1, 1999 $500,000

Decrease in Assets during 1999 (40,000)
Assets at December 31, 1999 $460,000

Liabilities at January 1, 1999 (Answer 1) $220,000

Decrease in Liabilities during 1999 (22,000)
Liabilities at December 31, 1999 $198,000

Assets = Liabilities + Owner's Equity

$460,000 = $198,000 + OE
$460,000 - $198,000 = OE
$262,000 = Owner's Equity at December 31, 1999

EXERCISE 1-2

Purpose: (S.O. 7) This exercise illustrates that:

(1) Each transaction has a dual effect on the basic accounting equation.
(2) The basic accounting equation remains in balance after each
transaction is properly analyzed and recorded.

Biffy Bean owns and operates the Motorboat Repair Shop. A list of the transactions that
took place in August 1999 follows:
1. August 1 Biffy began the business by depositing $5,000 of his personal funds
in the business bank account.

2. August 2 Biffy rented space for the shop behind a strip mall and paid August
rent of $800.

3. August 3 The shop purchased supplies for cash, $3,000.

4. August 4 The shop paid Cupboard News, a local newspaper, $300 for an ad
appearing in the Sunday edition.

5. August 5 Biffy repaired a boat for a customer. The customer paid cash of
$1,300 for services rendered.

6. August 11 Motorboat Repair Shop repaired a boat for a customer, Cheris

Vasallo, on credit, $500.

7. August 13 The shop purchased supplies for $900 by paying cash of $200 and
charging the rest on account.

8. August 14 The shop repaired a boat for Zonie Kinkennon, a champion skier,
for $1,900. Biffy collected $1,000 in cash and put the rest on
account.
 Accounting in Action 1-9
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9. August 22 Biffy took home supplies from the shop that had cost $100 when
purchased on August 3.

10. August 24 The shop collected cash of $400 from Cheris Vasallo.

11. August 28 The shop paid $200 to Mini Maid for cleaning services for the
month of August.

12. August 29 Biffy repaired a boat for Burt Reynolds for $1,200 on account.

13. August 31 Biffy transferred $500 from the business bank account to his
personal bank account.

Instructions
Prepare a tabular analysis of the transactions above to indicate the effect of each of the
transactions on the various balance sheet items. Use a "+" to indicate an increase and
a "-" to indicate a decrease. Indicate the new balances after each transaction. In the
owner's equity column, indicate the cause of each change in the owner's total claim on
assets. Use the following column headings:
LIABIL- OWNER'S
ASSETS = ITIES + EQUITY
Accounts Accounts B. Bean
Transaction Cash + Receivable + Supplies = Payable + Capital
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SOLUTION TO EXERCISE 1-2

 Accounting in Action 1-11
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TIP: Make sure the balances at any given point in time reflect equality in the
components of the basic accounting equation. If equality does not exist, the work
is incomplete or some error has been made. After all transactions are analyzed
for Motorboat Repair Shop, total assets = $8,700, total liabilities = $700, and total
owner's equity = $8,000. The equation is in balance.

TIP: Notice transaction number 7. Even though there were three items affected
(Cash, Supplies, and Accounts Payable), the analysis of the transaction
maintains balance in the basic accounting equation. Total assets increased by
$700 ($900 - $200), and liabilities increased by $700.

TIP: Notice transaction number 8. Even though there were three items affected
(Cash, Accounts Receivable, and B. Bean, Capital), the analysis of the
transaction maintains balance in the equation. Total assets increased by $1,900
($1,000 + $900), and owner's equity increased by $1,900.

Approach: Take each transaction and analyze it separately. Determine if the

transaction involves the following:

Assets: Assets are resources owned or controlled by a business. Thus, they are the
things of value used in carrying out such activities as production,
consumption, and exchange. As asset represents a future economic benefit
that will eventually result in an inflow of cash to the holder.

Liabilities: Liabilities are creditor sources of resources or creditorship claims on total

assets. They are existing debts and obligations which will become due in
the future and will normally require an outlay of cash to be liquidated.

Owner's The ownership claim on total assets is known as owner's equity. Total
Equity: assets less total liabilities equals total owner's equity. Accountants often
refer to total owner's equity by use of the word capital. The components of
owner's equity are as follows:
(1) Invested capitalthe owner's investment in the business.
(2) Earned capitalbusiness earnings retained for use in the business;
net income since the inception of the business less total owner
withdrawals (drawings) since the inception of the business.
(a) Net income is the amount of excess of total revenues over total
expenses for a particular period of time. (An excess of total
expenses over total revenues for a particular period of time is
referred to as net loss.)
(b) Revenues are the gross increases in owner's equity resulting
from business activities entered into for the purpose of earning
income. Generally, revenues result from the sale of merchandise,
the performance of services, the rental of property, or the lending
of money.
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(c) Expenses are the costs of assets consumed or services used up

in the process of earning revenue. Expenses are the decreases
in owner's equity that result from operating the business.
Expenses represent actual or expected cash outflows (payments).
(d) Drawings occur when an owner withdraws cash or other assets
for personal use. Owner withdrawals cause a decrease in total
owner's equity.

If a transaction involves assets or liabilities, identify which particular asset or liability is

affected and in what direction and by what amount. If a transaction involves owner's
equity, identify the specific reason for that changeowner investment, owner
withdrawal, revenue earned, or expense incurred. Be sure to classify each revenue and
expense item by type (for example, salaries expense or rent expense). Also identify the
amount and direction of each change in owner's equity.

TIP: A keen understanding of the definitions for the terms listed above (especially
assets, liabilities, owner's equity, revenues, and expenses) is vitally important for
your study of accounting. Proceed with your reading of the forthcoming chapters
only after you have mastered these terms! As you progress through the book,
periodically return here to review these concepts.
 Accounting in Action 1-13
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ILLUSTRATION 1-1
DUAL EFFECT OF TRANSACTIONS ON THE
BASIC ACCOUNTING EQUATION (S.O. 6, 7)

Each transaction affects items in the basic accounting equation in such a manner as to
maintain equality in the basic accounting equation. The possible combinations of dual
effects are illustrated below with examples of transactions that fit each category of
combinations. Some examples are too advanced to be comprehended at this level in
your accounting study so references are made to future chapters for those items. Do
not attempt to research those items at this timejust accept the fact that in the future
you will more readily understand those examples. These advanced examples are
included here to show you that there are illustrations of every conceivable combination
of dual effects on the equation.
Effects of Transaction
on Basic Equation Examples
1. A = L + OE a. Owner investment of personal assets
into the business.
b. Sale of services for cash or on account.

2. A = L + OE a. Owner withdrawal of assets from the

business for personal use.
b. Cash payment for various expenses,
such as salaries expense and
advertising expense. (Also, Chapter 3,
consumption of noncash assets in
operations, such as the consumption of
supplies.)

3. A = L + OE a. Acquisition of any asset on credit.

Borrowing money.

4. A = L + OE a. Paying off any debt.

5. A = L + OE a. Exchanging any asset for another asset,

such as purchase of equipment for cash
or collection of an account receivable.

6. A = L + OE a. Exchanging one liability for another,

such as settling an account payable by
issuing a note payable.

7. A = L + OE a. (Chapter 15Corporation declares a

stock dividend).
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ILLUSTRATION 1-1 (Continued)

8. A = L + OE a. Liquidating a debt by giving an owner-

ship interest in the entity.
b. (Chapter 3Entity earns revenue after
cash was previously received and
recorded).
9. A = L + OE
a. (Chapter 15Corporation declares cash
dividends on stock).
b. (Chapter 3Incurring expense-- consum-
ing benefits in carrying out operations--
before paying for the goods or services,
such as repairs made to an entity's
equipment before the vendor is paid.)

TIP: Examine the examples. Some of them are preceded by an a. and some are
preceded by a b. Notice that all of the a. type examples have no impact on the
income statement; whereas all of the b. type examples do impact the income
statement. All examples above impact the balance sheet.

TIP: A single transaction may affect more than two items in the basic accounting
equation and still maintain equality in the equation. For example, if a company
received a $700 bill for repairs to a copier and paid $500 cash to the vendor
along with a promise to pay the remaining $200 in one month, the transaction
would affect the components of the equation as follows:

A = L + OE
$500 = $200 + $700

The equation remains in balance.

TIP: As you progress through your accounting course(s) and possibly a career in
business, you will constantly encounter new transactions and familiar
transactions with a new twist. These unfamiliar situations can be addressed with
confidence if you carefully analyze the effects of each transaction on the basic
accounting equation.
 Accounting in Action 1-15
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EXERCISE 1-3

Purpose: (S.O. 8) This exercise will provide you with an illustration of an income
statement, owner's equity statement, a balance sheet, and a statement of
cash flows.

The Motorboat Repair Shop in Casselberry, Florida, prepares financial statements each
month.

Instructions
Refer to the Solution to Exercise 1-2 above. Use the information displayed to:
(a) Prepare an income statement for the month of August 1999.
(b) Prepare an owner's equity statement for the month of August 1999.
(c) Prepare a balance sheet at August 31, 1999.
(d) Prepare a statement of cash flows for the month of August 1999.

Approach: Think about what each statement is to report. A summary is as follows:

(a) The income statement reports the results of operations for a period of time.
Therefore, the income statement in this exercise reports revenues and expenses
for August.
(b) The owner's equity statement reports all changes in owner's equity for a period
of time. It starts with the balance of owner's equity at the beginning of the period.
It reports withdrawals (drawings), additional owner investments and includes the
net income (or net loss) figure from the income statement to arrive at the balance
of owner's equity at the end of the period.
(c) The balance sheet reports on the financial position at a point in time (August 31 in
this case). It reports assets, liabilities, and owner's equity. The balance of owner's
equity used here comes from the owner's equity statement.
(d) The statement of cash flows reports the cash inflows and cash outflows during a
period of time and classifies these flows into three activities: (1) operating, (2)
investing, and (3) financing.

SOLUTION TO EXERCISE 1-3

(a) MOTORBOAT REPAIR SHOP

Income Statement
For the Month Ended August 31, 1999
Revenues
Service revenue $4,900*
Expenses
Rent expense $800
Advertising expense 300
Cleaning expense 200
Total expenses 1,300
Net income $3,600

*Computation: $1,300 + $500 + $1,900 + $1,200 = $4,900.

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TIP: Even though there were four separate revenue transactions, they are reported in
the aggregate on the income statement. Also notice that there is no distinction
made on the income statement between cash revenue transactions and revenue
transactions that are on account.

TIP: As you might be wondering, there are likely some other expenses incurred by the
Motorboat Repair Shop during August that have not yet been addressed. For
example, some supplies were probably consumed in making repairs. Also,
services such as power and telephone likely were consumed in August. These
situations will be explained in Chapter 3.

TIP: Drawings are often called owner withdrawals or simply withdrawals. They do
not appear on the income statement because they are not expenses they have
no impact on operations. Withdrawals are a distribution of company profits and
not a determinant of profits (net income).

(b) MOTORBOAT REPAIR SHOP

Owner's Equity Statement
For the Month Ended August 31, 1999

Biffy Bean, Capital, August 1, 1999 $ 0

Add: Owner investments 5,000
Net income for August 1999 3,600
8,600
Less: Drawings 600*
Biffy Bean, Capital, August 31, 1999 $8,000

*Computation: $100 + $500 = $600.

(c) MOTORBOAT REPAIR SHOP

Balance Sheet
August 31, 1999
Assets
Cash $2,700
Accounts receivable 2,200
Supplies 3,800
Total assets $8,700

Liabilities and Owner's Equity

Liabilities
Accounts payable $ 700
Owner's Equity
Biffy Bean, Capital 8,000
Total liabilities and owner's equity$8,700

TIP: Supplies refers to supplies on hand. Therefore, this item is an asset.

 Accounting in Action 1-17
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(d) MOTORBOAT REPAIR SHOP

Statement of Cash Flows
For the Month Ended August 31, 1999

Cash flows from operating activities

Cash receipts from customers $2,700
Cash payments for expenses and supplies (4,500)
Net cash used by operating activities (1,800)

Cash flows from investing activities

[None illustrated here]
Net cash provided by investing activities 0

Cash flows from financing activities

Investments by owner $5,000
Drawings by owner (500)
Net cash provided by financing activities 4,500
Net increase in cash 2,700
Cash at the beginning of the period 0
Cash at the end of the period $2,700

Computations:
Cash receipts from customers: $1,300 + $1,000 + $400 = $2,700.
Cash payments for expenses and supplies: $800 + $3,000 + $300 + $200 +
$200 = $4,500.

TIP: Notice that although the owner's capital balance is $8,000, the balance of cash is
far less than that. Also notice what gave rise to that $8,000 balance of owner's
equity: the owner invested $5,000, the company has operated at a profit of
$3,600 (total revenues exceeded total expenses) since its inception, and total
company earnings ($3,600) exceed total owner withdrawals ($600). Therefore,
the ending owner's equity stems from owner investments of $5,000 and
undistributed earnings of $3,000.

TIP: Think about the logical order in which the financial statements are prepared:
income statement then owner's equity statement and then balance sheet. That's
because the income statement provides the net income figure used to compute
the change in owner's equity. All changes in owner's equity are reported on the
owner's equity statement to determine the ending balance for owner's equity.
That ending owner's equity balance is then used as a necessary component of
the balance sheet.
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TIP: Notice that everything on the balance sheet in the liabilities and owner's equity
section lacks physical existence. The balance of Accounts Payable represents
the total amount owed at the balance sheet date to suppliers of goods and
services because of past transactions. The balance of Biffy Bean, Capital tells
us the dollar amount of the entity's resources at the balance sheet date which
have resulted from the owner's investments and the entity's profitable operations
(i.e., profits that have not been distributed to the owner). Notice that in this
particular situation the ending balance of owner's equity exceeds the amount of
cash. Also, the amount of net income for the month of August exceeds the
amount of cash at August 31, 1999.

TIP: The owner's equity statement is often called the statement of owner's equity.

EXERCISE 1-4

Purpose: (S.O. 8) This exercise will give you practice in classifying items on financial
statements.

________ 1. Cash ________15. Fees incurred

________ 2. Accounts payable ________16. Telephone expense

________ 3. Equipment ________17. Cleaning supplies on hand

________ 4. Utilities expense ________18. Property taxes payable

________ 5. A. Hammer, capital ________19. Cleaning expense

________ 6. Salaries payable ________20. Commission expense

________ 7. Salaries expense ________21. Commision revenue

________ 8. Advertising expense ________22. Insurance expense

________ 9. Advertising payable ________23. Rent expense

________10. Office supplies ________24. Rent revenue

________11. Note payable ________25. Interest expense

________12. Note receivable ________26. Interest revenue

________13. A. Hammer, drawings ________27. Interest income

________14. Fees earned ________28. Office supplies expense

 Accounting in Action 1-19
___________________________________________________________________________

________29. Owner withdrawals ________35. Mortgage payable

________30. Service revenue ________36. Loan receivable

________31. Legal fees earned ________37. Bank loan payable

________32. Legal fees incurred ________38. Royalty revenue

________33. Prepaid insurance ________39. Royalty expense

________34. Property tax expense ________40. Medical supplies

Instructions
Indicate how each of the above should be classified on a set of financial statements.
Use the following abbreviations to communicate your responses.

A Asset on the balance sheet

L Liability on the balance sheet
OE Owner's equity balance on the balance sheet
D Drawings on the owner's equity statement
R Revenue on the income statement
E Expense on the income statement

SOLUTION TO EXERCISE 1-4

Approach: Look for the key word or words, if any, in each individual item. For
example, a list of key words or phrases follows along with the likely classifications:

Key word (phrases) Classification

Revenue Revenue on the income statement
Expense Expense on the income statement
Earned Revenue on the income statement
Incurred Expense on the income statement
On hand Asset on the balance sheet
Prepaid Asset on the balance sheet
Receivable Asset on the balance sheet
Payable Liability on the balance sheet
1-20 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
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1. A 11. L 21. R 31. R

2. L 12. A 22. E 32. E
3. A 13. D 23. E 33. A
4 E 14. R 24. R 34. E
5. OE 15. E 25. E 35. L
6. L 16. E 26. R 36. A
7. E 17. A 27. Ra 37. L
8. E 18. L 28. E 38. R
9. L 19. E 29. D 39. E
10. A 20. E 30. R 40. A

aThe word income in an item is often used instead of the word revenue. Such as rent
income, interest income, and commission income.

TIP: Keep in mind that an asset is an item that offers probable future economic
benefits. If something will assist the revenue generating process of a future
accounting period, it is an asset.

TIP: You can determine the position of an entity in a particular transaction by the
wording of the explanation. For example, we would use the item "bank loan
payable" (a liability) if we had borrowed money from the bank. The bank would
have "loan receivable" (an asset) item on their balance sheet. As another
example, we would have "legal fees incurred" (an expense) on our income
statement if we had used legal services. The law firm which provided the
services would report a corresponding "legal fees earned" (revenue) item on its
income statement.

EXERCISE 1-5
Purpose: (S.O. 6, 7, 8) This exercise reviews the basic accounting equation (A = L +
OE) and the connection between the income statement and the balance
sheet. The connection is a change in owner's equity due to the net income
or net loss for the period.
The following data were extracted from the records of Handy Hernanco, a sole
proprietorship:
Total assets, beginning of the period $250,000
Total liabilities, beginning of the period 90,000
Owner drawings during the period 75,000
Total assets, end of the period 270,000
Total liabilities, end of the period 95,000
Owner's contributions during the period 25,000
Instructions
Compute the amount of net income (or net loss) for the period. Show your
computations.
SOLUTION TO EXERCISE 1-5
 Accounting in Action 1-21
___________________________________________________________________________

Approach: The question asks you to solve for net income; however, no information is
given regarding revenues and expenses for the period. Only balance sheet data and
transactions affecting owner's equity are given. Net income (or net loss) for a period is
one reason for change in the balance of owner's equity. Write down the items that
reconcile the beginning owner's equity balance with the ending owner's equity balance,
enter the amounts known, compute beginning and ending owner's equity balances by
use of the basic accounting equation, and then solve for the amount of net income.

Beginning owner's equity $160,000a

Additional owner contributions 25,000
Owner withdrawals during the period (75,000)
Subtotal 110,000
Net income (loss) for the period + X
Ending owner's equity $175,000b

Solving for X, net income = $65,000

aA= L + OE
$250,000 = $90,000 + ?
Beginning owner's equity = $160,000

bA= L + OE
$270,000 = $95,000 + ?
Ending owner's equity = $175,000

TIP: Solving an exercise of this type requires a lot of thought and a clear
understanding of the relationships of accounting data.
1-22 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
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EXERCISE 1-6

Purpose: (S.O. 1 thru 8) This exercise will quiz you about terminology used in this
chapter.

A list of accounting terms with which you should be familiar appears below.

Accounting Liabilities
Assets Management consulting
Auditing Monetary unit assumption
Balance sheet Net income
Basic accounting equation Net loss
Bookkeeping Owner's equity
Corporation Owner's equity statement
Cost principle Partnership
Drawings Private (or managerial) accounting
Economic entity assumption Proprietorship
Ethics Public accounting
Expenses Revenues
Financial Accounting Standards Board Securities and Exchange Commission
(FASB) (SEC)
Generally accepted accounting principles Statement of cash flows
(GAAP) Taxation
Income statement Transactions
Investments by owner

Instructions
For each item below, enter in the blank the term that is described.

1. _____________________________________The process of identifying,

recording, and communicating the economic events of an organization to
interested users of the information.

2. _____________________________________An accounting principle that states

that assets should be recorded at their cost.

3. _____________________________________A financial statement that presents

the revenues and expenses and resulting net income or net loss of a company
for a specific period of time. Sometimes called the operating statement.

4. _____________________________________The gross increase in owner's

equity resulting from business activities entered into for the purpose of earning
income.

5. _____________________________________The cost of assets consumed or

services used in the process of earning revenue.
 Accounting in Action 1-23
___________________________________________________________________________

6. _____________________________________Assets = Liabilities + Owner's

equity.

7. _____________________________________Resources owned by a business.

8. _____________________________________Creditorship claims on total

assets.

9. _____________________________________The ownership claim on total

assets. Sometimes called net worth.

10. _____________________________________A financial statement that reports

the assets, liabilities, and owner's equity at a specific date. Sometimes called the
statement of financial position.

11. _____________________________________A common set of standards that

indicate how to report economic events.

12. _____________________________________A financial statement that

summarizes the changes in owner's equity for a specific period of time.

13. _____________________________________An assumption stating that only

transaction data that can be expressed in terms of money be included in the
accounting records of the economic entity.

14. _____________________________________An assumption that economic

events can be identified with a particular unit of accountability.

15. _____________________________________The economic events of the

enterprise recorded by accountants.

16. _____________________________________Withdrawal of cash or other assets

from an unincorporated business for the personal use of the owner(s).

17. _____________________________________A financial statement that provides

information about the cash inflows (receipts) and cash outflows (payments) of an
entity for a specific period of time.

18. _____________________________________The examination of financial

statements by a certified public accountant in order to express an opinion as to
the fairness of presentation.

19. _____________________________________An area of public accounting

involving tax advice, tax planning, and preparing tax returns.

20. _____________________________________An area of public accounting

involving financial planning and control and the development of accounting and
computer systems.
1-24 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
___________________________________________________________________________

21. _____________________________________An area of accounting in which the

accountant offers expert service to the general public.

22. _____________________________________An area of accounting within a

company that involves such activities as cost accounting, budgeting, and
accounting information systems.

23. _____________________________________A private organization that

establishes generally accepted accounting principles.

24. _____________________________________A governmental agency that

requires companies to file financial reports in accordance with generally accepted
accounting principles.

25. _____________________________________The amount by which revenues

exceed expenses for a specific period of time.

26. _____________________________________A business organized as a

separate legal entity under state corporation law having ownership divided into
transferable shares of stock.

27. _____________________________________An association of two or more

persons to carry on as co-owners of a business for profit.

28. _____________________________________A business owned by one person.

29. _____________________________________The amount of resources (assets)

put into the business by the owner.

30. _____________________________________A part of accounting that involves

only the recording of economic events.

31. _____________________________________The amount by which expenses

exceed revenues for a specific period of time.

32. _____________________________________The standards of conduct by

which one's actions are judged as right or wrong, honest or dishonest, fair or not
fair.
 Accounting in Action 1-25
___________________________________________________________________________

SOLUTION TO EXERCISE 1-6

1. Accounting 17. Statement of cash flows

2. Cost principle 18. Auditing
3. Income statement 19. Taxation
4. Revenues 20. Management consulting
5. Expenses 21. Public accounting
6. Basic accounting equation 22. Private (or managerial) accounting
7. Assets 23. Financial Accounting Standards Board
8. Liabilities 24. Securities and Exchange Commission
9. Owner's equity 25. Net income
10. Balance sheet 26. Corporation
11. Generally accepted accounting 27. Partnership
principles 28. Proprietorship
12. Owner's equity statement 29. Investments by owner
13. Monetary unit assumption 30. Bookkeeping
14. Economic entity assumption 31. Net loss
15. Transactions 32. Ethics
16. Drawings

ANALYSIS OF MULTIPLE-CHOICE TYPE QUESTIONS

1. Question
(S.O. 2) Which of the following terms refers to the process of reviewing the
accounting records and reports to evaluate the fairness of the presentations in the
reports and their compliance with established guidelines and rules?
a. Auditing.
b. Tax return preparation.
c. Management consulting work.
d. Public accounting.

Approach and Explanation: Briefly define each answer selection. Compare your
definitions with the question stem to determine your answer. Auditing services are
provided by public accounting firms. An audit is an examination of the financial
statements of a company by a CPA for the purpose of an expression of an opinion
as to the fairness of presentation. Tax return preparation involves preparing tax
returns, usually without any verification of the data to be used for completion.
Management consulting work involves giving advice to management on various
matters. Public accounting involves providing services to clients. As a public
accountant, an individual may perform one or more of the following services:
auditing, taxation, and management consulting. (Solution = a.)
1-26 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
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2. Question
(S.O. 5) Which accounting assumption or principle dictates that a business
owner's personal expenses should not be recorded on the books of the business?
a. Economic entity assumption.
b. Monetary unit assumption.
c. Cost principle.
d. Basic accounting equation.

Approach and Explanation: Briefly explain each answer selection. Compare

your explanations with the question. The economic entity assumption requires that
the activities of the entity be kept separate and distinct from (1) the activities of its
owner, and (2) all other economic entities. The monetary unit assumption requires
that only transaction data that can be expressed in terms of money be included in
the accounting records and provides that all transactions and events can be
measured in terms of a common denominatorunits of money. The cost principle
states that assets should be recorded at cost and indicates that cost is measured
by the value exchanged at the time something is acquired. The basic accounting
equation provides that total assets at a point in time equals total liabilities plus total
owner's equity at the same point in time. (Solution = a.)

3. Question
(S.O. 4) The Seller Company sold the Buyer Company a building on August 1,
1999. Buyer Company paid Seller Company $92,000 cash. The Seller Company
had originally purchased the building in 1996 for $80,000. The county taxing
authority showed an assessed valuation of $78,000 for the building for 1998 taxing
purposes and an independent appraisal agency appraised it at $95,000 on July 15,
1999. The Buyer Company should record the building in their accounting books at:
a. $78,000.
b. $80,000.
c. $92,000.
d. $95,000.

Approach and Explanation: Read the last sentence first. You can tell by that
last sentence the Buyer is acquiring a building (an asset). Think about the cost
principle. It provides that all assets be recorded at cost. Cost is measured by the
value exchanged at the time something is acquired. In any exchange transaction,
cost is therefore measured by the fair market value (cash equivalent value) of the
consideration given or by the fair market value of the consideration received,
whichever is more clearly (objectively) determinable. When cash is paid, there is
no question about the cash value of the consideration given. Read the rest of the
question. In this case, the cash payment of $92,000 clearly determines the cost of
the building to the Buyer Company. (Solution = c.)
 Accounting in Action 1-27
___________________________________________________________________________

4. Question
(S.O. 8) The balance sheet is sometimes called the:
a. Earnings statement.
b. Operating statement.
c. Profit and loss statement.
d. Statement of financial position.

Approach and Explanation: Read the question stem. Think of alternative names
for the balance sheet. Then take each answer selection and see if it agrees with
your response or not. Answer selections a., b., and c. are all alternative names for
the income statement. Statement of financial position is a name for the balance
sheet because it reports on the entity's financial position at a point in time.
Statement of assets and equities might be another (but not popular) alternative
name for the balance sheet. (Solution = d.)

5. Question
(S.O. 6, 7) At January 1, 1999, Tully Company's assets totaled $70,000, and its
liabilities amounted to $40,000. Net income for 1999 was $24,000 and owner
withdrawals amounted to $25,000. At December 31, 1999, assets totaled $90,000,
and liabilities amounted to $57,000. The amount of additional owner investments
during 1999 amounted to:
a. $0.
b. $2,000.
c. $3,000.
d. $4,000.
e. Cannot be determined from the facts given.

Approach: Use your knowledge of the basic accounting equation and reasons for
changes in owner's equity to solve.

Explanation: A = L + OE
$70,000 = $40,000 + $30,000a Balance at 1/1/99
24,000 Net income for 1999
(25,000) Drawings for 1999
+ X Investments for
1999
$90,000 = $57,000 + $33,000b Balance at 12/31/99

a$70,000 - $40,000 = $30,000

b$90,000 - $57,000 = $33,000

Solving for X: $30,000 + $24,000 - $25,000 + X = $33,000

$29,000 + X = $33,000
X = $33,000 - $29,000
X = $4,000 owner investments during 1999
(Solution = d.)
1-28 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
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6. Question
(S.O. 6, 7) At January 1, 1999, King Corporation's assets totaled $76,000, and its
liabilities amounted to $42,000. Net income for 1999 was $17,000, and owner
drawings amounted to $13,000. The amount of owner's equity at December 31,
1999 is:
a. $38,000.
b. $51,000.
c. $80,000.
d. $93,000.

Approach: Use your knowledge of the basic accounting equation and reasons for
changes in owner's equity to solve.

Explanation: A = L + OE
$76,000 = $42,000 + OE at 1/1/99
$76,000 - $42,000 = $34,000 OE at 1/1/99

$34,000 Owner's equity at January 1, 1999

17,000 Net income for 1999
(13,000) Drawings for 1999
0 Additional owner investments for 1999
$38,000 Owner's equity at December 31, 1999
(Solution = a.)

7. Question
(S.O. 7) Which of the following phrases describes the effects of the purchase of an
asset on account?
a. Increase in assets and increase in expenses.
b. Increase in assets and increase in liabilities.
c. Increase in expenses and increase in liabilities.
d. Increase in liabilities and decrease in owner's equity.

Approach: Determine the effects of the transaction and write them down before
you read the answer selections. Write down the basic accounting equation and
analyze the effects of the transaction on the elements of the equation. If the
transaction affects owner's equity, clearly state why and how.

Explanation: A = L + OE
(Solution = b.)
 Accounting in Action 1-29
___________________________________________________________________________

8. Question
(S.O. 6) Which of the following statements is not true about all expenses?
a. They result in a decrease in owner's equity.
b. They result from the consumption of goods and services.
c. They occur in the process of generating revenue.
d. They are the same thing as liabilities.

Approach and Explanation: Write down the definition of expense and the
possible effects of an expense type transaction on the basic accounting equation.
Then take each answer selection and see if it is true or not true about all expenses.
An expense is the cost of an asset or other goods or services consumed in the
process of generating revenue. The possible effects of an expense on the basic
accounting equation are as follows:

A = L + OE

OR

Liabilities are debts or obligations. A liability may arise because an asset is

acquired on credit or because money is borrowed. A liability may arise in an
expense transaction but not all expense transactions involve liabilities. Liabilities
and expenses are not synonymous terms. (Solution = d.)

9. Question
(S.O. 7) Which of the following statements is true regarding the current period's
consumption of office supplies which were purchased and recorded as an asset in
a prior accounting period?
a. Total assets remain unchanged.
b. Total owner's equity decreases.
c. Total liabilities increase.
d. Total assets increase.

Approach and Explanation: Write down the effects of the consumption of office
supplies previously on hand. The supplies were an asset when they were on
hand. Now, they are an expense because they have been consumed. Therefore,
assets decrease, and owner's equity decreases. (Solution = b.)

10. Question
(S.O. 7) Which of the following statements is true regarding the effect of the
purchase of equipment for cash?
a. Total assets decrease.
b. Total liabilities increase.
c. Total assets remain unchanged.
d. Total owner's equity decreases.
1-30 Self-Study Problems/Solutions for Accounting Principles, 5th Edition
___________________________________________________________________________

Approach and Explanation: Think about the transaction. Cash (an asset)
decreases. Equipment (another asset) increases by the same amount. There is
no effect on liabilities or owner's equity. Look for the answer selection that fits the
effects described. (Solution = c.)

A = L + OE

11. Question
(S.O. 6) Which of the following items is an example of a liability?
a. Wages expense.
b. Mortgage payable.
c. Accounts receivable.
d. Owner's equity

Approach and Explanation: Think about the definition of a liability. Key words
often associated with a liability are "debt," "obligation," or "payable." Examine
each answer selection and determine its classification on financial statements.
Write down your responses. Wages expense is an expense item on the income
statement. Mortgage payable is a liability (Bingo!). Accounts receivable is an
asset (key word is receivable). Owner's equity is owner's equity on the balance
sheet. (Solution = b.)

12. Question
(S.O. 7) The effects of a withdrawal by an owner are to
a. Increase expenses and decrease net income.
b. Increase expenses and decrease owner's equity.
c. Decrease assets and decrease net income.
d. Decrease assets and decrease owner's equity.

Approach and Explanation: Write down the basic accounting equation and use
arrows to indicate the effects of an owner withdrawal (of cash or other assets).

A = L + OE

Examine each answer selection and see if it fits your description. An owner
withdrawal is not an expense because it does not have anything to do with carrying
out operations and generating revenue; it is a distribution of profits to the owner.
(Solution = d.)