Chapter 1 Accounting in Action

Feature Story

Knowing the In business, accounting and financial

statements are the means for commu-
Numbers nicating the numbers. If you don’t
Many students who take this course do know how to read financial statements,
not plan to be accountants. If you are you can’t really know your business.
in that group, you might be thinking,
Many companies spend significant
“If I’m not going to be an accountant,
resources teaching their employees
why do I need to know accounting?”
basic accounting so that they can read
In response, consider the quote from
financial statements and understand
Harold Geneen, the former chairman of
how their actions affect the company’s
IT&T: “To be good at your business, you
financial results. One such company is
have to know the numbers—cold.”
Springfield ReManufacturing Corpora-
Success in any business comes back to tion (SRC). When Jack Stack and 11
the numbers. You will rely on them to other managers purchased SRC for
make decisions, and managers will use 10 cents a share, it was a failing
them to evaluate your performance. division of International Harvester.
That is true whether your job involves Jack’s 119 employees, however, were
marketing, production, management, counting on him for their livelihood.
or information systems. He decided that for the company to

The Navigator is a learning system designed

to prompt you to use the learning aids in the Learning Objectives give you a framework for learning the
chapter and set priorities as you study. specific concepts covered in the chapter.

✔ The Navigator

Learning Objectives
Scan Learning Objectives
After studying this chapter, you should be able to:
Read Feature Story
1 Explain what accounting is.
Read Preview 2 Identify the users and uses of accounting.
3 Understand why ethics is a fundamental business concept.
Read text and answer DO IT! p. 11
p. 14 p. 21 p. 25 4 Explain generally accepted accounting principles.
5 Explain the monetary unit assumption and the economic
Work Comprehensive DO IT! p. 26 entity assumption.

Review Summary of Learning Objectives 6 State the accounting equation, and define its components.
7 Analyze the effects of business transactions on the
Answer Self-Test Questions
accounting equation.
Complete Assignments 8 Understand the four financial statements and how they
are prepared.
Go to WileyPLUS for practice and tutorials
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Read A Look at IFRS p. 49

2
survive, every employee needed to think like a businessperson Taking this course will go a long way to making you financially
and to act like an owner. To accomplish this, all employees at literate. In this book, you will learn how to read and prepare
SRC took basic accounting courses financial statements, and how to use
and participated in weekly reviews of basic tools to evaluate financial results.
the company’s financial statements. SRC Appendices A and B provide real
survived, and eventually thrived. To financial statements of two well-
this day, every employee (now number- known U.S. companies, PepsiCo, Inc.
ing more than 1,000) undergoes this and The Coca-Cola Company.
same training. Appendix C includes the financial
statements of Zetar plc, a U.K. candy
Many other companies have adopted
company. Throughout this textbook,
this approach, which is called “open-
we attempt to increase your familiarity
book management.” Even in compa-
with financial reporting by providing
nies that do not practice open-book
numerous references, questions, and
management, employers generally
exercises that encourage you to
assume that managers in all areas of
explore these financial statements.
the company are “financially literate.”
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The Feature Story helps you picture how the chapter topic
relates to the real world of accounting and business. You will
find references to the story throughout the chapter.

Preview of Chapter 1
The opening story about Springfield ReManufacturing Corporation highlights the importance of having
good financial information and knowing how to use it to make effective business decisions. Whatever
your pursuits or occupation, the need for financial information is inescapable. You cannot earn a living,
spend money, buy on credit, make an investment, or pay taxes without receiving, using, or dispensing
financial information. Good decision-making depends on good information.
The purpose of this chapter is to show you that accounting is the The Preview describes and outlines the
system used to provide useful financial information. The content major topics and subtopics you will see
and organization of Chapter 1 are as follows. in the chapter.

ACCOUNTING IN ACTION

The Building Blocks The Basic Accounting Using the Accounting

What Is Accounting? of Accounting Equation Equation Financial Statements

• Three activities • Ethics in financial • Assets • Transaction analysis • Income statement

• Who uses reporting • Liabilities • Summary of • Retained earnings
accounting data • Generally accepted • Stockholders’ transactions statement
accounting equity • Balance sheet
principles
• Statement of cash
• Measurement flows
principles
• Assumptions

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3
4 1 Accounting in Action

What Is Accounting?
LEARNING OBJECTIVE 1 What consistently ranks as one of the top career opportunities in business? What
frequently rates among the most popular majors on campus? What was the
Explain what undergraduate degree chosen by Nike founder Phil Knight, Home Depot co-founder
accounting is. Arthur Blank, former acting director of the Federal Bureau of Investigation (FBI)
Thomas Pickard, and numerous members of Congress? Accounting.1 Why did
these people choose accounting? They wanted to understand what was happening
financially to their organizations. Accounting is the financial information system
Essential terms are that provides these insights. In short, to understand your organization, you have
printed in blue when they to know the numbers.
first appear, and are defined Accounting consists of three basic activities—it identifies, records, and
in the end-of-chapter communicates the economic events of an organization to interested users. Let’s
glossary. take a closer look at these three activities.

Three Activities
As a starting point to the accounting process, a company identifies the economic
events relevant to its business. Examples of economic events are the sale of
snack chips by PepsiCo, the providing of telephone services by AT&T, and the
payment of wages by Ford Motor Company.
Once a company like PepsiCo identifies economic events, it records those
events in order to provide a history of its financial activities. Recording consists
of keeping a systematic, chronological diary of events, measured in dollars
and cents. In recording, PepsiCo also classifies and summarizes economic events.
Finally, PepsiCo communicates the collected information to interested users
by means of accounting reports. The most common of these reports are called
financial statements. To make the reported financial information meaningful,
PepsiCo reports the recorded data in a standardized way. It accumulates infor-
mation resulting from similar transactions. For example, PepsiCo accumulates
all sales transactions over a certain period of time and reports the data as one
amount in the company’s financial statements. Such data are said to be reported
in the aggregate. By presenting the recorded data in the aggregate, the account-
ing process simplifies a multitude of transactions and makes a series of activities
understandable and meaningful.
A vital element in communicating economic events is the accountant’s ability
to analyze and interpret the reported information. Analysis involves use of
ratios, percentages, graphs, and charts to highlight significant financial trends
and relationships. Interpretation involves explaining the uses, meaning, and
limitations of reported data. Appendix A of this textbook shows the financial
statements of PepsiCo, Inc. Appendix B illustrates the financial statements of
The Coca-Cola Company. We refer to these statements at various places through-
out the textbook. (In addition, in the A Look at IFRS section at the end of each
chapter, the U.K. company Zetar plc is analyzed.) At this point, these financial
statements probably strike you as complex and confusing. By the end of this
course, you’ll be surprised at your ability to understand, analyze, and interpret
them.
Illustration 1-1 summarizes the activities of the accounting process.

1
The appendix to this chapter describes job opportunities for accounting majors and explains why
accounting is such a popular major.
 What Is Accounting? 5

Communication

Identification Recording

Prepare accounting reports

Select economic events (transactions) Record, classify, and summarize

NOK KIAIAeppoortrt
l RRe
nuuaal
An
A

Analyze and interpret for users

Illustration 1-1
You should understand that the accounting process includes the bookkeeping The activities of the
function. Bookkeeping usually involves only the recording of economic events. It accounting process
is therefore just one part of the accounting process. In total, accounting involves the
entire process of identifying, recording, and communicating economic events.2

Who Uses Accounting Data

The specific financial information that a user needs depends upon the kinds of LEARNING OBJECTIVE 2
decisions the user makes. There are two broad groups of users of financial infor-
mation: internal users and external users. Identify the users and
uses of accounting.
INTERNAL USERS
Internal users of accounting information are managers who plan, organize, and
run the business. These include marketing managers, production supervisors,
finance directors, and company officers. In running a business, internal users Illustration 1-2
must answer many important questions, as shown in Illustration 1-2. Questions that internal
users ask

Questions Asked by Internal Users

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Finance Marketing Human Resources Management

Is cash sufficient to pay What price for an Apple iPod Can we afford to give Which PepsiCo product line is
dividends to will maximize the company's General Motors employees the most profitable? Should any
Microsoft stockholders? net income? pay raises this year? product lines be eliminated?

2
The origins of accounting are generally attributed to the work of Luca Pacioli, an Italian Renaissance
mathematician. Pacioli was a close friend and tutor to Leonardo da Vinci and a contemporary of
Christopher Columbus. In his 1494 text Summa de Arithmetica, Geometria, Proportione et Proportionalite,
Pacioli described a system to ensure that financial information was recorded efficiently and accurately.
6 1 Accounting in Action

To answer these and other questions, internal users need detailed informa-
tion on a timely basis. Managerial accounting provides internal reports to help
users make decisions about their companies. Examples are financial compari-
sons of operating alternatives, projections of income from new sales campaigns,
and forecasts of cash needs for the next year.

ACCOUNTING ACROSS THE ORGANIZATION

The Scoop on Accounting
Accounting can serve as a useful recruiting tool even for the human resources department.
Rhino Foods, located in Burlington, Vermont, is a manufacturer of specialty ice cream. Its
corporate website includes the following:

“Wouldn’t it be great to work where you were part of a team? Where your input and hard
work made a difference? Where you weren’t kept in the dark about what management
was thinking? . . . Well—it’s not a dream! It’s the way we do business . . . Rhino Foods be-
lieves in family, honesty and open communication—we really care about and appreciate
our employees—and it shows. Operating results are posted and monthly group meetings
Accounting Across the inform all employees about what’s happening in the Company. Employees also share in the
Organization boxes Company’s profits, in addition to having an excellent comprehensive benefits package.”
demonstrate applications
of accounting information Source: www.rhinofoods.com/workforus/workforus.html.
in various business
What are the benefits to the company and to the employees of making the financial
functions.
? statements available to all employees? (See page 48.)

EXTERNAL USERS
External users are individuals and organizations outside a company who want
financial information about the company. The two most common types of exter-
nal users are investors and creditors. Investors (owners) use accounting infor-
mation to make decisions to buy, hold, or sell ownership shares of a company.
Creditors (such as suppliers and bankers) use accounting information to evalu-
ate the risks of granting credit or lending money. Illustration 1-3 shows some
Illustration 1-3 questions that investors and creditors may ask.
Questions that external
users ask

Questions Asked by External Users

Yeah!
What do we do
if they catch us?

BILL
COLLECTOR

Investors Investors Creditors

Is General Electric earning How does Disney compare in size Will United Airlines be able
satisfactory income? and profitability with Time Warner? to pay its debts as they come due?

Financial accounting answers these questions. It provides economic and

financial information for investors, creditors, and other external users. The infor-
 The Building Blocks of Accounting 7

mation needs of external users vary considerably. Taxing authorities, such as the
Internal Revenue Service, want to know whether the company complies with tax
laws. Regulatory agencies, such as the Securities and Exchange Commission or
the Federal Trade Commission, want to know whether the company is operating
within prescribed rules. Customers are interested in whether a company like
General Motors will continue to honor product warranties and support its prod-
uct lines. Labor unions, such as the Major League Baseball Players Association,
want to know whether the owners have the ability to pay increased wages and
benefits.

The Building Blocks of Accounting

A doctor follows certain standards in treating a patient’s illness. An architect
follows certain standards in designing a building. An accountant follows certain
standards in reporting financial information. For these standards to work, a
fundamental business concept must be at work—ethical behavior.

Ethics in Financial Reporting

People won’t gamble in a casino if they think it is “rigged.” Similarly, people LEARNING OBJECTIVE 3
won’t play the stock market if they think stock prices are rigged. In recent years,
the financial press has been full of articles about financial scandals at Enron, Understand why ethics is
WorldCom, HealthSouth, AIG, and others. As the scandals came to light, mis- a fundamental business
trust of financial reporting in general grew. One article in the Wall Street Jour- concept.
nal noted that “repeated disclosures about questionable accounting practices
have bruised investors’ faith in the reliability of earnings reports, which in turn
has sent stock prices tumbling.” Imagine trying to carry on a business or in-
vest money if you could not depend on the financial statements to be hon-
estly prepared. Information would have no credibility. There is no doubt that a
sound, well-functioning economy depends on accurate and dependable finan-
cial reporting.
United States regulators and lawmakers were very concerned that the
economy would suffer if investors lost confidence in corporate accounting
because of unethical financial reporting. In response, Congress passed
the Sarbanes-Oxley Act (SOX, or Sarbox). Its intent is to reduce Ethics Note
unethical corporate behavior and decrease the likelihood of future
corporate scandals. As a result of SOX, top management must now Circus-founder P.T. Barnum is
certify the accuracy of financial information. In addition, penalties for alleged to have said, “Trust
everyone, but cut the deck.”
fraudulent financial activity are much more severe. Also, SOX increased
What Sarbanes-Oxley does is
the independence of the outside auditors who review the accuracy of
to provide measures that (like
corporate financial statements and increased the oversight role of cutting the deck of playing
boards of directors. cards) help ensure that fraud
The standards of conduct by which one’s actions are judged as right will not occur.
or wrong, honest or dishonest, fair or not fair, are ethics. Effective
financial reporting depends on sound ethical behavior. To sensitize you to ethical Ethics Notes help sensitize
situations in business and to give you practice at solving ethical dilemmas, we ad- you to some of the ethical
dress ethics in a number of ways in this book: issues in accounting.
1. A number of the Feature Stories and other parts of the textbook discuss the
central importance of ethical behavior to financial reporting.
2. Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and
issues in actual business settings.
8 1 Accounting in Action

3. Many of the People, Planet, and Profit Insight boxes focus on ethical issues
that companies face in measuring and reporting social and environmen-
tal issues.
4. At the end of the chapter, an Ethics Case simulates a business situation
and asks you to put yourself in the position of a decision-maker in that
case.
When analyzing these various ethics cases, as well as experiences in your
own life, it is useful to apply the three steps outlined in Illustration 1-4.
Illustration 1-4
Steps in analyzing ethics cases
and situations

1. Recognize an ethical 2. Identify and analyze 3. Identify the alternatives,

situation and the ethical the principal elements and weigh the impact of
issues involved. in the situation. each alternative on various
Use your personal ethics to Identify the stakeholders— stakeholders.
identify ethical situations and persons or groups who may Select the most ethical
#1 #2 issues. Some businesses and
professional organizations
be harmed or benefited. Ask
the question: What are the
alternative, considering all the
consequences. Sometimes there
ALT ALT provide written codes of responsibilities and obligations will be one right answer. Other
ethics for guidance in some of the parties involved? situations involve more than
business situations. one right solution; these
situations require an evaluation
of each and a selection of the
best alternative.

Insights provide examples of business situations from various perspectives—ethics, investor, international, and corporate
social responsibility.

ETHICS INSIGHT
The Numbers Behind Not-for-Profit Organizations
Accounting plays an important role for a wide range of business organizations worldwide.
Just as the integrity of the numbers matters for business, it matters at least as much for not-
for-profit organizations. Proper control and reporting help ensure that money is used the way
donors intended. Donors are less inclined to give to an organization if they think the organiza-
tion is subject to waste or theft. The accounting challenges of some large international not-
for-profits rival those of the world’s largest businesses. For example, after the Haitian earth-
quake, the Haitian-born musician Wyclef Jean was criticized for the poor accounting controls
in a relief fund that he founded. Since then, he has hired a new accountant and improved the
transparency regarding funds raised and spent.

What benefits does a sound accounting system provide to a not-for-profit

? organization? (See page 48.)

LEARNING OBJECTIVE 4 Generally Accepted Accounting Principles

The accounting profession has developed standards that are generally accepted
Explain generally
and universally practiced. This common set of standards is called generally
accepted accounting
principles.
accepted accounting principles (GAAP). These standards indicate how to
report economic events.
 The Building Blocks of Accounting 9

The primary accounting standard-setting body in the United

States is the Financial Accounting Standards Board (FASB). The International
Securities and Exchange Commission (SEC) is the agency of the Note
U.S. government that oversees U.S. financial markets and account-
Over 100 countries use
ing standard-setting bodies. The SEC relies on the FASB to develop
International Financial Reporting
accounting standards, which public companies must follow. Many Standards (called IFRS). For
countries outside of the United States have adopted the accounting example, all companies in the
standards issued by the International Accounting Standards Board European Union follow interna-
(IASB). These standards are called International Financial Reporting tional standards. The differences
Standards (IFRS). between U.S. and international
As markets become more global, it is often desirable to compare the standards are not generally
result of companies from different countries that report using different significant.
accounting standards. In order to increase comparability, in recent years
the two standard-setting bodies have made efforts to reduce the differences International Notes high-
between U.S. GAAP and IFRS. This process is referred to as convergence. As a light differences between
U.S. and international
result of these convergence efforts, it is likely that someday there will be a single
accounting standards.
set of high-quality accounting standards that are used by companies around the
world. Because convergence is such an important issue, we highlight any major
differences between GAAP and IFRS in International Notes (as shown in the mar-
gin here) and provide a more in-depth discussion in the A Look at IRFS section at
the end of each chapter.

Measurement Principles
GAAP generally uses one of two measurement principles, the cost principle or Helpful Hint
the fair value principle. Selection of which principle to follow generally relates to Relevance and faithful
trade-offs between relevance and faithful representation. Relevance means that representation are two
financial information is capable of making a difference in a decision. Faithful primary qualities that
representation means that the numbers and descriptions match what really make accounting
information useful for
existed or happened—it is factual.
decision-making.

Helpful Hints further

COST PRINCIPLE clarify concepts being
The cost principle (or historical cost principle) dictates that companies record discussed.
assets at their cost. This is true not only at the time the asset is purchased, but
also over the time the asset is held. For example, if Best Buy purchases land for
$300,000, the company initially reports it in its accounting records at $300,000.
But what does Best Buy do if, by the end of the next year, the fair value of the
land has increased to $400,000? Under the cost principle, it continues to report
the land at $300,000.

FAIR VALUE PRINCIPLE

The fair value principle states that assets and liabilities should be reported at
fair value (the price received to sell an asset or settle a liability). Fair value infor-
mation may be more useful than historical cost for certain types of assets and
liabilities. For example, certain investment securities are reported at fair value
because market value information is usually readily available for these types of
assets. In determining which measurement principle to use, companies weigh
the factual nature of cost figures versus the relevance of fair value. In general,
most companies choose to use cost. Only in situations where assets are actively
traded, such as investment securities, do companies apply the fair value principle
extensively.
10 1 Accounting in Action

INTERNATIONAL INSIGHT
The Korean Discount
If you think that accounting standards don’t matter, consider recent events in South Korea.
For many years, international investors complained that the financial reports of South Korean
companies were inadequate and inaccurate. Accounting practices there often resulted in huge
differences between stated revenues and actual revenues. Because investors did not have faith
in the accuracy of the numbers, they were unwilling to pay as much for the shares of these
companies relative to shares of comparable companies in different countries. This difference
in stock price was often referred to as the “Korean discount.”
In response, Korean regulators decided that, beginning in 2011, companies will have to
comply with international accounting standards. This change was motivated by a desire to
“make the country’s businesses more transparent” in order to build investor confidence and
spur economic growth. Many other Asian countries, including China, India, Japan, and Hong
Kong, have also decided either to adopt international standards or to create standards that
are based on the international standards.

Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).

What is meant by the phrase “make the country’s businesses more transparent”?
? Why would increasing transparency spur economic growth? (See page 48.)

Assumptions
LEARNING OBJECTIVE 4
5 Assumptions provide a foundation for the accounting process. Two main assump-
tions are the monetary unit assumption and the economic entity assumption.
Explain the monetary
unit assumption and MONETARY UNIT ASSUMPTION
the economic entity The monetary unit assumption requires that companies include in the accounting
assumption. records only transaction data that can be expressed in money terms. This
assumption enables accounting to quantify (measure) economic events. The
monetary unit assumption is vital to applying the cost principle.
This assumption prevents the inclusion of some relevant information in the
accounting records. For example, the health of a company’s owner, the quality of
service, and the morale of employees are not included. The reason: Companies
cannot quantify this information in money terms. Though this information is
important, companies record only events that can be measured in money.

ECONOMIC ENTITY ASSUMPTION

An economic entity can be any organization or unit in society. It may
be a company (such as Crocs, Inc.), a governmental unit (the state of
Ohio), a municipality (Seattle), a school district (St. Louis District 48), or
Ethics Note a church (Southern Baptist). The economic entity assumption requires
that the activities of the entity be kept separate and distinct from the
The importance of the economic
activities of its owner and all other economic entities. To illustrate, Sal-
entity assumption is illustrated by
ly Rider, owner of Sally’s Boutique, must keep her personal living costs
scandals involving Adelphia. In this
case, senior company employees separate from the expenses of the boutique. Similarly, McDonald’s,
entered into transactions that Coca-Cola, and Cadbury-Schweppes are segregated into separate eco-
blurred the line between the nomic entities for accounting purposes.
employees’ financial interests and
PROPRIETORSHIP A business owned by one person is generally a propri-
those of the company. For example,
etorship. The owner is often the manager/operator of the business. Small
Aldephia guaranteed over $2 billion
of loans to the founding family. service-type businesses (plumbing companies, beauty salons, and auto repair
shops), farms, and small retail stores (antique shops, clothing stores, and
 The Building Blocks of Accounting 11

used-book stores) are often proprietorships. Usually only a relatively small amount
of money (capital) is necessary to start in business as a proprietorship. The
owner (proprietor) receives any profits, suffers any losses, and is personally
liable for all debts of the business. There is no legal distinction between the busi-
ness as an economic unit and the owner, but the accounting records of the business
activities are kept separate from the personal records and activities of the owner.
PARTNERSHIP A business owned by two or more persons associated as partners
is a partnership. In most respects a partnership is like a proprietorship except
that more than one owner is involved. Typically a partnership agreement (writ-
ten or oral) sets forth such terms as initial investment, duties of each partner,
division of net income (or net loss), and settlement to be made upon death or
withdrawal of a partner. Each partner generally has unlimited personal liability
for the debts of the partnership. Like a proprietorship, for accounting pur-
poses the partnership transactions must be kept separate from the personal
activities of the partners. Partnerships are often used to organize retail and
service-type businesses, including professional practices (lawyers, doctors, archi-
tects, and certified public accountants).
CORPORATION A business organized as a separate legal entity under state cor-
poration law and having ownership divided into transferable shares of stock is a
corporation. The holders of the shares (stockholders) enjoy limited liability; that
is, they are not personally liable for the debts of the corporate entity. Stockholders
may transfer all or part of their ownership shares to other investors at any
time (i.e., sell their shares). The ease with which ownership can change adds to the
attractiveness of investing in a corporation. Because ownership can be transferred
without dissolving the corporation, the corporation enjoys an unlimited life.
Although the combined number of proprietorships and partnerships in the
United States is more than five times the number of corporations, the revenue pro-
duced by corporations is eight times greater. Most of the largest companies in the
United States—for example, ExxonMobil, Ford, Wal-Mart Stores Inc., Citigroup,
and Apple—are corporations.

> DO IT!

Basic Concepts Indicate whether each of the five statements presented below is true or false.
1. The three steps in the accounting process are identification, recording, and communication.
The DO IT! exercises ask 2. The two most common types of external users are investors and company officers.
you to put newly acquired
3. Congress passed the Sarbanes-Oxley Act to reduce unethical behavior and decrease the
knowledge to work. They
likelihood of future corporate scandals.
outline the Action Plan
necessary to complete the 4. The primary accounting standard-setting body in the United States is the Financial
exercise, and they show a Accounting Standards Board (FASB).
Solution. 5. The cost principle dictates that companies record assets at their cost. In later periods,
however, the fair value of the asset must be used if fair value is higher than its cost.
Solution
Action Plan
1. True 2. False. The two most common types of external users are investors and
✔ Review the basic
concepts learned to
creditors. 3. True. 4. True. 5. False. The cost principle dictates that companies re-
date. cord assets at their cost. Under the cost principle, the company must also use cost in
✔ Develop an under- later periods.
standing of the key
Related exercise material: E1-1, E1-2, E1-3, E1-4, and DO IT! 1-1.
terms used.
✔ The Navigator
12 1 Accounting in Action

ACCOUNTING ACROSS THE ORGANIZATION

Spinning the Career Wheel
One question that students frequently ask is, “How will the study of accounting help me?”
It should help you a great deal, because a working knowledge of accounting is desirable for
virtually every field of endeavor. Some examples of how accounting is used in other careers
include:
General management: Imagine running Ford Motors, Massachusetts General Hospital,
Northern Virginia Community College, a Subway franchise, a Trek bike shop. All general man-
agers need to understand accounting data in order to make wise business decisions.
Marketing: A marketing specialist at a company like Procter & Gamble develops strategies
to help the sales force be successful. But making a sale is meaningless unless it is a profitable
sale. Marketing people must be sensitive to costs and benefits, which accounting helps them
quantify and understand.
Finance: Do you want to be a banker for Bank of America, an investment analyst for Goldman
Sachs, a stock broker for Merrill Lynch? These fields rely heavily on accounting. In all of them
you will regularly examine and analyze financial statements. In fact, it is difficult to get a good
finance job without two or three courses in accounting.
Real estate: Are you interested in being a real estate broker for Prudential Real Estate?
Because a third party—the bank—is almost always involved in financing a real estate transaction,
brokers must understand the numbers involved: Can the buyer afford to make the payments
to the bank? Does the cash flow from an industrial property justify the purchase price? What
are the tax benefits of the purchase?

How might accounting help you? (See page 48.)

?
The Basic Accounting Equation
LEARNING OBJECTIVE 6 The two basic elements of a business are what it owns and what it owes. Assets
are the resources a business owns. For example, Google has total assets
State the accounting of approximately $40.5 billion. Liabilities and owner’s equity are the rights or
equation, and define its claims against these resources. Thus, Google has $40.5 billion of claims against
components. its $40.5 billion of assets. Claims of those to whom the company owes money
(creditors) are called liabilities. Claims of owners are called stockholders’ equity.
Google has liabilities of $4.5 billion and stockholders’ equity of $36 billion.
We can express the relationship of assets, liabilities, and stockholders’ equity
as an equation, as shown in Illustration 1-5.
Illustration 1-5
The basic accounting equation
Assets ⫽ Liabilities ⫹ Stockholders' Equity

This relationship is the basic accounting equation. Assets must equal the sum of
liabilities and stockholders’ equity. Liabilities appear before stockholders’ equity in
the basic accounting equation because they are paid first if a business is liquidated.
The accounting equation applies to all economic entities regardless of size,
nature of business, or form of business organization. It applies to a small propri-
etorship such as a corner grocery store as well as to a giant corporation such as
PepsiCo. The equation provides the underlying framework for recording and
summarizing economic events.
Let’s look in more detail at the categories in the basic accounting equation.
 The Basic Accounting Equation 13

Assets
As noted above, assets are resources a business owns. The business uses its assets in
carrying out such activities as production and sales. The common characteristic pos-
sessed by all assets is the capacity to provide future services or benefits. In a busi-
ness, that service potential or future economic benefit eventually results in cash inflows
(receipts). For example, consider Campus Pizza, a local restaurant. It owns a delivery
truck that provides economic benefits from delivering pizzas. Other assets of Campus
Pizza are tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.

Liabilities
Liabilities are claims against assets—that is, existing debts and obligations. Busi-
nesses of all sizes usually borrow money and purchase merchandise on credit.
These economic activities result in payables of various sorts:
• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages
on credit from suppliers. These obligations are called accounts payable.
• Campus Pizza also has a note payable to First National Bank for the money
borrowed to purchase the delivery truck.
• Campus Pizza may also have salaries and wages payable to employees
and sales and real estate taxes payable to the local government.
All of these persons or entities to whom Campus Pizza owes money are its creditors.
Creditors may legally force the liquidation of a business that does not pay its debts.
In that case, the law requires that creditor claims be paid before ownership claims.

Stockholders’ Equity
The ownership claim on total assets is stockholders’ equity. It is equal to total Helpful Hint
assets minus total liabilities. Here is why: The assets of a business are claimed In some situations,
by either creditors or stockholders. To find out what belongs to stockholders, we accountants use the term
subtract creditors’ claims (the liabilities) from the assets. The remainder is the owner’s equity and in
others owners’ equity.
stockholders’ claim on the assets—stockholders’ equity. It is often referred to as
Owner’s refers to one
residual equity—that is, the equity “left over” after creditors’ claims are satisfied.
owner (the case with a
The stockholders’ equity section of a corporation’s balance sheet generally sole proprietorship), and
consists of (1) common stock and (2) retained earnings. owners’ refers to multiple
owners (the case with
COMMON STOCK partnerships). The term
A corporation may obtain funds by selling shares of stock to investors. Common stockholders’ equity refers
stock is the term used to describe the total amount paid in by stockholders for to ownership in corporations.
the shares they purchase.

RETAINED EARNINGS
The retained earnings section of the balance sheet is determined by three items:
revenues, expenses, and dividends.

REVENUES Revenues are the gross increases in stockholders’ equity result- Helpful Hint
ing from business activities entered into for the purpose of earning income. The effect of revenues is
Generally, revenues result from selling merchandise, performing services, renting positive—an increase in
property, and lending money. stockholders’ equity coupled
with an increase in assets or a
Revenues usually result in an increase in an asset. They may arise from
decrease in liabilities.
different sources and are called various names depending on the nature of the
business. Campus Pizza, for instance, has two categories of sales revenues—
pizza sales and beverage sales. Other titles for and sources of revenue common
to many businesses are sales, fees, services, commissions, interest, dividends,
royalties, and rent.
14 1 Accounting in Action

Helpful Hint EXPENSES Expenses are the cost of assets consumed or services used in the pro-
The effect of expenses is cess of earning revenue. They are decreases in stockholders’ equity that result
negative—a decrease in from operating the business. Like revenues, expenses take many forms and are
stockholders’ equity coupled called various names depending on the type of asset consumed or service used. For
with a decrease in assets or
example, Campus Pizza recognizes the following types of expenses: cost of ingredi-
an increase in liabilities.
ents (flour, cheese, tomato paste, meat, mushrooms, etc.); cost of beverages; wages
expense; utilities expense (electric, gas, and water expense); telephone expense;
delivery expense (gasoline, repairs, licenses, etc.); supplies expense (napkins,
detergents, aprons, etc.); rent expense; interest expense; and property tax expense.

DIVIDENDS Net income represents an increase in net assets which are then
available to distribute to stockholders. The distribution of cash or other assets to
stockholders is called a dividend. Dividends reduce retained earnings. However,
dividends are not an expense. A corporation first determines its revenues and
expenses and then computes net income or net loss. If it has net income, and
decides it has no better use for that income, a corporation may decide to distrib-
ute a dividend to its owners (the stockholders).
In summary, the principal sources (increases) of stockholders’ equity are in-
vestments by stockholders and revenues from business operations. In contrast,
reductions (decreases) in stockholders’ equity result from expenses and divi-
dends. These relationships are shown in Illustration 1-6.

Illustration 1-6
Increases and decreases in INCREASES DECREASES
stockholders’ equity
Investments by stockholders Dividends to stockholders
Stockholders’
Equity
Revenues Expenses

> DO IT!

Stockholders’ Classify the following items as issuance of stock (I), dividends (D), revenues (R), or expenses
(E). Then indicate whether each item increases or decreases stockholders’ equity.
Equity Effects
(1) Rent Expense (3) Dividends
Action Plan
(2) Service Revenue (4) Salaries and Wages Expense
✔ Understand the
sources of revenue. Solution
✔ Understand what
causes expenses. 1. Rent Expense is an expense (E); it decreases stockholders’ equity. 2. Service
✔ Review the rules for Revenue is a revenue (R); it increases stockholders’ equity. 3. Dividends is a distri-
changes in stockhold- bution to stockholders (D); it decreases stockholders’ equity. 4. Salaries and Wages
ers’ equity: Investments Expense is an expense (E); it decreases stockholders’ equity.
and revenues increase
stockholders’ equity. Related exercise material: BE1-1, BE1-2, BE1-3, BE1-4, BE1-5, E1-5, E1-6, E1-7, and DO IT! 1-2.
Expenses and divi-
dends decrease stock-
holders’ equity.
✔ The Navigator

✔ Recognize that divi-

dends are distributions
of cash or other assets
to stockholders.
 Using the Accounting Equation 15

Using the Accounting Equation

Transactions (business transactions) are a business’s economic events recorded LEARNING OBJECTIVE 7
by accountants. Transactions may be external or internal. External transactions
involve economic events between the company and some outside enterprise. For Analyze the effects of
example, Campus Pizza’s purchase of cooking equipment from a supplier, pay- business transactions on
ment of monthly rent to the landlord, and sale of pizzas to customers are exter- the accounting equation.
nal transactions. Internal transactions are economic events that occur entirely
within one company. The use of cooking and cleaning supplies are internal trans-
actions for Campus Pizza.
Companies carry on many activities that do not represent business transac-
tions. Examples are hiring employees, answering the telephone, talking with
customers, and placing merchandise orders. Some of these activities may lead to
business transactions: Employees will earn wages, and suppliers will deliver ordered
merchandise. The company must analyze each event to find out if it affects the
components of the accounting equation. If it does, the company will record the
transaction. Illustration 1-7 demonstrates the transaction-identification process.

Bank
Home

Accounting

Ballence

Events
Z

Purchase computer Discuss product design with Pay rent

potential customer

Criterion Is the financial position (assets, liabilities, or stockholders’ equity) of the company changed?

Yes No Yes

Don't
Record Record
record
Record/
Don’t Record

Illustration 1-7
Each transaction must have a dual effect on the accounting equation. For exam- Transaction-identification
ple, if an asset is increased, there must be a corresponding (1) decrease in another process
asset, (2) increase in a specific liability, or (3) increase in stockholders’ equity.
Two or more items could be affected. For example, as one asset is increased
$10,000, another asset could decrease $6,000 and a liability could increase $4,000.
Any change in a liability or ownership claim is subject to similar analysis.

Transaction Analysis
In order to analyze transactions, we will examine a computer programming busi-
ness (Softbyte Inc.) during its first month of operations. As part of this analysis,
we will expand the basic accounting equation. This will allow us to better
16 1 Accounting in Action

illustrate the impact of transactions on stockholders’ equity. Recall that stockhold-

ers’ equity is comprised of two parts: common stock and retained earnings. Common
stock is affected when the company issues new shares of stock in exchange for cash.
Retained earnings is affected when the company earns revenue, incurs expenses, or
Illustration 1-8 pays dividends. Illustration 1-8 shows the expanded accounting equation.
Expanded accounting equation

Assets ⫽ Liabilities ⫹ Stockholders' Equity

Common Stock ⫹ Retained Earnings

Revenues ⫺ Expenses ⫺ Dividends

Helpful Hint If you are tempted to skip ahead after you’ve read a few of the following
You will want to study transaction analyses, don’t do it. Each has something unique to teach, something
these transactions until you’ll need later. (We assure you that we’ve kept them to the minimum needed!)
you are sure you under-
stand them. They are not
TRANSACTION 1. INVESTMENT BY STOCKHOLDERS Ray and Barbara Neal
difficult, but understanding
them is important to your
decide to open a computer programming company that they incorporate as Softbyte
success in this course. Inc. On September 1, 2014, they invest $15,000 cash in the business in exchange
The ability to analyze for $15,000 of common stock. The common stock indicates the ownership interest
transactions in terms of that the Neals have in Softbyte Inc. This transaction results in an equal increase
the basic accounting in both assets and stockholders’ equity.
equation is essential in
accounting.
Basic The asset Cash increases $15,000, and stockholders’ equity identified as
Analysis Common Stock increases $15,000.

Assets 5 Liabilities 1 Stockholders’ Equity

Equation Common
Cash 5
Analysis Stock
(1) 1$15,000 5 1$15,000 Issued Stock

Observe that the equality of the basic equation has been maintained. Note also
that the source of the increase in stockholders’ equity (in this case, issued stock)
is indicated. Why does this matter? Because investments by stockholders do not
represent revenues, and they are excluded in determining net income. Therefore,
it is necessary to make clear that the increase is an investment rather than rev-
enue from operations. Additional investments (i.e., investments made by stock-
holders after the corporation has been initially formed) have the same effect on
stockholders’ equity as the initial investment.

TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. pur-

chases computer equipment for $7,000 cash. This transaction results in an equal
increase and decrease in total assets, though the composition of assets changes.
 Using the Accounting Equation 17

Basic
Cash decreases $7,000, and the asset Equipment increases $7,000.
Analysis

Assets 5 Liabilities 1 Stockholders’ Equity

Cash 1 Equipment 5 Common Stock
Equation $15,000 $15,000
Analysis (2) 27,000 1$7,000
$ 8,000 1 $ 7,000 5 $15,000
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$15,000

Observe that total assets are still $15,000. Common stock also remains at $15,000,
the amount of the original investment.

TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. purchases

for $1,600 from Acme Supply Company computer paper and other supplies
expected to last several months. Acme agrees to allow Softbyte to pay this bill
in October. This transaction is a purchase on account (a credit purchase). Assets
increase because of the expected future benefits of using the paper and supplies,
and liabilities increase by the amount due Acme Company.

Basic
The asset Supplies increases $1,600, and the liability Accounts Payable increases by $1,600.
Analysis

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Common
Cash 1 Supplies 1 Equipment 5 1
Payable Stock
Equation $8,000 $7,000 $15,000
Analysis
(3) 1$1,600 1$1,600
$8,000 1 $ 1,600 1 $7,000 5 $ 1,600 1 $15,000
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$16,600 $16,600

Total assets are now $16,600. This total is matched by a $1,600 creditor’s claim
and a $15,000 ownership claim.

TRANSACTION 4. SERVICES PROVIDED FOR CASH Softbyte Inc. receives $1,200

cash from customers for programming services it has provided. This transaction
represents Softbyte’s principal revenue-producing activity. Recall that revenue
increases stockholders’ equity.

Basic
Cash increases $1,200, and revenues (specifically, Service Revenue) increase $1,200.
Analysis

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Common Retained Earnings
Cash 1 Supplies 1 Equipment 5 Payable 1 Stock 1 Rev. 2 Exp. 2 Div.
Equation $8,000 $1,600 $7,000 $1,600 $15,000
Analysis
(4) 11,200 1$1,200 Service
Revenue
$9,200 1 $1,600 1 $7,000 5 $1,600 1 $15,000 1 $ 1,200
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$17,800 $17,800
18 1 Accounting in Action

The two sides of the equation balance at $17,800. Service Revenue is included in
determining Softbyte’s net income.
Note that we do not have room to give details for each individual revenue and
expense account in this illustration. Thus, revenues (and expenses when we get
to them) are summarized under one column heading for Revenues and one for
Expenses. However, it is important to keep track of the category (account) titles
affected (e.g., Service Revenue) as they will be needed when we prepare financial
statements later in the chapter.

TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte receives a

bill for $250 from the Daily News for advertising but postpones payment until a
later date. This transaction results in an increase in liabilities and a decrease in
stockholders’ equity.

Basic
Accounts Payable increases $250, and stockholders’ equity decreases $250 due to Advertising Expense.
Analysis

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Common Retained Earnings
Cash 1 Supplies 1 Equipment 5 Payable 1 Stock 1 Rev. 2 Exp. 2 Div.
Equation $9,200 $1,600 $7,000 $1,600 $15,000 $1,200
Analysis (5) 1250 2$250 Advertising
$9,200 1 $1,600 1 $7,000 5 $1,850 1 $15,000 1 $1,200 2 $ 250 Expense
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$17,800 $17,800

The two sides of the equation still balance at $17,800. Retained Earnings
decreases when Softbyte incurs the expense. Expenses do not have to be paid
in cash at the time they are incurred. When Softbyte pays at a later date, the
liability Accounts Payable will decrease and the asset Cash will decrease (see
Transaction 8). The cost of advertising is an expense (rather than an asset)
because Softbyte has used the benefits. Advertising Expense is included in
determining net income.

TRANSACTION 6. SERVICES RENDERED FOR CASH AND CREDIT Softbyte

Inc. provides $3,500 of programming services for customers. The company
receives cash of $1,500 from customers, and it bills the balance of $2,000 on
account. This transaction results in an equal increase in assets and stockholders’
equity.

Basic Three specific items are affected: Cash increases $1,500, Accounts Receivable increases $2,000, and
Analysis Service Revenue increases $3,500.

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
Receivable Payable Stock Rev. 2 Exp. 2 Div.
Equation $ 9,200 $1,600 $7,000 $1,850 $15,000 $1,200 $250
Analysis (6) 11,500 1$2,000 13,500 Service
Revenue
$10,700 1 $ 2,000 1 $1,600 1 $7,000 5 $1,850 1 $15,000 1 $4,700 2 $250
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$21,300 $21,300
 Using the Accounting Equation 19

Softbyte earns revenues when it provides the service, and therefore it recognizes
$3,500 in revenue. In exchange for this service, it received $1,500 in Cash and Accounts
Receivable of $2,000. This Accounts Receivable represents customers’ promise to pay
$2,000 to Softbyte in the future. When it later receives collections on account, Softbyte
will increase Cash and will decrease Accounts Receivable (see Transaction 9).

TRANSACTION 7. PAYMENT OF EXPENSES Softbyte pays the following expenses

in cash for September: store rent $600, salaries and wages of employees $900, and
utilities $200. These payments result in an equal decrease in assets and expenses.

Basic Cash decreases $1,700, and the specific expense categories (Rent Expense, Salaries and Wages
Analysis Expense, and Utilities Expense) decrease stockholders’ equity by the same amount.

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
Receivable Payable Stock Rev. 2 Exp. 2 Div.
$10,700 $2,000 $1,600 $7,000 $1,850 $15,000 $4,700 $ 250
Equation
(7) 21,700 2600 Rent Exp.
Analysis 2900 Sal./Wages Exp.
2200 Utilities Exp.
$ 9,000 1 $2,000 1 $1,600 1 $7,000 5 $1,850 1 $15,000 1 $4,700 2 $1,950
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$19,600 $19,600

The two sides of the equation now balance at $19,600. Three lines are required in
the analysis to indicate the different types of expenses that have been incurred.

TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte pays its $250

Daily News bill in cash. The company previously (in Transaction 5) recorded the
bill as an increase in Accounts Payable and a decrease in stockholders’ equity.

Basic This cash payment “on account” decreases the asset Cash by $250 and also decreases the liability
Analysis Accounts Payable by $250.

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
Receivable Payable Stock Rev. 2Exp. 2 Div.
Equation $9,000 $2,000 $1,600 $7,000 $1,850 $15,000 $4,700 $1,950
Analysis (8) 2250 2250
$8,750 1 $2,000 1 $1,600 1 $7,000 5 $1,600 1 $15,000 1 $4,700 2 $1,950
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$19,350 $19,350

Observe that the payment of a liability related to an expense that has previously
been recorded does not affect stockholders’ equity. Softbyte recorded the expense
(in Transaction 5) and should not record it again.

TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte receives $600 in

cash from customers who had been billed for services (in Transaction 6). This trans-
action does not change total assets, but it changes the composition of those assets.
20 1 Accounting in Action

Basic
Cash increases $600, and Accounts Receivable decreases $600.
Analysis

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
Receivable Payable Stock Rev. 2 Exp. 2 Div.
Equation $8,750 $2,000 $1,600 $7,000 $1,600 $15,000 $4,700 $1,950
Analysis (9) 1600 2600
$9,350 1 $1,400 1 $1,600 1 $7,000 5 $1,600 1 $15,000 1 $4,700 2 $1,950

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$19,350 $19,350

Note that the collection of an account receivable for services previously billed
and recorded does not affect stockholders’ equity. Softbyte already recorded this
revenue (in Transaction 6) and should not record it again.

TRANSACTION 10. DIVIDENDS The corporation pays a dividend of $1,300 in

cash to Ray and Barbara Neal, the stockholders of Softbyte Inc. This transaction
results in an equal decrease in assets and stockholders’ equity.

Basic
Cash decreases $1,300, and stockholders’ equity decreases $1,300 due to dividends.
Analysis

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
Receivable Payable Stock Rev. 2 Exp. 2 Div.
Equation $ 9,350 $1,400 $1,600 $7,000 $1,600 $15,000 $4,700 $1,950
Analysis (10) 21,300 2 $1,300 Dividends
$ 8,050 1 $1,400 1 $1,600 1 $7,000 5 $1,600 1 $15,000 1 $4,700 2 $1,950 2 $ 1,300
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$18,050 ⎩ $18,050

Note that the dividend reduces retained earnings, which is part of stockholders’
equity. Dividends are not expenses. Like stockholders’ investments, dividends
are excluded in determining net income.

Summary of Transactions
Illustration 1-9 summarizes the September transactions of Softbyte Inc. to show
their cumulative effect on the basic accounting equation. It also indicates the
transaction number and the specific effects of each transaction. Finally, Illustra-
tion 1-9 demonstrates a number of significant facts:
1. Each transaction must be analyzed in terms of its effect on:
(a) The three components of the basic accounting equation.
(b) Specific types (kinds) of items within each component.
2. The two sides of the equation must always be equal.
3. The Common Stock and Retained Earnings columns indicate the causes of
each change in the stockholders’ claim on assets.
 Using the Accounting Equation 21

Assets 5 Liabilities 1 Stockholders’ Equity

Trans- Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
action Receivable Payable Stock Rev. 2 Exp. 2 Div.
(1) 1$15,000 1 $15,000 Issued Stock
(2) 27,000 1$7,000
(3) 1$1,600 1$1,600
(4) 11,200 1$1,200 Service Revenue
(5) 1250 2$250 Advert. Expense
(6) 11,500 1$2,000 13,500 Service Revenue
(7) 21,700 2600 Rent Expense
2900 Sal./Wages Exp.
2200 Utilities Expense
(8) 2250 2250
(9) 1600 2600
(10) 21,300 2$1,300 Dividends
$ 8,050 1 $1,400 1 $1,600 1 $7,000 5 $1,600 1 $15,000 1 $4,700 2 $1,950 2 $1,300

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$18,050 $18,050

Illustration 1-9
Tabular summary of Softbyte
There! You made it through transaction analysis. If you feel a bit shaky on Inc. transactions
any of the transactions, it might be a good idea at this point to get up, take a short
break, and come back again for a brief (10- to 15-minute) review of the transac-
tions, to make sure you understand them before you go on to the next section.

> DO IT!

Tabular Analysis Transactions made by Virmari & Co., a public accounting firm, for the month of August
are shown below. Prepare a tabular analysis which shows the effects of these transactions
Action Plan on the expanded accounting equation, similar to that shown in Illustration 1-9.
✔ Analyze the effects of 1. Stockholders purchased shares of stock for $25,000 cash.
each transaction on the
accounting equation. 2. The company purchased $7,000 of office equipment on credit.
✔ Use appropriate 3. The company received $8,000 cash in exchange for services performed.
category names (not 4. The company paid $850 for this month’s rent.
descriptions).
✔ Keep the accounting 5. The company paid a dividend of $1,000 in cash to stockholders.
equation in balance.
Solution

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Common Retained Earnings
Cash 1 Equipment 5 1 1
Payable Stock Rev. 2 Exp. 2 Div.
Transaction
(1) 1$25,000 1$25,000
(2) 1$7,000 1$7,000
(3) 18,000 1$8,000 Service Revenue
(4) 2850 2$850 Rent Expense
(5) 21,000 2 $1,000 Dividends
$31,150 1 $7,000 5 $7,000 1 $25,000 1 $8,000 2 $850 2 $1,000
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$38,150 $38,150

Related exercise material: BE1-6, BE1-7, BE1-8, BE1-9, E1-6, E1-7, E1-8, E1-9, E1-10, and DO IT! 1-3.

✔ The Navigator
22 1 Accounting in Action

Financial Statements
LEARNING OBJECTIVE 8 Companies prepare four financial statements from the summarized accounting
data:
Understand the four 1. An income statement presents the revenues and expenses and resulting net
financial statements and income or net loss for a specific period of time.
how they are prepared.
2. A retained earnings statement summarizes the changes in retained earnings
for a specific period of time.
International 3. A balance sheet reports the assets, liabilities, and stockholders’
Note equity of a company at a specific date.
The primary types of financial 4. A statement of cash flows summarizes information about the cash
statements required by GAAP inflows (receipts) and outflows (payments) for a specific period of
and IFRS are the same. In practice, time.
some format differences do These statements provide relevant financial data for internal and
exist in presentations employed external users. Illustration 1-10 shows the financial statements of
by GAAP companies compared Softbyte Inc. Note that the statements shown in Illustration 1-10 are
to IFRS companies.
interrelated:
1. Net income of $2,750 on the income statement is added to the beginning bal-
Helpful Hint ance of retained earnings in the retained earnings statement.
The income statement,
2. Retained earnings of $1,450 at the end of the reporting period shown in the
retained earnings state-
ment, and statement of retained earnings statement is reported on the balance sheet.
cash flows are all for a 3. Cash of $8,050 on the balance sheet is reported on the statement of cash flows.
period of time, whereas Also, explanatory notes and supporting schedules are an integral part of every
the balance sheet is for a
set of financial statements. We illustrate these notes and schedules in later chap-
point in time.
ters of this textbook.
Be sure to carefully examine the format and content of each statement in
Illustration 1-10. We describe the essential features of each in the following sections.

Income Statement
The income statement reports the success or profitability of the company’s
operations over a specific period of time. For example, Softbyte Inc.’s income
Alternative Terminology statement is dated “For the Month Ended September 30, 2014.” It is prepared
The income statement is from the data appearing in the revenue and expense columns of Illustration 1-9
sometimes referred to (page 21). The heading of the statement identifies the company, the type of statement,
as the statement of and the time period covered by the statement.
operations, earnings The income statement lists revenues first, followed by expenses. Finally, the
statement, or profit and
statement shows net income (or net loss). When revenues exceed expenses, net
loss statement.
income results. When expenses exceed revenues, a net loss results.
Alternative Terminology Although practice varies, we have chosen in our illustrations and homework
notes present synonymous solutions to list expenses in order of magnitude. (We will consider alternative
terms that you may come formats for the income statement in later chapters.)
across in practice. Note that the income statement does not include investment and dividend
transactions between the stockholders and the business in measuring net in-
come. For example, as explained earlier, the cash dividend from Softbyte Inc.
was not regarded as a business expense. This type of transaction is considered a
reduction of retained earnings, which causes a decrease in stockholders’ equity.

Retained Earnings Statement

Softbyte Inc.’s retained earnings statement reports the changes in retained earn-
ings for a specific period of time. The time period is the same as that covered by
 Financial Statements 23

Illustration 1-10
Softbyte Inc.
Financial statements and their
Income Statement
interrelationships
For the Month Ended September 30, 2014
Revenues
Service revenue $ 4,700 Helpful Hint
Expenses The heading of each
Salaries and wages expense $900 statement identifies the
Rent expense 600 company, the type of
Advertising expense 250 statement, and the specific
Utilities expense 200 date or time period
Total expenses 1,950 covered by the statement.
Net income $2,750

Softbyte Inc.
Retained Earnings Statement 1
For the Month Ended September 30, 2014
Retained earnings, September 1 $ 0 Helpful Hint
Add: Net income 2,750 Note that final sums are
double-underlined, and
2,750 negative amounts (in the
Less: Dividends 1,300 statement of cash flows)
Retained earnings, September 30 $1,450 are presented in
parentheses.
Softbyte Inc.
Balance Sheet
September 30, 2014
Assets
Cash $ 8,050
Accounts receivable 1,400
Supplies 1,600 2
Equipment 7,000
Total assets $18,050
Liabilities and Stockholders’ Equity
Liabilities
Accounts payable $ 1,600
Stockholders’ equity
Common stock $15,000
Retained earnings 1,450 16,450
Total liabilities and stockholder’s equity $18,050

Softbyte Inc.
Helpful Hint
Statement of Cash Flows
The arrows in this
For the Month Ended September 30, 2014 illustration show the
3
Cash flows from operating activities interrelationships of the
Cash receipts from revenues $ 3,300 four financial statements.
Cash payments for expenses (1,950) 1. Net income is computed
first and is needed to
Net cash provided by operating activities 1,350
determine the ending bal-
Cash flows from investing activities
ance in retained earnings.
Purchase of equipment (7,000)
2. The ending balance
Cash flows from financing activities
in retained earnings is
Sale of common stock $15,000)
needed in preparing the
Payment of cash dividends (1,300) 13,700
balance sheet.
Net increase in cash 8,050 3. The cash shown on the
Cash at the beginning of the period 0 balance sheet is needed in
Cash at the end of the period $8,050 preparing the statement
of cash flows.
24 1 Accounting in Action

the income statement (“For the Month Ended September 30, 2014”). Data for the
preparation of the retained earnings statement come from the retained earnings
columns of the tabular summary (Illustration 1-9) and from the income state-
ment (Illustration 1-10, page 23).
The first line of the statement shows the beginning retained earnings amount.
Then come net income and dividends. The retained earnings ending balance is the
final amount on the statement. The information provided by this statement indi-
cates the reasons why retained earnings increased or decreased during the period. If
there is a net loss, it is deducted with dividends in the retained earnings statement.

Balance Sheet
Softbyte Inc.’s balance sheet reports the assets, liabilities, and stockholders’ equity
at a specific date (September 30, 2014). The company prepares the balance sheet
from the column headings and the month-end data shown in the last line of the
tabular summary (Illustration 1-9).
Observe that the balance sheet lists assets at the top, followed by liabilities
and stockholders’ equity. Total assets must equal total liabilities and stockholders’
equity. Softbyte Inc. reports only one liability, Accounts Payable, on its balance
sheet. In most cases, there will be more than one liability. When two or more
liabilities are involved, a customary way of listing is as shown in Illustration 1-11.

Illustration 1-11
Liabilities
Presentation of liabilities
Notes payable $ 10,000
Accounts payable 63,000
Salaries and wages payable 18,000
Total liabilities $91,000

The balance sheet is like a snapshot of the company’s financial condition at a

specific moment in time (usually the month-end or year-end).

Statement of Cash Flows

Helpful Hint The statement of cash flows provides information on the cash receipts and payments
Investing activities pertain for a specific period of time. The statement of cash flows reports (1) the cash
to investments made by effects of a company’s operations during a period, (2) its investing transactions,
the company, not (3) its financing transactions, (4) the net increase or decrease in cash during the
investments made by period, and (5) the cash amount at the end of the period.
the owners.
Reporting the sources, uses, and change in cash is useful because investors,
creditors, and others want to know what is happening to a company’s most liquid
resource. The statement of cash flows provides answers to the following simple
but important questions.
1. Where did cash come from during the period?
2. What was cash used for during the period?
3. What was the change in the cash balance during the period?
As shown in Softbyte Inc.’s statement of cash flows in Illustration 1-10, cash
increased $8,050 during the period. Net cash flow provided from operating
activities increased cash $1,350. Cash flow from investing transactions decreased
cash $7,000. And cash flow from financing transactions increased cash $13,700.
At this time, you need not be concerned with how these amounts are determined.
Chapter 13 will examine in detail how the statement is prepared.
 Financial Statements 25

PEOPLE, PLANET, AND PROFIT INSIGHT

Beyond Financial Statements
Should we expand our financial statements beyond the income statement, retained earnings
statement, balance sheet, and statement of cash flows? Some believe we should take into
account ecological and social performance, in addition to financial results, in evaluating a
company. The argument is that a company’s responsibility lies with anyone who is influenced
by its actions. In other words, a company should be interested in benefiting many different
parties, instead of only maximizing stockholder’s interests.
A socially responsible business does not exploit or endanger any group of individuals. It
follows fair trade practices, provides safe environments for workers, and bears responsibility
for environmental damage. Granted, measurement of these factors is difficult. How to report
this information is also controversial. But, many interesting and useful efforts are underway.
Throughout this textbook, we provide additional insights into how companies are attempting
to meet the challenge of measuring and reporting their contributions to society, as well as
their financial results, to stockholders.

Why might a company’s stockholders be interested in its environmental and social

? performance? (See page 48.)

> DO IT!

Financial Presented below is selected information related to Flanagan Corporation at December 31,
2014. Flanagan reports financial information monthly.
Statement Items
Equipment $10,000 Utilities Expense $ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(a) Determine the total assets of Flanagan at December 31, 2014.
(b) Determine the net income that Flanagan reported for December 2014.
(c) Determine the stockholders’ equity of Flanagan at December 31, 2014.

Solution
Action Plan
(a) The total assets are $27,000, comprised of Cash $8,000, Accounts Receivable
✔ Remember the basic
accounting equation:
$9,000, and Equipment $10,000.
assets must equal (b) Net income is $14,000, computed as follows.
liabilities plus stock- Revenues
holders’ equity. Service revenue $36,000
✔ Review previous Expenses
financial statements to Rent expense $11,000
determine how total
assets, net income, and Salaries and wages expense 7,000
stockholders’ equity Utilities expense 4,000
are computed. Total expenses 22,000
Net income $14,000
26 1 Accounting in Action

(c) The ending stockholders’ equity of Flanagan Corporation is $8,500. By rewriting

the accounting equation, we can compute stockholders’ equity as assets minus
liabilities, as follows.
Total assets [as computed in (a)] $27,000
Less: Liabilities
Notes payable $16,500
Accounts payable 2,000 18,500
Stockholders’ equity $ 8,500

Note that it is not possible to determine the corporation’s stockholders’ equity in any
other way, because the beginning total for stockholders’ equity is not provided.

Related exercise material: BE1-10, BE1-11, E1-9, E1-12, E1-13, E1-14, E1-15, E1-16, and DO IT! 1-4.

✔ The Navigator

> Comprehensive DO IT!

Legal Services Inc. was incorporated on July 1, 2014. During the first month of operations,
the following transactions occurred.
The Comprehensive DO 1. Stockholders invested $10,000 in cash in exchange for common stock of Legal
IT! is a final review of the Services Inc.
chapter. The Action Plan 2. Paid $800 for July rent on office space.
gives tips about how to 3. Purchased office equipment on account $3,000.
approach the problem,
and the Solution dem- 4. Provided legal services to clients for cash $1,500.
onstrates both the form 5. Borrowed $700 cash from a bank on a note payable.
and content of complete 6. Performed legal services for client on account $2,000.
answers.
7. Paid monthly expenses: salaries $500, utilities $300, and advertising $100.

Instructions
(a) Prepare a tabular summary of the transactions.
(b) Prepare the income statement, retained earnings statement, and balance sheet at
July 31 for Legal Services Inc.
Solution to Comprehensive DO IT!
(a) Assets 5 Liabilities 1 Stockholder’s Equity
Trans- 1 Accounts 1 Equipment 5 Notes 1 Accounts 1
Cash Common Retained Earnings
1
action Receivable Payable Payable Stock Rev. 2 Exp. 2 Div.

(1) 1$10,000 5 1$10,000 Issued Stock

(2) 2800 2$800 Rent Expense
(3) 1$3,000 5 1$3,000
(4) 11,500 1$1,500 Service Revenue
(5) 1700 1$700
(6) 1$2,000 12,000 Service Revenue
(7) 2500 2500 Sal./Wages Exp.
2300 2300 Utilities Expense
2100 2100 Advertising Expense
$10,500 1 $2,000 1 $3,000 5 $700 1 $3,000 1 $10,000 1 $3,500 2 $1,700
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$15,500 $15,500
 Comprehensive DO IT! 27

Action Plan (b)

✔ Make sure that assets
equal liabilities plus Legal Services Inc.
stockholders’ equity Income Statement
after each transaction.
For the Month Ended July 31, 2014
✔ Investments and
revenues increase Revenues
stockholders’ equity.
Service revenue $3,500
Dividends and expenses
decrease stockholders’ Expenses
equity. Rent expense $800
✔ Prepare the financial Salaries and wages expense 500
statements in the order Utilities expense 300
listed. Advertising expense 100
✔ The income statement Total expenses 1,700
shows revenues and
expenses for a period Net income $1,800
of time.
✔ The retained earnings
statement shows the
changes in retained
earnings for the same
period of time as the
income statement.
✔ The balance sheet
Legal Services Inc.
reports assets, liabili- Retained Earnings Statement
ties, and stockholders’ For the Month Ended July 31, 2014
equity at a specific
date. Retained earnings, July 1 $ –0–
Add: Net income 1,800
Retained earnings, July 31 $1,800

Legal Services Inc.

Balance Sheet
July 31, 2014

Assets
Cash $10,500
Accounts receivable 2,000
Equipment 3,000
Total assets $15,500

Liabilities and Stockholder’s Equity

Liabilities
Notes payable $ 700
Accounts payable 3,000
Total liabilities $ 3,700
Stockholder’s equity
Common stock 10,000
Retained earnings 1,800 11,800
Total liabilities and stockholder’s equity $15,500

✔ The Navigator
28 1 Accounting in Action

SUMMARY OF LEARNING OBJECTIVES ✔ The Navigator

1 Explain what accounting is. Accounting is an informa- Assets 5 Liabilities 1 Stockholders’ Equity
tion system that identifies, records, and communicates
Assets are resources a business owns. Liabilities are
the economic events of an organization to interested
creditorship claims on total assets. Stockholders’ equity
users.
is the ownership claim on total assets.
2 Identify the users and uses of accounting. The major The expanded accounting equation is:
users and uses of accounting are as follows. (a) Man-
Assets 5 Liabilities 1 Common Stock
agement uses accounting information to plan, organize,
1 Revenues 2 Expenses 2 Dividends
and run the business. (b) Investors (owners) decide
whether to buy, hold, or sell their financial interests Common stock is affected when the company issues
on the basis of accounting data. (c) Creditors (suppli- new shares of stock in exchange for cash. Revenues are
ers and bankers) evaluate the risks of granting credit increases in assets resulting from income-earning activ-
or lending money on the basis of accounting informa- ities. Expenses are the costs of assets consumed or ser-
tion. Other groups that use accounting information are vices used in the process of earning revenue. Dividends
taxing authorities, regulatory agencies, customers, and are payments the company makes to its stockholders.
labor unions.
7 Analyze the effects of business transactions on the
3 Understand why ethics is a fundamental business concept. accounting equation. Each business transaction must
Ethics are the standards of conduct by which actions have a dual effect on the accounting equation. For
are judged as right or wrong. Effective financial report- example, if an individual asset increases, there must
ing depends on sound ethical behavior. be a corresponding (1) decrease in another asset, or
(2) increase in a specific liability, or (3) increase in
4 Explain generally accepted accounting principles.
stockholders’ equity.
Generally accepted accounting principles are a com-
mon set of standards used by accountants. 8 Understand the four financial statements and how
they are prepared. An income statement presents the
5 Explain the monetary unit assumption and the economic
revenues and expenses, and resulting net income or
entity assumption. The monetary unit assumption re-
net loss, for a specific period of time. A retained
quires that companies include in the accounting records
earnings statement summarizes the changes in retained
only transaction data that can be expressed in terms of
earnings for a specific period of time. A balance sheet
money. The economic entity assumption requires that
reports the assets, liabilities, and stockholders’ equity at
the activities of each economic entity be kept separate
a specific date. A statement of cash flows summarizes in-
from the activities of its owner(s) and other economic
formation about the cash inflows (receipts) and outflows
entities.
(payments) for a specific period of time.
6 State the accounting equation, and define its compo-
nents. The basic accounting equation is:

GLOSSARY

Accounting The information system that identifies, Corporation A business organized as a separate
records, and communicates the economic events of an legal entity under state corporation law, having
organization to interested users. (p. 4). ownership divided into transferable shares of stock.
Assets Resources a business owns. (p. 13). (p. 11).
Balance sheet A financial statement that reports the as- Cost principle An accounting principle that states that
sets, liabilities, and stockholders’ equity of a company companies should record assets at their cost. (p. 9).
at a specific date. (p. 22). Dividend A distribution by a corporation to its stock-
Basic accounting equation Assets 5 Liabilities 1 holders. (p. 14).
Stockholders’ Equity. (p. 12). Economic entity assumption An assumption that re-
Bookkeeping A part of accounting that involves only the quires that the activities of the entity be kept separate
recording of economic events. (p. 5). and distinct from the activities of its owner and all other
Common stock Term used to describe the total amount paid economic entities. (p. 10).
in by stockholders for the shares they purchase. (p. 13). Ethics The standards of conduct by which one’s actions
Convergence Effort to reduce differences between U.S. are judged as right or wrong, honest or dishonest, fair
GAAP and IFRS to enhance comparability. (p. 9). or not fair. (p. 7).
 Appendix 1A: Accounting Career Opportunities 29

Expanded accounting equation Assets 5 Liabilities 1 Monetary unit assumption An assumption stating
Common Stock 1 Revenues 2 Expenses 2 Dividends. that companies include in the accounting records only
(p. 16). transaction data that can be expressed in terms of
Expenses The cost of assets consumed or services used money. (p. 10).
in the process of earning revenue. (p. 14). Net income The amount by which revenues exceed
Fair value principle An accounting principle stating expenses. (p. 22).
that assets and liabilities should be reported at fair Net loss The amount by which expenses exceed rev-
value (the price received to sell an asset or settle a enues. (p. 22).
liability). (p. 9). Partnership A business owned by two or more persons
Faithful representation Numbers and descriptions match associated as partners. (p. 11).
what really existed or happened—it is factual. (p. 9). Proprietorship A business owned by one person. (p. 10).
Financial accounting The field of accounting that pro- Relevance Financial information that is capable of making
vides economic and financial information for investors, a difference in a decision. (p. 9).
creditors, and other external users. (p. 6). Retained earnings statement A financial statement
Financial Accounting Standards Board (FASB) A that summarizes the changes in retained earnings for a
private organization that establishes generally accepted specific period of time. (p. 22).
accounting principles in the United States (GAAP). (p. 9). Revenues The gross increase in stockholders’ equity
Generally accepted accounting principles (GAAP) resulting from business activities entered into for the
Common standards that indicate how to report eco- purpose of earning income. (p. 13).
nomic events. (p. 8). Sarbanes-Oxley Act (SOX) Law passed by Congress in
Income statement A financial statement that presents 2002 intended to reduce unethical corporate behavior.
the revenues and expenses and resulting net income or (p. 7).
net loss of a company for a specific period of time. (p. 22). Securities and Exchange Commission (SEC) A gov-
International Accounting Standards Board (IASB) ernmental agency that oversees U.S. financial markets
An accounting standard-setting body that issues stan- and accounting standard-setting bodies. (p. 9).
dards adopted by many countries outside of the United Statement of cash flows A financial statement that
States. (p. 9). summarizes information about the cash inflows (re-
International Financial Reporting Standards (IFRS) ceipts) and cash outflows (payments) for a specific period
International accounting standards set by the Interna- of time. (p. 22).
tional Accounting Standards Board (IASB). (p. 9). Stockholders’ equity The ownership claim on a corpo-
Liabilities Creditor claims on total assets. (p. 13). ration’s total assets. (p. 13).
Managerial accounting The field of accounting that Transactions The economic events of a business that are
provides internal reports to help users make decisions recorded by accountants. (p. 15).
about their companies. (p. 6).

APPENDIX 1A ACCOUNTING CAREER OPPORTUNITIES

Why is accounting such a popular major and career choice? First, there are a lot LEARNING OBJECTIVE 9
of jobs. In many cities in recent years, the demand for accountants exceeded the
supply. Not only are there a lot of jobs, but there are a wide array of opportuni- Explain the career oppor-
ties. As one accounting organization observed, “accounting is one degree with tunities in accounting.
360 degrees of opportunity.”
Accounting is also hot because it is obvious that accounting matters. Interest
in accounting has increased, ironically, because of the attention caused by the
accounting failures of companies such as Enron and WorldCom. These widely
publicized scandals revealed the important role that accounting plays in society.
Most people want to make a difference, and an accounting career provides many
opportunities to contribute to society. Finally, the Sarbanes-Oxley Act (SOX) (see
page 7) significantly increased the accounting and internal control requirements
for corporations. This dramatically increased demand for professionals with
accounting training.
Accountants are in such demand that it is not uncommon for accounting stu-
dents to have accepted a job offer a year before graduation. As the following discus-
sion reveals, the job options of people with accounting degrees are virtually unlimited.
30 1 Accounting in Action

Public Accounting
Individuals in public accounting offer expert service to the general public, in
much the same way that doctors serve patients and lawyers serve clients. A major
portion of public accounting involves auditing. In auditing, a certified public ac-
countant (CPA) examines company financial statements and provides an opinion
as to how accurately the financial statements present the company’s results and
financial position. Analysts, investors, and creditors rely heavily on these “audit
opinions,” which CPAs have the exclusive authority to issue.
Taxation is another major area of public accounting. The work that tax spe-
cialists perform includes tax advice and planning, preparing tax returns, and
representing clients before governmental agencies such as the Internal Revenue
Service.
A third area in public accounting is management consulting. It ranges from
installing basic accounting software or highly complex enterprise resource plan-
ning systems, to providing support services for major marketing projects and
merger and acquisition activities.
Many CPAs are entrepreneurs. They form small- or medium-sized practices
that frequently specialize in tax or consulting services.

Private Accounting
Instead of working in public accounting, you might choose to be an employee
of a for-profit company such as Starbucks, Google, or PepsiCo. In private (or
managerial) accounting, you would be involved in activities such as cost ac-
counting (finding the cost of producing specific products), budgeting, accounting
information system design and support, and tax planning and preparation. You
might also be a member of your company’s internal audit team. In response to
SOX, the internal auditors’ job of reviewing the company’s operations to ensure
compliance with company policies and to increase efficiency has taken on in-
creased importance.
Alternatively, many accountants work for not-for-profit organizations such as
the Red Cross or the Bill and Melinda Gates Foundation, or for museums, libraries,
or performing arts organizations.

Governmental Accounting
Another option is to pursue one of the many accounting opportunities in govern-
mental agencies. For example, the Internal Revenue Service (IRS), Federal Bureau
of Investigation (FBI), and the Securities and Exchange Commission (SEC) all
employ accountants. The FBI has a stated goal that at least 15 percent of its new
agents should be CPAs. There is also a very high demand for accounting educa-
tors at public colleges and universities and in state and local governments.

Forensic Accounting
Forensic accounting uses accounting, auditing, and investigative skills to con-
duct investigations into theft and fraud. It is listed among the top 20 career paths
of the future. The job of forensic accountants is to catch the perpetrators of the
estimated $600 billion per year of theft and fraud occurring at U.S. companies.
This includes tracing money-laundering and identity-theft activities as well as
tax evasion. Insurance companies hire forensic accountants to detect insurance
frauds such as arson, and law offices employ forensic accountants to identify
marital assets in divorces. Forensic accountants often have FBI, IRS, or similar
government experience.
 Glossary for Appendix 1A 31

“Show Me the Money”

How much can a new accountant make? Take a look at the average salaries for
college graduates in public and private accounting.3 Keep in mind if you also
have a CPA license, you’ll make 10–15% more when you start out.

Illustration 1A-1
Employer Jr. Level (0–3 yrs.) Sr. Level (4–6 yrs.)
Salary estimates for jobs
Public accounting (large firm) $48,750–$69,250 $66,750–$86,000 in public and corporate
Public accounting (small firm) $41,000–$56,000 $54,000–$69,750 accounting
Corporate accounting (large company) $38,000–$57,250 $55,750–$73,500
Corporate accounting (small company) $33,500–$49,000 $46,500–$58,750

Serious earning potential over time gives CPAs great job security. Here are
some examples of upper-level salaries for managers in corporate accounting.
Note that geographic region, experience, education, CPA certification, and company
size each play a role in determining salary.

Illustration 1A-2
Position Large Company Small to Medium Company
Upper-level management
Chief financial officer $183,250–$384,000 $94,250–$175,750 salaries in corporate
Corporate controller $122,000–$180,000 $80,500–$134,750 accounting
Tax manager $ 92,250–$130,250 $74,250–$100,250

For up-to-date salary estimates, as well as a wealth of additional information

regarding accounting as a career, check out www.startheregoplaces.com.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 1A ✔ The Navigator

9 Explain the career opportunities in accounting. Account- Accounting is a popular major because there are many
ing offers many different jobs in fields such as public and different types of jobs, with unlimited potential for
private accounting, government, and forensic accounting. career advancement.

GLOSSARY FOR APPENDIX 1A

Auditing The examination of financial statements by a Private (or managerial) accounting An area of ac-
certified public accountant in order to express an opin- counting within a company that involves such activi-
ion as to the fairness of presentation. (p. 30). ties as cost accounting, budgeting, design and support
Forensic accounting An area of accounting that uses of accounting information systems, and tax planning
accounting, auditing, and investigative skills to and preparation. (p. 30).
conduct investigations into theft and fraud. (p. 30). Public accounting An area of accounting in which the ac-
Management consulting An area of public accounting countant offers expert service to the general public. (p. 30).
ranging from development of accounting and computer Taxation An area of public accounting involving tax ad-
systems to support services for marketing projects and vice, tax planning, preparing tax returns, and repre-
merger and acquisition activities. (p. 30). senting clients before governmental agencies. (p. 30).

3
“http://www.startheregoplaces.com/why-accounting/salary-and-demand/ (accessed April 24, 2011).
 32 1 Accounting in Action

Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are
available for practice in WileyPLUS.

*Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

SELF-TEST QUESTIONS

Answers are on page 48. 9. Which of the following events is not recorded in the (LO 7)
(LO 1) 1. Which of the following is not a step in the accounting accounting records?
process? (a) Equipment is purchased on account.
(a) Identification. (c) Recording. (b) An employee is terminated.
(b) Verification. (d) Communication. (c) A cash investment is made into the business.
(LO 2) 2. Which of the following statements about users of (d) The company pays a cash dividend.
accounting information is incorrect? 10. During 2014, Gibson Company’s assets decreased (LO 7)
(a) Management is an internal user. $50,000 and its liabilities decreased $90,000. Its
(b) Taxing authorities are external users. stockholders’ equity therefore:
(c) Present creditors are external users. (a) increased $40,000. (c) decreased $40,000.
(d) Regulatory authorities are internal users. (b) decreased $140,000. (d) increased $140,000.
(LO 4) 3. The cost principle states that: 11. Payment of an account payable affects the compo- (LO 7)
(a) assets should be initially recorded at cost and nents of the accounting equation in the following way:
adjusted when the fair value changes. (a) decreases stockholders’ equity and decreases
(b) activities of an entity are to be kept separate and liabilities.
distinct from its owner. (b) increases assets and decreases liabilities.
(c) assets should be recorded at their cost. (c) decreases assets and increases stockholders’ equity.
(d) only transaction data capable of being expressed (d) decreases assets and decreases liabilities.
in terms of money be included in the accounting 12. Which of the following statements is false? (LO 8)
records. (a) A statement of cash flows summarizes informa-
(LO 5) 4. Which of the following statements about basic as- tion about the cash inflows (receipts) and out-
sumptions is correct? flows (payments) for a specific period of time.
(a) Basic assumptions are the same as accounting (b) A balance sheet reports the assets, liabilities, and
principles. stockholders’ equity at a specific date.
(b) The economic entity assumption states that there (c) An income statement presents the revenues, expenses,
should be a particular unit of accountability. changes in stockholders’ equity, and resulting net
(c) The monetary unit assumption enables account- income or net loss for a specific period of time.
ing to measure employee morale. (d) A retained earnings statement summarizes the
(d) Partnerships are not economic entities. changes in retained earnings for a specific period
(LO 5) 5. The three types of business entities are: of time.
(a) proprietorships, small businesses, and partnerships. 13. On the last day of the period, Jim Otto Company buys a (LO 8)
(b) proprietorships, partnerships, and corporations. $900 machine on credit. This transaction will affect the:
(c) proprietorships, partnerships, and large businesses. (a) income statement only.
(d) financial, manufacturing, and service companies. (b) balance sheet only.
(LO 6) 6. Net income will result during a time period when: (c) income statement and retained earnings state-
(a) assets exceed liabilities. ment only.
(b) assets exceed revenues. (d) income statement, retained earnings statement,
(c) expenses exceed revenues. and balance sheet.
(d) revenues exceed expenses. 14. The financial statement that reports assets, liabilities, (LO 8)
(LO 7) 7. Performing services on account will have the following ef- and stockholders’ equity is the:
fects on the components of the basic accounting equation: (a) income statement.
(a) increase assets and decrease stockholders’ equity. (b) retained earnings statement.
(b) increase assets and increase stockholders’ equity. (c) balance sheet.
(c) increase assets and increase liabilities. (d) statement of cash flows.
(d) increase liabilities and increase stockholders’ equity. *15. Services provided by a public accountant include: (LO 9)
(LO 7) 8. As of December 31, 2014, Stoneland Company has (a) auditing, taxation, and management consulting.
assets of $3,500 and stockholders’ equity of $2,000. (b) auditing, budgeting, and management consulting.
What are the liabilities for Stoneland Company as of (c) auditing, budgeting, and cost accounting.
December 31, 2014? (d) internal auditing, budgeting, and management
(a) $1,500. (b) $1,000. (c) $2,500. (d) $2,000. consulting.
Go to the book’s companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.
✔ The Navigator
 Brief Exercises 33

QUESTIONS

1. “Accounting is ingrained in our society and it is vital 16. Indicate how the following business transactions
to our economic system.” Do you agree? Explain. affect the basic accounting equation.
2. Identify and describe the steps in the accounting (a) Paid cash for janitorial services.
process. (b) Purchased equipment for cash.
3. (a) Who are internal users of accounting data? (c) Invested cash in the business for stock.
(b) How does accounting provide relevant data to (d) Paid accounts payable in full.
these users? 17. Listed below are some items found in the financial
4. What uses of financial accounting information are statements of Alex Greenway Co. Indicate in which finan-
made by (a) investors and (b) creditors? cial statement(s) the following items would appear.
5. “Bookkeeping and accounting are the same.” Do you (a) Service revenue. (e) Retained earnings.
agree? Explain. (b) Equipment. (f) Salaries and wages
6. Jackie Remmers Travel Agency purchased land for (c) Advertising expense. payable.
$85,000 cash on December 10, 2014. At December 31, (d) Accounts receivable.
2014, the land’s value has increased to $93,000. What 18. In February 2014, Paula Klink invested an additional
amount should be reported for land on Jackie Remmers’ $10,000 in Midtown Company. Midtown’s accoun-
balance sheet at December 31, 2014? Explain. tant, Jon Shin, recorded this receipt as an increase
7. What is the monetary unit assumption? in cash and revenues. Is this treatment appropriate?
8. What is the economic entity assumption? Why or why not?
9. What are the three basic forms of profit-oriented 19. “A company’s net income appears directly on the in-
business organizations? come statement and the retained earnings statement,
10. Teresa Alvarez is the owner of a successful printing and it is included indirectly in the company’s balance
shop. Recently, her business has been increasing, and sheet.” Do you agree? Explain.
Teresa has been thinking about changing the orga- 20. Jardine Enterprises had a stockholders’ equity balance
nization of her business from a proprietorship to a of $158,000 at the beginning of the period. At the end
corporation. Discuss some of the advantages Teresa of the accounting period, the stockholders’ equity balance
would enjoy if she were to incorporate her business. was $198,000.
11. What is the basic accounting equation? (a) Assuming no additional investment or distribu-
12. (a) Define the terms assets, liabilities, and stock- tions during the period, what is the net income
holders’ equity. for the period?
(b) What items affect stockholders’ equity? (b) Assuming an additional investment of $13,000
13. Which of the following items are liabilities of Designer but no distributions during the period, what is
Jewelry Stores? the net income for the period?
(a) Cash. (f) Equipment. 21. Summarized operations for H. J. Oslo Co. for the
(b) Accounts payable. (h) Service revenue. month of July are as follows.
(c) Dividends. (g) Salaries and wages Revenues earned: for cash $30,000; on account
(d) Accounts receivable. payable. $70,000.
(e) Supplies. (i) Rent expense. Expenses incurred: for cash $26,000; on account
14. Can a business enter into a transaction in which only $40,000.
the left side of the basic accounting equation is af- Indicate for H. J. Oslo Co. (a) the total revenues,
fected? If so, give an example. (b) the total expenses, and (c) net income for the
15. Are the following events recorded in the accounting month of July.
records? Explain your answer in each case. 22. The basic accounting equation is: Assets 5 Liabilities 1
(a) The president of the company dies. Stockholders’ Equity. Replacing the words in that equation
(b) Supplies are purchased on account. with dollar amounts, what is The Coca-Cola Company’s
(c) An employee is fired. accounting equation at December 31, 2010?

BRIEF EXERCISES

BE1-1 Presented below is the basic accounting equation. Determine the missing amounts. Use basic accounting
equation.
Assets 5 Liabilities 1 Stockholders’ Equity
(LO 6)
(a) $90,000 $50,000 ?
(b) ? $45,000 $70,000
(c) $94,000 ? $60,000
34 1 Accounting in Action

Use basic accounting BE1-2 Given the accounting equation, answer each of the following questions.
equation. (a) The liabilities of Shumway Company are $120,000 and the stockholders’ equity is
(LO 6) $232,000. What is the amount of Shumway Company’s total assets?
(b) The total assets of Shumway Company are $190,000 and its stockholders’ equity is
$80,000. What is the amount of its total liabilities?
(c) The total assets of Shumway Company are $600,000 and its liabilities are equal to one
half of its total assets. What is the amount of Shumway Company’s stockholders’ equity?
Use basic accounting BE1-3 At the beginning of the year, Gonzales Company had total assets of $870,000 and
equation. total liabilities of $500,000. Answer the following questions.
(LO 6) (a) If total assets increased $150,000 during the year and total liabilities decreased
$80,000, what is the amount of stockholders’ equity at the end of the year?
(b) During the year, total liabilities increased $100,000 and stockholders’ equity decreased
$70,000. What is the amount of total assets at the end of the year?
(c) If total assets decreased $80,000 and stockholders’ equity increased $120,000 during
the year, what is the amount of total liabilities at the end of the year?
Solve accounting BE1-4 Use the accounting equation to answer each of the following questions.
equation. (a) The liabilities of Alli Company are $90,000. Common stock account is $150,000; divi-
(LO 6) dends are $40,000; revenues, $450,000; and expenses, $320,000. What is the amount
of Alli Company’s total assets?
(b) The total assets of Planke Company are $57,000. Common stock account is $23,000;
dividends are $7,000; revenues, $50,000; and expenses, $35,000. What is the amount
of the company’s total liabilities?
(c) The total assets of Thao Co. are $600,000 and its liabilities are equal to two-thirds of
its total assets. What is the amount of Thao Co.’s stockholders’ equity?
Identify assets, liabilities, BE1-5 Indicate whether each of the following items is an asset (A), liability (L), or part of
and stockholders’ equity. stockholders’ equity (SE).
(LO 6) _______ (a) Accounts receivable _______ (d) Supplies
_______ (b) Salaries and wages payable _______ (e) Owner’s investment
_______ (c) Equipment _______ (f) Notes payable
Determine effect of BE1-6 Presented below are three business transactions. On a sheet of paper, list the letters
transactions on basic (a), (b), and (c) with columns for assets, liabilities, and stockholders’ equity. For each
accounting equation. column, indicate whether the transactions increased (1), decreased (2), or had no effect
(LO 7) (NE) on assets, liabilities, and stockholders’ equity.
(a) Purchased supplies on account.
(b) Received cash for providing a service.
(c) Paid expenses in cash.
Determine effect of BE1-7 Follow the same format as BE1-6 above. Determine the effect on assets, liabilities,
transactions on and stockholders’ equity of the following three transactions.
accounting equation. (a) Stockholders invested cash in the business for common stock.
(LO 7) (b) Paid a cash dividend.
(c) Received cash from a customer who had previously been billed for services provided.
Classify items affecting BE1-8 Classify each of the following items as dividends (D), revenue (R), or expense (E).
stockholders’ equity. _______ (a) Advertising expense _______ (e) Dividends
(LO 6) _______ (b) Service revenue _______ (f) Rent revenue
_______ (c) Insurance expense _______ (g) Utilities expense
_______ (d) Salaries and wages expense
Determine effect of BE1-9 Presented below are three transactions. Mark each transaction as affecting common
transactions on stock (C), dividends (D), revenue (R), expense (E), or not affecting stockholders’ equity (NSE).
stockholders’ equity. _______ (a) Received cash for services performed
(LO 6) _______ (b) Paid cash to purchase equipment
_______ (c) Paid employee salaries.
Prepare a balance sheet. BE1-10 In alphabetical order below are balance sheet items for Grande Company at
(LO 8) December 31, 2014. Kit Grande is the owner of Grande Company. Prepare a balance sheet,
following the format of Illustration 1-10.
Accounts payable $85,000
Accounts receivable $72,500
Cash $44,000
Common stock $31,500
 Exercises 35

BE1-11 Indicate whether the following items would appear on the income statement (IS), Determine where items
balance sheet (BS), or retained earnings statement (RE). appear on financial
_______ (a) Notes payable _______ (d) Cash statements.
_______ (b) Advertising expense _______ (e) Service revenue (LO 8)
_______ (c) Common stock _______ (f) Dividends

> DO IT! REVIEW

DO IT! 1-1 Indicate whether each of the five statements presented below is true or false. Review basic concepts.
1. The three steps in the accounting process are identification, recording, and examination. (LO 1, 2, 4)
2. The two most common types of external users are investors and creditors.
3. Congress passed the Sarbanes-Oxley Act to ensure that investors invest only in com-
panies that will be profitable.
4. The primary accounting standard-setting body in the United States is the Securities
and Exchange Commission (SEC).
5. The cost principle dictates that companies record assets at their cost and continue to
report them at their cost over the time the asset is held.
DO IT! 1-2 Classify the following items as issuance of stock (I), dividends (D), revenues Evaluate effects of
(R), or expenses (E). Then indicate whether each item increases or decreases stockholders’ transactions on
equity. stockholders’ equity.

1. Dividends 3. Advertising expense (LO 6)

2. Rent revenue 4. Stockholders invest cash in the business
DO IT! 1-3 Transactions made by Callahan and Co., a law firm, for the month of March Prepare tabular analysis.
are shown below. Prepare a tabular analysis which shows the effects of these transac- (LO 7)
tions on the accounting equation, similar to that shown in Illustration 1-9.
1. The company provided $23,000 of services for customers, on credit.
2. The company received $23,000 in cash from customers who had been billed for
services (in transaction 1).
3. The company received a bill for $2,000 of advertising, but will not pay it until a later
date.
4. The company paid a dividend of $5,000 in cash to stockholders.
DO IT! 1-4 Presented below is selected information related to Narrow Gage Company at Calculate effects of
December 31, 2014. Narrow Gage reports financial information monthly. transactions on financial
statement items.
Accounts Payable $ 3,000 Salaries and Wages Expense $16,500
(LO 8)
Cash 9,000 Notes Payable 25,000
Advertising Expense 6,000 Rent Expense 9,800
Service Revenue 54,000 Accounts Receivable 13,500
Equipment 29,000 Dividends 7,500
(a) Determine the total assets of Narrow Gage Company at December 31, 2014.
(b) Determine the net income that Narrow Gage Company reported for December 2014.
(c) Determine the stockholders’ equity of Narrow Gage Company at December 31, 2014.

✔ The Navigator

EXERCISES

E1-1 Sondgeroth Company performs the following accounting tasks during the year. Classify the three activities of
accounting.
______Analyzing and interpreting information.
(LO 1)
______Classifying economic events.
______Explaining uses, meaning, and limitations of data.
______Keeping a systematic chronological diary of events.
36 1 Accounting in Action

______Measuring events in dollars and cents.

______Preparing accounting reports.
______Reporting information in a standard format.
______Selecting economic activities relevant to the company.
______Summarizing economic events.
Accounting is “an information system that identifies, records, and communicates the
economic events of an organization to interested users.”
Instructions
Categorize the accounting tasks performed by Sondgeroth as relating to either the identi-
fication (I), recording (R), or communication (C) aspects of accounting.
Identify users of E1-2 (a) The following are users of financial statements.
accounting information.
______Customers ______Securities and Exchange Commission
(LO 2) ______Internal Revenue Service ______Store manager
______Labor unions ______Suppliers
______Marketing manager ______Vice president of finance
______Production supervisor
Instructions
Identify the users as being either external users or internal users.
(b) The following questions could be asked by an internal user or an external user.
______ Can we afford to give our employees a pay raise?
______ Did the company earn a satisfactory income?
______ Do we need to borrow in the near future?
______ How does the company’s profitability compare to other companies?
______ What does it cost us to manufacture each unit produced?
______ Which product should we emphasize?
______ Will the company be able to pay its short-term debts?
Instructions
Identify each of the questions as being more likely asked by an internal user or an external
user.
Discuss ethics and the E1-3 Leon Manternach, president of Manternach Company, has instructed Carla Ruden,
cost principle. the head of the accounting department for Manternach Company, to report the company’s
(LO 3) land in the company’s accounting reports at its fair value of $170,000 instead of its cost of
$100,000. Manternach says, “Showing the land at $170,000 will make our company look
like a better investment when we try to attract new investors next month.”
Instructions
Explain the ethical situation involved for Carla Ruden, identifying the stakeholders and
the alternatives.
Use accounting concepts. E1-4 The following situations involve accounting principles and assumptions.
(LO 4, 5) 1. Julia Company owns buildings that are worth substantially more than they originally
cost. In an effort to provide more relevant information, Julia reports the buildings at
fair value in its accounting reports.
2. Dekalb Company includes in its accounting records only transaction data that can be
expressed in terms of money.
3. Omar Shariff, president of Omar’s Oasis, records his personal living costs as expenses
of the Oasis.
Instructions
For each of the three situations, state if the accounting method used is correct or incor-
rect. If correct, identify which principle or assumption supports the method used. If incor-
rect, identify which principle or assumption has been violated.
Classify accounts as assets, E1-5 Robinson Cleaners has the following balance sheet items.
liabilities, and stockholders’
Accounts payable Accounts receivable
equity.
Cash Notes payable
(LO 6) Equipment Salaries and wages payable
Supplies Common stock
 Exercises 37

Instructions
Classify each item as an asset, liability, or stockholders’ equity.
E1-6 Selected transactions for Spring Green Lawn Care Company are listed below. Analyze the effect of
1. Sold common stock for cash to start business. transactions.
2. Paid monthly rent. (LO 6, 7)
3. Purchased equipment on account.
4. Billed customers for services performed.
5. Paid dividends.
6. Received cash from customers billed in (4).
7. Incurred advertising expense on account.
8. Purchased additional equipment for cash.
9. Received cash from customers when service was performed.
Instructions
List the numbers of the above transactions and describe the effect of each transaction on
assets, liabilities, and stockholders’ equity. For example, the first answer is (1) Increase in
assets and increase in stockholders’ equity.
E1-7 Collins Computer Timeshare Company entered into the following transactions Analyze the effect of
during May 2014. transactions on assets,
liabilities, and stockholders’
1. Purchased computer terminals for $20,000 from Digital Equipment on account.
equity.
2. Paid $3,000 cash for May rent on storage space.
3. Received $15,000 cash from customers for contracts billed in April. (LO 6, 7)
4. Provided computer services to Schmidt Construction Company for $2,400 cash.
5. Paid Central States Power Co. $11,000 cash for energy usage in May.
6. Stockholders invested an additional $32,000 in the business.
7. Paid Digital Equipment for the terminals purchased in (1) above.
8. Incurred advertising expense for May of $900 on account.
Instructions
Indicate with the appropriate letter whether each of the transactions above results in:
(a) An increase in assets and a decrease in assets.
(b) An increase in assets and an increase in stockholders’ equity.
(c) An increase in assets and an increase in liabilities.
(d) A decrease in assets and a decrease in stockholders’ equity.
(e) A decrease in assets and a decrease in liabilities.
(f) An increase in liabilities and a decrease in stockholders’ equity.
(g) An increase in stockholders’ equity and a decrease in liabilities.
E1-8 An analysis of the transactions made by J. L. Kang & Co., a certified public accounting Analyze transactions and
firm, for the month of August is shown below. Each increase and decrease in stockholders’ compute net income.
equity is explained. (LO 7, 8)

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Accounts Common Retained Earnings
Cash 1 1 Supplies 1 Equipment 5 1 1
Receivable Payable Stock Rev. 2 Exp. 2 Div.
1. 1$15,000 1$15,000
2. 22,000 1$5,000 1$3,000
3. 2750 1$750
4. 14,600 1$4,500 1$9,100 Service Revenue
5. 21,500 21,500
6. 22,000 2$2,000
7. 2650 2$650 Rent Expense
8. 1450 2450
9. 23,900 23,900 Sal./Wages Expense
10. 1500 2500 Utilities Expense

Instructions
(a) Describe each transaction that occurred for the month.
(b) Determine how much stockholders’ equity increased for the month.
(c) Compute the amount of net income for the month.
38 1 Accounting in Action

Prepare financial E1-9 An analysis of transactions for J. L. Kang & Co. was presented in E1–8.
statements.
(LO 8) Instructions
Prepare an income statement and a retained earnings statement for August and a balance
sheet at August 31, 2014.
Determine net income E1-10 Kimmy Company had the following assets and liabilities on the dates indicated.
(or loss).
(LO 7) December 31 Total Assets Total Liabilities
2013 $400,000 $260,000
2014 $480,000 $300,000
2015 $590,000 $400,000
Kimmy began business on January 1, 2013, with an investment of $100,000 from stock-
holders.
Instructions
From an analysis of the change in stockholders’ equity during the year, compute the net
income (or loss) for:
(a) 2013, assuming Kimmy paid $15,000 in dividends for the year.
(b) 2014, assuming stockholders made an additional investment of $50,000 and Kimmy
paid no dividends in 2014.
(c) 2015, assuming stockholders made an additional investment of $15,000 and Kimmy
paid dividends of $30,000 in 2015.
Analyze financial E1-11 Two items are omitted from each of the following summaries of balance sheet and
statements items. income statement data for two corporations for the year 2014, Steven Craig and Georgia
(LO 6, 7) Enterprises.

Steven Georgia
Craig Enterprises
Beginning of year:
Total assets $ 97,000 $129,000
Total liabilities 85,000 (c)
Total stockholders’ equity (a) 75,000
End of year:
Total assets 160,000 180,000
Total liabilities 120,000 50,000
Total stockholders’ equity 40,000 130,000
Changes during year in stockholders’ equity:
Additional investment (b) 25,000
Dividends 24,000 (d)
Total revenues 215,000 100,000
Total expenses 175,000 55,000

Instructions
Determine the missing amounts.

Prepare income statement E1-12 The following information relates to Karen Weigel Co. for the year 2014.
and retained earnings
statement. Retained earnings, January 1, 2014 $48,000 Advertising expense $ 1,800
Dividends during 2014 5,000 Rent expense 10,400
(LO 8)
Service revenue 62,500 Utilities expense 3,100
Salaries and wages expense 28,000

Instructions
After analyzing the data, prepare an income statement and a retained earnings statement
for the year ending December 31, 2014.

Correct an incorrectly E1-13 Lynn Dreise is the bookkeeper for Sanculi Company. Lynn has been trying to get
prepared balance sheet. the balance sheet of Sanculi Company to balance. Sanculi’s balance sheet is shown on
(LO 8) the next page.
 Exercises 39

Sanculi Company
Balance Sheet
December 31, 2014
Assets Liabilities
Cash $14,000 Accounts payable $20,000
Supplies 8,000 Accounts receivable (8,500)
Equipment 48,000 Common stock 50,000
Dividends 9,000 Retained earnings 17,500
Total assets $79,000 Total liabilities and
stockholders’ equity $79,000
Instructions
Prepare a correct balance sheet.
E1-14 Bear Park, a public camping ground near the Lake Mead National Recreation Area, Compute net income and
has compiled the following financial information as of December 31, 2014. prepare a balance sheet.

Revenues during 2014—camping fees $140,000 Notes payable $ 60,000 (LO 8)

Revenues during 2014—general store 47,000 Expenses during 2014 150,000
Accounts payable 11,000 Supplies on hand 2,500
Cash on hand 20,000 Common stock 20,000
Original cost of equipment 105,500 Retained earnings ?
Fair value of equipment 140,000
Instructions
(a) Determine Bear Park’s net income for 2014.
(b) Prepare a balance sheet for Bear Park as of December 31, 2014.
E1-15 Presented below is financial information related to the 2014 operations of Donna Prepare an income
Marie Cruise Company. statement.

Maintenance and repairs expense $ 97,000 (LO 8)

Utilities expense 10,000
Salaries and wages expense 142,000
Advertising expense 3,500
Ticket revenue 335,000
Instructions
Prepare the 2014 income statement for Donna Marie Cruise Company.
E1-16 Presented below is information related to Williams and Douglas, Attorneys at Law. Prepare a retained
earnings statement.
Retained earnings, January 1, 2014 $ 23,000
(LO 8)
Legal service revenue—2014 340,000
Total expenses—2014 211,000
Assets, January 1, 2014 85,000
Liabilities, January 1, 2014 62,000
Assets, December 31, 2014 168,000
Liabilities, December 31, 2014 80,000
Dividends—2014 64,000
Instructions
Prepare the 2014 retained earnings statement for Williams and Douglas, Attorneys at Law.
E1-17 This information is for Belleview Company for the year ended December 31, 2014. Prepare a cash flow
statement.
Cash received from revenues from customers $600,000
Cash received for issuance of common stock 280,000 (LO 8)
Cash paid for new equipment 100,000
Cash dividends paid 20,000
Cash paid for expenses 430,000
Cash balance 1/1/14 30,000
Instructions
Prepare the 2014 statement of cash flows for Belleview Company.
40 1 Accounting in Action

EXERCISES: SET B AND

CHALLENGE EXERCISES

Visit the book’s companion website, at www.wiley.com/college/weygandt, and choose

the Student Companion site to access Exercise Set B and Challenge Exercises.

PROBLEMS: SET A

Analyze transactions and P1-1A Kinney’s Repair Inc. was started on May 1. A summary of May transactions is
compute net income. presented below.
(LO 6, 7) 1. Stockholders invested $10,000 cash in the business in exchange for common stock.
2. Purchased equipment for $5,000 cash.
3. Paid $400 cash for May office rent.
4. Paid $500 cash for supplies.
5. Incurred $250 of advertising costs in the Beacon News on account.
6. Received $4,700 in cash from customers for repair service.
7. Declared and paid a $1,000 cash dividend.
Check figures next to some 8. Paid part-time employee salaries $1,000.
Problems give you a key 9. Paid utility bills $140.
number, to let you know if 10. Provided repair service on account to customers $980.
you are on the right track 11. Collected cash of $120 for services billed in transaction (10).
with your solution. Instructions
(a) Total assets $13,140 (a) Prepare a tabular analysis of the transactions, using the following column headings:
Cash, Accounts Receivable, Supplies, Equipment, Accounts Payable, Common Stock,
and Retained Earnings (with separate columns for Revenues, Expenses, and Divi-
dends). Include margin explanations for any changes in Retained Earnings. Revenue
(b) Net income $3,890 is called Service Revenue.
(b) From an analysis of the Retained Earnings columns, compute the net income or net
loss for May.
Analyze transactions and P1-2A On August 31, the balance sheet of Donahue Veterinary Clinic showed Cash $9,000,
prepare income statement, Accounts Receivable $1,700, Supplies $600, Equipment $6,000, Accounts Payable $3,600,
retained earnings Common Stock $13,000, and Retained Earnings $700. During September, the following
statement, and balance sheet. transactions occurred.
(LO 6, 7, 8) 1. Paid $2,900 cash for accounts payable due.
2. Collected $1,300 of accounts receivable.
3. Purchased additional office equipment for $2,100, paying $800 in cash and the balance
on account.
4. Earned revenue of $7,300, of which $2,500 is collected in cash and the balance is due
in October.
5. Declared and paid a $400 cash dividend.
6. Paid salaries $1,700, rent for September $900, and advertising expense $200.
7. Incurred utilities expense for month on account $170.
8. Received $10,000 from Capital Bank on a 6-month note payable.
Instructions
(a) Ending cash $15,900 (a) Prepare a tabular analysis of the September transactions beginning with August 31
balances. The column headings should be as follows: Cash 1 Accounts Receivable 1
Supplies 1 Equipment 5 Notes Payable 1 Accounts Payable 1 Common Stock 1
(b) Net income $4,330 Retained Earnings 1 Revenues 2 Expenses 2 Dividends.
Total assets $29,800 (b) Prepare an income statement for September, a retained earnings statement for
September, and a balance sheet at September 30.
Prepare income statement,
retained earnings statement, P1-3A On May 1, Blue Sky Flying School, a company that provides flying lessons, was started
and balance sheet. with an investment of $45,000 cash in the business. Following are the assets and liabilities of
(LO 8) the company on May 31, 2014, and the revenues and expenses for the month of May.
 Problems: Set A 41

Cash $ 4,500 Notes Payable $28,000

Accounts Receivable 7,200 Rent Expense 1,200
Equipment 64,000 Maintenance and
Service Revenue 6,800 Repairs Expense 400
Advertising Expense 500 Gasoline Expense 2,500
Accounts Payable 1,400 Utilities Expense 400

No additional investments were made in May, but the company paid dividends of $500
during the month.
Instructions
(a) Prepare an income statement and a retained earnings statement for the month of May (a) Net income $1,800
and a balance sheet at May 31. Total assets $75,700
(b) Prepare an income statement and a retained earnings statement for May assuming the (b) Net income $1,200
following data are not included above: (1) $900 of revenue was earned and billed but
not collected at May 31, and (2) $1,500 of gasoline expense was incurred but not paid.
P1-4A Matt Stiner started a delivery service, Stiner Deliveries, on June 1, 2014. The Analyze transactions
following transactions occurred during the month of June. and prepare financial
statements.
June 1 Stockholders invested $10,000 cash in the business in exchange for common stock.
2 Purchased a used van for deliveries for $14,000. Matt paid $2,000 cash and (LO 6, 7, 8)
signed a note payable for the remaining balance.
3 Paid $500 for office rent for the month.
5 Performed $4,800 of services on account.
9 Declared and paid $300 in cash dividends.
12 Purchased supplies for $150 on account.
15 Received a cash payment of $1,250 for services provided on June 5.
17 Purchased gasoline for $100 on account.
20 Received a cash payment of $1,500 for services provided.
23 Made a cash payment of $500 on the note payable.
26 Paid $250 for utilities.
29 Paid for the gasoline purchased on account on June 17.
30 Paid $1,000 for employee salaries.
Instructions
(a) Show the effects of the previous transactions on the accounting equation using the (a) Total assets $25,800
following format.
Assets 5 Liabilities 1 Stockholders’ Equity
Accounts Notes Accounts Common Retained Earnings
Date Cash 1 1 Supplies 1 Equipment 5 1 1 1
Receivable Payable Payable Stock Rev. 2 Exp. 2 Div.

Include margin explanations for any changes in the Retained Earnings account in your analysis.
(b) Prepare an income statement for the month of June. (b) Net income $4,450
(c) Prepare a balance sheet at June 30, 2014. (c) Cash $8,100
P1-5A Financial statement information about four different companies is as follows. Determine financial state-
ment amounts and prepare
Crosby Stills Nash Young
retained earnings statement.
Company Company Company Company
January 1, 2014 (LO 7, 8)
Assets $ 75,000 $110,000 (g) $150,000
Liabilities 50,000 (d) $ 75,000 (j)
Stockholders’ equity (a) 60,000 45,000 100,000
December 31, 2014
Assets (b) 137,000 200,000 (k)
Liabilities 55,000 75,000 (h) 80,000
Stockholders’ equity 40,000 (e) 130,000 140,000
Stockholders’ equity changes in year
Additional investment (c) 15,000 10,000 15,000
Dividends 10,000 (f) 14,000 10,000
Total revenues 350,000 420,000 (i) 500,000
Total expenses 330,000 385,000 342,000 (l)
42 1 Accounting in Action

Instructions
(a) Determine the missing amounts. (Hint: For example, to solve for (a), Assets 2 Liabili-
ties 5 Stockholders’ Equity 5 $25,000.)
(b) Prepare the retained earnings statement for Stills Company. Assume beginning
retained earnings was $20,000.
(c) Write a memorandum explaining the sequence for preparing financial state-
ments and the interrelationship of the retained earnings statement to the income
statement and balance sheet.

PROBLEMS: SET B

Analyze transactions and P1-1B On April 1, Holly Dahl established Holiday Travel Agency. The following transac-
compute net income. tions were completed during the month.
(LO 6, 7) 1. Stockholders invested $10,000 cash in the business in exchange for common stock.
2. Paid $400 cash for April office rent.
3. Purchased office equipment for $2,500 cash.
4. Incurred $300 of advertising costs in the Chicago Tribune, on account.
5. Paid $600 cash for office supplies.
6. Earned $8,500 for services provided: $2,000 cash is received from customers, and the
balance of $6,500 is billed to customers on account.
7. Declared and paid a $200 cash dividend.
8. Paid Chicago Tribune amount due in transaction (4).
9. Paid employees’ salaries $2,200.
10. Received $5,700 in cash from customers billed previously in transaction (6).

Instructions
(a) Ending cash $11,500 (a) Prepare a tabular analysis of the transactions using the following column headings:
Cash, Accounts Receivable, Supplies, Equipment, Accounts Payable, Common Stock,
and Retained Earnings (with separate columns for Revenues, Expenses, and Divi-
dends). Include margin explanation for any changes in Retained Earnings.
(b) Net income $5,600 (b) From an analysis of the Retained Earnings columns, compute the net income or net
loss for April.
Analyze transactions and P1-2B Mandy Arnold opened a law office, Mandy Arnold, Attorney at Law, on July 1, 2014.
prepare income statement, On July 31, the balance sheet showed Cash $4,000, Accounts Receivable $1,500, Supplies
retained earnings statement, $500, Equipment $5,000, Accounts Payable $4,200, and Common Stock $6,000, and
and balance sheet.
Retained Earnings $800. During August, the following transactions occurred.
(LO 6, 7, 8) 1. Collected $1,400 of accounts receivable due from clients.
2. Paid $2,700 cash for accounts payable due.
3. Earned revenue of $7,900 of which $3,000 is collected in cash and the balance is due
in September.
4. Purchased additional office equipment for $1,000, paying $400 in cash and the balance
on account.
5. Paid salaries $3,000, rent for August $900, and advertising expenses $350.
6. Declared and paid a $450 cash dividend.
7. Received $2,000 from Standard Federal Bank; the money was borrowed on a 4-month
note payable.
8. Incurred utility expenses for month on account $210.

Instructions
(a) Ending expenses $4,460 (a) Prepare a tabular analysis of the August transactions beginning with July 31 balances.
The column headings should be as follows: Cash 1 Accounts Receivable 1 Supplies 1
Equipment 5 Notes Payable 1 Accounts Payable 1 Common Stock 1 Retained Earn-
ings 1 Revenues 2 Expenses 2 Dividends.
(b) Net income $3,440 (b) Prepare an income statement for August, a retained earnings statement for August,
Total assets $14,100 and a balance sheet at August 31.
 Problems: Set B 43

P1-3B Angelic Cosmetics Co., a company that provides individual skin care treatment, Prepare income statement,
was started on June 1 with an investment of $25,000 cash. Following are the assets and retained earnings statement,
liabilities of the company at June 30 and the revenues and expenses for the month of June. and balance sheet.
(LO 8)
Cash $10,000 Notes Payable $13,000
Accounts Receivable 4,000 Accounts Payable 1,400
Service Revenue 5,500 Rent Expense 1,600
Supplies 2,000 Gasoline Expense 600
Advertising Expense 500 Utilities Expense 300
Equipment 25,000
Stockholders made no additional investments in June. The company paid a cash dividend
of $900 during the month.
Instructions
(a) Prepare an income statement and a retained earnings statement for the month of June (a) Net income $2,500
and a balance sheet at June 30, 2014. Total assets $41,000
(b) Prepare an income statement and a retained earnings statement for June assuming the (b) Net income $3,200
following data are not included above: (1) $800 of revenue was earned and billed but
not collected at June 30, and (2) $100 of gasoline expense was incurred but not paid.
P1-4B Jessi Paulis started a consulting firm, Paulis Consulting, on May 1, 2014. The Analyze transactions and
following transactions occurred during the month of May. prepare financial statements.

May 1 Paulis invested $8,000 cash in the business in exchange for stock. (LO 6, 7, 8)
2 Paid $800 for office rent for the month.
3 Purchased $500 of supplies on account.
5 Paid $50 to advertise in the County News.
9 Received $3,000 cash for services provided.
12 Declared and paid a $700 cash dividend.
15 Performed $3,300 of services on account.
17 Paid $2,100 for employee salaries.
20 Paid for the supplies purchased on account on May 3.
23 Received a cash payment of $2,000 for services provided on account on May 15.
26 Borrowed $5,000 from the bank on a note payable.
29 Purchased office equipment for $2,300 on account.
30 Paid $150 for utilities.
Instructions
(a) Show the effects of the previous transactions on the accounting equation using the (a) Total assets $17,800
following format.

Assets 5 Liabilities 1 Stockholders’ Equity

Accounts Notes Accounts Common Retained Earnings
Date Cash 1 1 Supplies 1 Equipment 5 1 1 1
Receivable Payable Payable Stock Rev. 2 Exp. 2 Div.

Include margin explanations for any changes in the Retained Earnings account in your
analysis.
(b) Prepare an income statement for the month of May. (b) Net income $3,200
(c) Prepare a balance sheet at May 31, 2014. (c) Cash $13,700

P1-5B Financial statement information about four different companies is shown on the Determine financial state-
next page. ment amounts and prepare
retained earnings statement.
Instructions
(LO 7, 8)
(a) Determine the missing amounts. (Hint: For example, to solve for (a), Assets 2 Liabili-
ties 5 Stockholders’ Equity 5 $28,000.)
(b) Prepare the retained earnings statement for John Company. Assume beginning
retained earnings was $0.
(c) Write a memorandum explaining the sequence for preparing financial state-
ments and the interrelationship of the retained earnings statement to the income
statement and balance sheet.
44 1 Accounting in Action

John Paul George Ringo

Company Company Company Company
January 1, 2014
Assets $ 78,000 $ 90,000 (g) $150,000
Liabilities 50,000 (d) $ 75,000 (j)
Stockholders’ equity (a) 50,000 54,000 100,000
December 31, 2014
Assets (b) 117,000 180,000 (k)
Liabilities 55,000 79,000 (h) 80,000
Stockholders’ equity 40,000 (e) 100,000 145,000
Stockholders’ equity changes in year
Additional investment (c) 8,000 10,000 15,000
Dividends 10,000 (f) 12,000 10,000
Total revenues 350,000 390,000 (i) 500,000
Total expenses 335,000 400,000 360,000 (l)

PROBLEMS: SET C

Visit the book’s website, at www.wiley.com/college/weygandt, and choose the Student

Companion site to access Problem Set C.

CONTINUING COOKIE CHRONICLE

CCC1 Natalie Koebel spent much of her childhood learning the art of cookie-making from
her grandmother. They passed many happy hours mastering every type of cookie imagin-
able and later creating new recipes that were both healthy and delicious. Now at the start
of her second year in college, Natalie is investigating various possibilities for starting her
own business as part of the requirements of the entrepreneurship program in which she
is enrolled.
A long-time friend insists that Natalie has to somehow include cookies in her
business plan. After a series of brainstorming sessions, Natalie settles on the idea of
operating a cookie-making school. She will start on a part-time basis and offer her
The Continuing Cookie
services in people’s homes. Now that she has started thinking about it, the possibili-
Chronicle starts in this
ties seem endless. During the fall, she will concentrate on holiday cookies. She will
chapter and continues in
offer individual lessons and group sessions (which will probably be more entertain-
every chapter. You also can
ment than education for the participants). Natalie also decides to include children in
find this problem at the
her target market.
book’s companion website.
The first difficult decision is coming up with the perfect name for her business. In the
end, she settles on “Cookie Creations” and then moves on to more important issues.
Instructions
(a) What form of business organization—proprietorship, partnership, or corporation—
do you recommend that Natalie use for her business? Discuss the benefits and weak-
nesses of each form and give the reasons for your choice.
(b) Will Natalie need accounting information? If yes, what information will she need and
why? How often will she need this information?
(c) Identify specific asset, liability, and owner’s/stockholders’ equity accounts that Cookie
Creations will likely use to record its business transactions.
(d) Should Natalie open a separate bank account for the business? Why or why not?
 Broadening Your Perspective 45

Broadening Your PERSPECTIVE

Financial Reporting and Analysis

Financial Reporting Problem: PepsiCo, Inc.

BYP1-1 The actual financial statements of PepsiCo, Inc., as presented in the company’s 2010
Annual Report, are contained in Appendix A (at the back of the textbook).
Instructions
Refer to PepsiCo’s financial statements and answer the following questions.
(a) What were PepsiCo’s total assets at December 25, 2010? At December 26, 2009?
(b) How much cash (and cash equivalents) did PepsiCo have on December 25, 2010?
(c) What amount of accounts payable did PepsiCo report on December 25, 2010? On December 26,
2009?
(d) What were PepsiCo’s net sales in 2008? In 2009? In 2010?
(e) What is the amount of the change in PepsiCo’s net income from 2009 to 2010?

Comparative Analysis Problem: PepsiCo, Inc. vs. The Coca-Cola Company

BYP1-2 PepsiCo’s financial statements are presented in Appendix A. The Coca-Cola Company’s
financial statements are presented in Appendix B.
Instructions
Refer to the financial statements and answer the following questions.
(a) Based on the information contained in these financial statements, determine the following for
each company.
(1) Total assets at December 25, 2010, for PepsiCo, and for Coca-Cola at December 31, 2010.
(2) Accounts (notes) receivable, net at December 25, 2010, for PepsiCo and at December 31,
2010, for Coca-Cola.
(3) Net sales for year ended in 2010.
(4) Net income for year ended in 2010.
(b) What conclusions concerning the two companies can be drawn from these data?

Real-World Focus
BYP1-3 This exercise will familiarize you with skill requirements, job descriptions, and salaries
for accounting careers.
Address: www.careers-in-accounting.com, or go to www.wiley.com/college/weygandt
Instructions
Go to the site shown above. Answer the following questions.
(a) What are the three broad areas of accounting (from “Skills and Talents Required”)?
(b) List eight skills required in accounting.
(c) How do the three accounting areas differ in terms of these eight required skills?
(d) Explain one of the key job functions in accounting.
(e) What is the salary range for a junior staff accountant to a Big 4 firm?

Critical Thinking

Decision-Making Across the Organization

BYP1-4 Lucy and Nick Lars, local golf stars, opened the Chip-Shot Driving Range Company on
March 1, 2014. They invested $20,000 cash and received common stock in exchange for their in-
vestment. A caddy shack was constructed for cash at a cost of $6,000, and $800 was spent on golf
46 1 Accounting in Action

balls and golf clubs. The Lars leased five acres of land at a cost of $1,000 per month and paid the
first month’s rent. During the first month, advertising costs totaled $750, of which $150 was unpaid
at March 31, and $400 was paid to members of the high school golf team for retrieving golf balls.
All revenues from customers were deposited in the company’s bank account. On March 15, Lucy
and Nick received a dividend of $800. A $100 utility bill was received on March 31 but was not paid.
On March 31, the balance in the company’s bank account was $15,100.
Lucy and Nick thought they had a pretty good first month of operations. But, their estimates
of profitability ranged from a loss of $4,900 to net income of $1,650.
Instructions
With the class divided into groups, answer the following.
(a) How could the Lars have concluded that the business operated at a loss of $4,900? Was this a
valid basis on which to determine net income?
(b) How could the Lars have concluded that the business operated at a net income of $1,650?
(Hint: Prepare a balance sheet at March 31.) Was this a valid basis on which to determine net
income?
(c) Without preparing an income statement, determine the actual net income for March.
(d) What was the revenue earned in March?

Communication Activity
BYP1-5 Erin Danielle, the bookkeeper for New York Company, has been trying to get the balance
sheet to balance. The company’s balance sheet is shown below.

New York Company

Balance Sheet
For the Month Ended December 31, 2014
Assets Liabilities
Equipment $22,500 Common stock $23,000
Cash 9,000 Accounts receivable (6,000)
Supplies 2,000 Retained earnings (2,000)
Accounts payable (8,000) Notes payable 10,500
$25,500 $25,500

Instructions
Explain to Erin Danielle in a memo why the original balance sheet is incorrect, and what should
be done to correct it.

Ethics Case
BYP1-6 After numerous campus interviews, Jeff Hunter, a senior at Great Northern College,
received two office interview invitations from the Baltimore offices of two large firms. Both firms
offered to cover his out-of-pocket expenses (travel, hotel, and meals). He scheduled the interviews
for both firms on the same day, one in the morning and one in the afternoon. At the conclusion
of each interview, he submitted to both firms his total out-of-pocket expenses for the trip to Balti-
more: mileage $112 (280 miles at $0.40), hotel $130, meals $36, parking and tolls $18, for a total of
$296. He believes this approach is appropriate. If he had made two trips, his cost would have been
two times $296. He is also certain that neither firm knew he had visited the other on that same trip.
Within 10 days, Jeff received two checks in the mail, each in the amount of $296.
Instructions
(a) Who are the stakeholders (affected parties) in this situation?
(b) What are the ethical issues in this case?
(c) What would you do in this situation?
 Broadening Your Perspective 47

All About You

BYP1-7 Some people are tempted to make their finances look worse to get financial aid. Com-
panies sometimes also manage their financial numbers in order to accomplish certain goals.
Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth
out bumps in net income. In managing earnings, companies’ actions vary from being within the
range of ethical activity, to being both unethical and illegal attempts to mislead investors and
creditors.

Instructions
Provide responses for each of the following questions.
(a) Discuss whether you think each of the following actions (adapted from www.finaid.org/fafsa/)
to increase the chances of receiving financial aid is ethical.
(1) Spend down the student’s assets and income first, before spending parents’ assets and
income.
(2) Accelerate necessary expenses to reduce available cash. For example, if you need a new car,
buy it before applying for financial aid.
(3) State that a truly financially dependent child is independent.
(4) Have a parent take an unpaid leave of absence for long enough to get below the “threshold”
level of income.
(b) What are some reasons why a company might want to overstate its earnings?
(c) What are some reasons why a company might want to understate its earnings?
(d) Under what circumstances might an otherwise ethical person decide to illegally overstate or
understate earnings?
BYP1-8 When companies need money, they go to investors or creditors. Before investors or credi-
tors will give a company cash, they want to know the company’s financial position and perfor-
mance. They want to see the company’s financial statements—the balance sheet and the income
statement. When students need money for school, they often apply for financial aid. When you
apply for financial aid, you must submit your own version of a financial statement—the Free
Application for Federal Student Aid (FAFSA) form.
Suppose you have $4,000 in cash and $4,000 in credit card bills. The more cash and other
assets that you have, the less likely you are to get financial aid. Also, if you have a lot of consumer
debt (credit card bills), schools are not more likely to loan you money. To increase your chances of
receiving aid, should you use the cash to pay off your credit card bills, and therefore make yourself
look “worse off” to the financial aid decision-makers?
YES: You are playing within the rules. You are not hiding assets. You are simply restructuring
your assets and liabilities to best conform with the preferences that are built into the federal aid
formulas.
NO: You are engaging in a transaction solely to take advantage of a loophole in the federal aid
rules. In doing so, you are potentially depriving someone who is actually worse off than you from
receiving aid.
Instructions
Write a response indicating your position regarding this situation. Provide support for your view.

FASB Codification Activity

BYP1-9 The FASB has developed the Financial Accounting Standards Board Accounting
Standards Codification (or more simply “the Codification”). The FASB’s primary goal in de-
veloping the Codification is to provide in one place all the authoritative literature related to
a particular topic. To provide easy access to the Codification, the FASB also developed the
Financial Accounting Standards Board Codification Research System (CRS). CRS is an on-
line, real-time database that provides easy access to the Codification. The Codification and the
related CRS provide a topically organized structure, subdivided into topic, subtopics, sections,
and paragraphs, using a numerical index system.
You may find this system useful in your present and future studies, and so we have provided
an opportunity to use this online system as part of the Broadening Your Perspective section.
48 1 Accounting in Action

Instructions
Academic access to the FASB Codification is available through university subscriptions, obtained
from the American Accounting Association (at http://aaahq.org/FASB/Access.cfm), for an annual
fee of $150. This subscription covers an unlimited number of students within a single institution.
Once this access has been obtained by your school, you should log in (at http://aaahq.org/ascLogin.
cfm) and familiarize yourself with the resources that are accessible at the FASB Codification site.

Answers to Chapter Questions

Answers to Insight and Accounting Across the Organization Questions

p. 6 The Scoop on Accounting Q: What are the benefits to the company and to the employees of
making the financial statements available to all employees? A: If employees can read and use financial
reports, a company will benefit in the following ways. The marketing department will make better deci-
sions about products to offer and prices to charge. The finance department will make better decisions
about debt and equity financing and how much to distribute in dividends. The production department
will make better decisions about when to buy new equipment and how much inventory to produce. The
human resources department will be better able to determine whether employees can be given raises.
Finally, all employees will be better informed about the basis on which they are evaluated, which will
increase employee morale.
p. 8 The Numbers Behind Not-for-Profit Organizations Q: What benefits does a sound
accounting system provide to a not-for-profit organization? A: Accounting provides at least two
benefits to not-for-profit organizations. First, it helps to ensure that money is used in the way that
donors intended. Second, it assures donors that their money is not going to waste and thus in-
creases the likelihood of future donations.
p. 10 The Korean Discount Q: What is meant by the phrase “make the country’s businesses
more transparent”? Why would increasing transparency spur economic growth? A: Transpar-
ency refers to the extent to which outsiders have knowledge regarding a company’s financial
performance and financial position. If a company lacks transparency, its financial reports do
not adequately inform investors of critical information that is needed to make investment
decisions. If corporate transparency is increased, investors will be more willing to supply the
financial capital that businesses need in order to grow, which would spur the country’s eco-
nomic growth.
p. 12 Spinning the Career Wheel Q: How might accounting help you? A: You will need to un-
derstand financial reports in any enterprise with which you are associated. Whether you become a
manager, a doctor, a lawyer, a social worker, a teacher, an engineer, an architect, or an entrepreneur,
a working knowledge of accounting is relevant.
p. 25 Beyond Financial Statements Q: Why might a company’s stockholders be interested in its
environmental and social performance? A: Many companies now recognize that being a socially
responsible organization is not only the right thing to do, but it also is good for business. Many in-
vestment professionals understand, for example, that environmental, social, and proper corporate
governance of companies affects the performance of their investment portfolios. For example,
British Petroleum’s oil leak disaster is a classic example of the problems that can occur for a company
and its stockholders. BP’s stock price was slashed, its dividend reduced, its executives replaced,
and its reputation badly damaged. It is interesting that socially responsible investment funds are
now gaining momentum in the marketplace such that companies now recognize this segment as
an important investment group.

Answers to Self-Test Questions

1. b 2. d 3. c 4. b 5. b 6. d 7. b 8. a ($3,500 2 $2,000) 9. b 10. a ($90,000 2 $50,000)
11. d 12. c 13. b 14. c *15. a
 A Look at IFRS 49

A Look at IFRS

Most agree that there is a need for one set of international accounting standards. Here is why:
Multinational corporations. Today’s companies view the entire world as their market. For example,
Coca-Cola, Intel, and McDonald’s generate more than 50% of their sales outside the United States, and
many foreign companies, such as Toyota, Nestlé, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/Mannesmann sug-
gest that we will see even more such business combinations in the future.
Information technology. As communication barriers continue to topple through advances in
technology, companies and individuals in different countries and markets are becoming more com-
fortable buying and selling goods and services from one another.
Financial markets. Financial markets are of international significance today. Whether it is cur-
rency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the
world trading these types of instruments.

Key Points
• International standards are referred to as International Financial Reporting Standards (IFRS),
developed by the International Accounting Standards Board (IASB).
• Recent events in the global capital markets have underscored the importance of financial dis-
closure and transparency not only in the United States but in markets around the world. As a
result, many are examining which accounting and financial disclosure rules should be followed.
As indicated in the graphic below, much of the world has voted for the standards issued by the
IASB. Over 115 countries require or permit use of IFRS.

Countries that require

or permit IFRS or have
fixed dates for adoption

Countries seeking conver-

gence with the IASB or
pursuing adoption of IFRS

Source: http://www.pwc.com/us/en/issues/ifrs-reporting/country-adoption/index.jhtml.

• U.S standards, referred to as generally accepted accounting principles (GAAP), are developed by
the Financial Accounting Standards Board (FASB). The fact that there are differences between
what is in this textbook (which is based on U.S. standards) and IFRS should not be surprising
because the FASB and IASB have responded to different user needs. In some countries, the primary
users of financial statements are private investors. In others, the primary users are tax authorities
50 1 Accounting in Action

or central government planners. It appears that the United States and the international standard-
setting environment are primarily driven by meeting the needs of investors and creditors.
• The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public compa-
nies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. companies should
have to comply with this extra layer of regulation. Debate about international companies (non-U.S.)
adopting SOX-type standards centers on whether the benefits exceed the costs. The concern is that the
higher costs of SOX compliance are making the U.S. securities markets less competitive.
• The textbook mentions a number of ethics violations, such as Enron, WorldCom, and AIG. These
problems have also occurred internationally, for example, at Satyam Computer Services (India),
Parmalat (Italy), and Royal Ahold (the Netherlands).
• IFRS tends to be simpler in its accounting and disclosure requirements; some people say more “prin-
ciples-based.” GAAP is more detailed; some people say it is more “rules-based.” This difference in ap-
proach has resulted in a debate about the merits of “principles-based” versus “rules-based” standards.
• U.S. regulators have recently eliminated the need for foreign companies that trade shares in U.S.
markets to reconcile their accounting with GAAP.
• The three most common forms of business organization, proprietorships, partnerships, and
corporations, are also found in countries that use IFRS. Because the choice of business or-
ganization is influenced by factors such as legal environment, tax rates and regulations, and
degree of entrepreneurism, the relative use of each form will vary across countries.
• The conceptual framework that underlies IFRS is very similar to that used to develop GAAP. The
basic definitions provided in this textbook for the key elements of financial statements, that is,
assets, liabilities, equity, revenues (referred to as income), and expenses, are simplified versions
of the official definitions provided by the FASB. The more substantive definitions, using the IASB
definitional structure, are as follows.
Assets. A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
Liabilities. A present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic
benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e.,
they can arise due to normal business practice or customs.
Equity. A residual interest in the assets of the entity after deducting all its liabilities.
Income. Increases in economic benefits that result in increases in equity (other than those
related to contributions from shareholders). Income includes both revenues (resulting from
ordinary activities) and gains.
Expenses. Decreases in economic benefits that result in decreases in equity (other than
those related to distributions to shareholders). Expenses includes losses that are not the
result of ordinary activities.

Looking to the Future

Both the IASB and the FASB are hard at work developing standards that will lead to the elimina-
tion of major differences in the way certain transactions are accounted for and reported. In fact,
at one time the IASB stated that no new major standards would become effective until 2011. The
major reason for this policy was to provide companies the time to translate and implement IFRS
into practice, as much has happened in a very short period of time. Consider, for example, that as a
result of a joint project on the conceptual framework, the definitions of the most fundamental ele-
ments (assets, liabilities, equity, revenues, and expenses) may actually change. However, whether
the IASB adopts internal control provisions similar to those in SOX remains to be seen.

IFRS Practice
IFRS Self-Test Questions
1. Which of the following is not a reason why a single set of high-quality international accounting
standards would be beneficial?
(a) Mergers and acquisition activity.
(b) Financial markets.
 A Look at IFRS 51

(c) Multinational corporations.

(d) GAAP is widely considered to be a superior reporting system.
2. The Sarbanes-Oxley Act determines:
(a) international tax regulations.
(b) internal control standards as enforced by the IASB.
(c) internal control standards of U.S. publicly traded companies.
(d) U.S. tax regulations.
3. IFRS is considered to be more:
(a) principles-based and less rules-based than GAAP.
(b) rules-based and less principles-based than GAAP.
(c) detailed than GAAP.
(d) None of the above.
4. Which of the following statements is false?
(a) IFRS is based on a conceptual framework that is similar to that used to develop GAAP.
(b) Assets are defined by the IASB as resources controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the entity.
(c) Non-U.S. companies that trade shares in U.S. markets must reconcile their accounting with
GAAP.
(d) Proprietorships, partnerships, and corporations are also found in countries that use IFRS.
5. Which of the following statements is true?
(a) Under IFRS, the term income refers to what would be called revenues and gains under
GAAP.
(b) The term income is not used under IFRS.
(c) The term income refers only to gains on investments.
(d) Under IFRS, expenses include distributions to owners.

IFRS Exercises
IFRS1-1 Who are the two key international players in the development of international accounting
standards? Explain their role.
IFRS1-2 What might explain the fact that different accounting standard-setters have developed
accounting standards that are sometimes quite different in nature?
IFRS1-3 What is the benefit of a single set of high-quality accounting standards?
IFRS1-4 Discuss the potential advantages and disadvantages that countries outside the United
States should consider before adopting regulations, such as those in the Sarbanes-Oxley Act, that
increase corporate internal control requirements.

International Financial Reporting Problem: Zetar plc

IFRS1-5 The financial statements of Zetar plc are presented in Appendix C. The company’s com-
plete annual report, including the notes to its financial statements, is available at www.zetarplc.com.
Instructions
Visit Zetar’s corporate website and answer the following questions from Zetar’s 2010 annual report.
(a) What accounting firm performed the audit of Zetar’s financial statements?
(b) What is the address of the company’s corporate headquarters?
(c) What is the company’s reporting currency?
(d) What two segments does the company operate in, and what were the sales for each segment in
the year ended April 30, 2010?

Answers to IFRS Self-Test Questions

1. d 2. c 3. a 4. c 5. a

✔ The Navigator

✔ Remember to go back to The Navigator box on the chapter opening page and check off your completed work.