As you have learned in this week’s readings, the Accounting Equation is Assets = Liabilities + Owners’ Equity. Is the accounting equation true in all instances? Provide sample transactions from your own experiences to demonstrate the validity of the Accounting Equation. Guidance: Must be a minimum of 200 words. Support your answer using the provided textbook. chapter 1 Introduction to Accounting Copyright Barbara Chase/Corbis/AP Images Learning Goals waL80144_01_c01_001-026.indd 1 • Develop a general understanding of alternative forms of business entities. • Differentiate between financial and managerial accounting. • Acquire knowledge about the conceptual underpinnings of accounting. • Learn the fundamental accounting equation and the impact of transactions. • Discover alternative career paths within the accounting profession. 8/29/12 2:43 PM CHAPTER 1 Chapter Outline Chapter Outline 1.1 Entity Concepts 1.2 The Language of Business Disciplines of Accounting Financial Accounting 1.3 Key Concepts 1.4 The Financial Reporting Model Sources of Capital Comprehensive Illustration Statement of Cash Flows: A Fourth Financial Statement 1.5 Usefulness of Accounting in Careers and Life 1.6 The Importance of Ethics T he stereotypical accountant is characterized as a boring number cruncher, charged with maintaining the books and accounts of a business. This image may be traced back to the 1843 book by Charles Dickens entitled A Christmas Carol. In that tale, Ebenezer Scrooge is a penny-pinching miser who cares nothing for the people around him. His sole purpose is making money, and his trusted but suffering accountant is Bob Cratchit, who painstakingly tracks every penny. Mr. Scrooge eventually sees the light, but that’s another story. Today’s accountant is also another story. The mundane aspects of accounting are now largely accomplished by sophisticated computer software. For small businesses, the software may reside on a simple personal computer. Larger businesses may use elaborate enterprise resource packages that integrate accounting with all other aspects of managing the business. Such complex business systems may be maintained internally by a specific business or be contracted for through a third-party “cloud computing” service provider. The changed environment has redefined what it means to be an accountant. Although accountants certainly need to have comprehensive understanding of the fundamental practices, rules, and procedures constituting the foundation of accounting, they are oftentimes more focused on broader measurement, reporting, and managerial tasks. Less time is spent on data capture, and more time is devoted to analyzing information and helping with sound business decisions. Furthermore, to understand and monitor results produced by sophisticated information systems, accountants need to be knowledgeable and vigilant. If their organizations solely rely on the data produced by their computers, decision making can be quickly handicapped by erroneous output. The accountant must have a keen “forensic” eye to make sure that reported information is logical and correct. Indeed, the role of accounting has grown more complex, and with that, the value of the accountant has increased. A large proportion of business leaders start out as accountants. 2 waL80144_01_c01_001-026.indd 2 8/29/12 2:43 PM CHAPTER 1 Section 1.1 Entity Concepts 1.1 Entity Concepts B roadly speaking, accounting describes the concepts and techniques that are used to measure and report financial information. This information relates to a particular entity. There are many types of entities—business entities, governmental entities, and nonprofit entities. Each type has unique goals, objectives, and attributes, and those elements influence the nature of accounting procedures and reports. This course will focus on business enterprises that come in a variety of forms. Some businesses are sole proprietorships. This means they are owned by one person. Sole proprietorships can be started informally and are not technically separate legal entities from the owner. Just about any business activity that you undertake without the help of others (or through a formally structured legal entity) can be regarded as a sole proprietorship. Importantly, a sole proprietor must maintain clearly identifiable business records for such business activities. To judge business success, segregating personal affairs from business affairs is imperative. Thus, the sole proprietorship constitutes a separate entity for purposes of accountability. Throughout your studies, you will learn accounting principles and methods that are necessary and useful in tracking the business affairs of a sole proprietorship. When more than one person is engaged in a business activity, the importance of accountability over their comingled business efforts becomes even more critical. A popular business form is the partnership (or limited liability partnership). A partnership can come into existence accidentally. No formal action is required to create a simple partnership. A partnership is considered to exist when there is co-ownership of a business activity carried on with the objective of making a profit (unless specific actions are taken to avoid the formation of a partnership, such as legally incorporating). Most of the general accounting principles you will study also apply to partnerships. However, a later chapter will look closely at the unique benefits, risks, and accounting issues that are introduced for the partnership form of organization. A more structured form of business entity is the corporation. A corporation is a legally created entity that is owned by one or more persons. A corporation is both a legal and economic entity, and it is probably apparent that it represents a unique area of accountability. The corporate form of organization has several key advantages, particularly the ability to attract investment capital from a broad group of investors. However, those investors depend heavily on accounting information about the entity that they have invested in, thus the need for financial reports for each specific entity. This course will build your foundational knowledge of accounting, beginning with core accounting principles. Although most of the examples will be styled around the corporate form of organization, the basic principles generally relate to each form of entity. Future chapters will draw distinctions as appropriate for unique issues pertaining to alternative forms of business organization. 3 waL80144_01_c01_001-026.indd 3 8/29/12 2:43 PM CHAPTER 1 Section 1.2 The Language of Business 1.2 The Language of Business A s noted, accounting is the collective concepts and techniques used to measure and report financial information about an entity. In essence, accounting is the language of business. Businesspeople are generally expected to possess at least rudimentary knowledge of this language. It is not essential that they know every nuance or specific rule, but they must be at least functionally literate in basic concepts. Indeed, it is very difficult to intelligently read and understand essential accounting reports without a firm grasp of accounting principles. No matter what career you pursue, you will come to appreciate the material you will learn in this course. Disciplines of Accounting At its core, accounting is a tool for providing information for decision making. Decision makers include owner(s), managers, creditors, employees, government, and other interested parties. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity, and each may have different ideas about the information they seek. This leads to a natural division of specialties within the accounting field. Some accountants focus on taxation. Tax returns must be prepared, according to established laws, rules, and regulations. Tax accountants are also heavily involved in planning and strategy. The tax ramifications of significant transactions must be carefully evaluated. Businesses must consider complex implications of doing business in multiple states and countries. Other accountants focus on managerial accounting. Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire specialized reports, budgets, product-costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be developed. Another major area of accounting emphasis is financial accounting and auditing. Financial accounting is targeted toward reporting financial information about a business to external users such as the owner(s) and creditors. These parties often lack direct access to underlying details about day-to-day operations of the business and depend on summarized (frequently audited) financial statements to form their opinions about whether to invest in or lend to the business. As a result, their ability to understand and have confidence in reports directly depends on the standardization of principles and practices used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare. Auditors provide independent oversight and assurance about the fairness and accuracy of reported financial accounting information. This introductory course is largely about financial accounting. It is the right place to begin your studies of accounting because understanding core financial accounting principles is essential for business success. Furthermore, many tax and managerial accounting processes are derivatives of the financial accounting model. 4 waL80144_01_c01_001-026.indd 4 8/29/12 2:43 PM CHAPTER 1 Section 1.3 Key Concepts Financial Accounting Financial accounting focuses on correctly measuring and reporting information about a business’s transactions and events. This information must be captured and summarized into reports that are used by persons interested in the entity. This task is far more complex than most people appreciate. It involves a talented blending of technical knowledge and applied judgment. Understanding financial accounting begins with an understanding of the overall structure of accounting and the fundamental reporting model that is common to all business entities. As noted, standardization of reporting is a hallmark of financial accounting. Such standardization derives from certain well-organized processes and organizations. In the United States, a private-sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB http:// www.ifrs.org/The-organisation/Pages/IFRS-Foundation-and-the-IASB.aspx and FASB http://www.fasb.org/home work cooperatively on many projects, and a single harmonious set of international financial reporting standards (IFRS) might eventually emerge. This effort to establish consistency in global financial reporting is motivated by the increase in global business. Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard-setting bodies are intended to be general purpose in orientation. This means that they are not prepared especially for owners, creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups. 1.3 Key Concepts T he development of GAAP has occurred over many decades, and serious attempts have been made to base individual rules on thoughtful conceptual guideposts. Foremost is the idea of decision usefulness. Financial accounting information is intended to facilitate decisions about investing and lending. At a macrolevel, accounting information is the basis upon which capital is allocated in a free market economy. Investors like to invest where profits are best, and creditors like to loan when they foresee that they are apt to be repaid. The best businesses and business opportunities attract capital via signals about their performance, and those signals emanate from the financial reporting model. Without this flow of information and capital, a modern economy would stutter. To be useful for decision making, accounting information should be relevant and reliable. Relevance means the degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance. Information is also seen as relevant if it possesses predictive value. Reliability relates mostly to truthfulness but also contemplates freedom from bias (neutral). Accounting information should also possess the qualities of comparability and consistency. Comparability generally relates to the ability to make relative assessments of companies. Investors and creditors all have limited resources and will clearly seek to place their funds with companies offering the best returns commensurate with understandable 5 waL80144_01_c01_001-026.indd 5 8/29/12 2:43 PM CHAPTER 1 Section 1.3 Key Concepts risk levels. This necessarily entails the need to compare companies. Accounting should facilitate such comparisons. This does not mean that all companies must use identical accounting techniques. Accounting disclosures, however, should possess sufficient detail so that careful users can discern differences in firms that are based on economic differences rather than accounting choice. Consistency is a concept that relates to performance assessments over time. Basically, if a firm’s economic activity is consistent from period to period, its accounting measures should also be consistent. Differences in measured outcomes from period to period should be indicative of deviations in business results. Despite accounting’s appearance as concrete and absolute, this is not quite true. Accounting information is often based on arbitrary allocations, assumptions, and individual judgment. Although rooted in mathematics, it nevertheless remains a social science. This concept is often misunderstood, resulting in perhaps excessive fixation on reported results for a single period of time. For example, how much profit is earned in a particular month or quarter when a cell phone is sold for less than cost, but the purchaser is also required to subscribe to a profitable 2-year service plan? There are no absolute answers to such questions; instead accountants routinely embrace estimates and assumptions in the development of periodic financial reports. It is also important to note that it has not been accounting’s historic role to value a business. Accounting information may be useful in supporting this objective, but it is not a primary objective. As such, many transactions and events are reported based on their historical cost. For example, land is typically recorded and carried in the accounting records at its purchase price. The historical cost principle is based on the concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions. An often-debated alternative to historical cost is the fair value (in contrast to historical cost), or fair market value (FMV), approach. Under this technique, assets and liabilities would be periodically revalued based on assessments of current worth, or FMV. Although problematic to implement, proponents of this view argue that it provides more relevant information for decision making. The competing viewpoint holds that FMV accounting is entirely too subjective to form a reliable basis for reporting. Currently, selected financial instruments may be valued at fair value. Otherwise, most U.S. companies fairly well adhere to historical cost measurement principles. Some global firms deploy more extensive fair value reporting, and it is possible that fair value accounting will gain more traction in years to come. The accountant of the future may be called on to develop added skills in valuation methods. This observation is consistent with the ever-changing role of the accounting profession. There are many other guiding principles that you will be exposed to throughout this course. Table 1.1 provides a very high-level view of additional selected concepts and principles that drive accounting practice and judgment. 6 waL80144_01_c01_001-026.indd 6 8/29/12 2:43 PM CHAPTER 1 Section 1.4 The Financial Reporting Model Table 1.1: Selected concepts and principles Basic Concepts, Principles, and Assumptions Materiality Accountants are only concerned with decisions about how to account for matters that would bear on a decision-making process about the entity. Monetary unit Accountants describe the amounts reported on financial statements in measures of money rather than some other basis (e.g., land in acres). Going concern In the absence of evidence to the contrary, accountants assume that the business will continue to operate into the future. Periodicity Accountants assume that business activity can be divided into measurement intervals, such as months, quarters, and years. Economic entity Accountants present information along the lines of distinct economic units. Full disclosure Accountants hold to the principle that all relevant information is adequately described and presented within financial statements and related notes. Stable currency Accountants presume that the currency used to measure financial statement elements is not significantly changed over time because of inflationary effects. 1.4 The Financial Reporting Model D espite major advances in accounting technology and significant growth in the controlling rule set (there are well in excess of 20,000 specific accounting rules), the intrinsic model has changed little in more than 500 years. The model traces its roots to the Renaissance era. A monk named Luca Pacioli developed a method for tracking the success or failure of ocean-going trading ventures. Capitalists of that era pooled their money to invest in ships that circled significant parts of the globe to trade goods. These returning ships then sold the collected wares. What was lacking was a way to track the costs and benefits of these efforts. Friar Pacioli met the challenge by developing a mathematical model that is still central to even the most sophisticated accounting systems of the modern age. Central to the model is the concept that a business entity can be described as a collection of assets and corresponding claims against those assets. Some claims belong to creditors of the business, and the residual claims belong to the owner(s). This gives rise to the following accounting equation: Assets  Liabilities  Owner’s Equity Depending on your life’s experiences, this may or may not seem intuitive. If you own your home or car (an asset) but bought it with a loan on which you still owe some amount, you can probably relate. For example, assume that you bought a house for $200,000 but still owe $125,000 on the loan. Your fundamental accounting equation would be $200,000 (your asset)  $125,000 (your liability)  $75,000 (your equity) You would report that you have equity in your home of $75,000. This is the amount you would get to keep if you sold the home for $200,000. 7 waL80144_01_c01_001-026.indd 7 8/29/12 2:43 PM CHAPTER 1 Section 1.4 The Financial Reporting Model In general, assets are the economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets such as patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner. As previously noted, many assets are measured and reported at their historical cost in the accounting records. Liabilities are the amounts owed to others. Such obligations arise from loans, extensions of credit, and other obligations that occur in the normal course of business. Owner’s equity is the owner “interest” in the business. Because it is equivalent to assets minus liabilities, it also referred to as the net assets of a particular business. For a sole proprietorship, the equity would typically consist of a single owner’s capital account. With a partnership, a separate capital account is maintained for each investor. A corporation’s ownership is represented by divisible units called shares of capital stock. These shares are easily transferable, with the current holder(s) of the stock being the owner(s). The total owner’s equity (i.e., stockholders’ equity) of a corporation usually consists of several amounts. This generally corresponds to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends. (Dividends are distributions to shareholders as a return on their investment.) These undistributed earnings are customarily termed the retained earnings of the business. Knowledge of the fundamental accounting equation is key to understanding one of the most basic financial statements: the balance sheet. A balance sheet reveals the assets, liabilities, and equity of a business at a particular time. Examine Exhibit 1.1, the balance sheet for Clearview Window Washers. Note that the balance sheet’s date is as of a particular time, as indicated by the specific date attached to the statement. Exhibit 1.1: Balance sheet for Clearview Window Washers Clearview Window Washers Balance Sheet December 31, 20X3 Assets Cash Accounts receivable Supplies Land Liabilities Accounts payable $ 54,000 135,000 Loan payable 4,500 Total liabilities 57,000 $ 61,500 Stockholders’ equity 95,000 – Total assets $ 4,500 Capital stock $ 62,000 Retained earnings 165,000 Total liabilities and equity $ 288,500 227,000 $ 288,500 Notice that the balance sheet reveals a listing of assets totaling $288,500. The business owes various creditors a total of $61,500, leaving $227,000 of residual equity attributable to the shareholders of the business. The fundamental accounting equation for Clearview Window Washers is 8 waL80144_01_c01_001-026.indd 8 8/29/12 2:43 PM CHAPTER 1 Section 1.4 The Financial Reporting Model $288,500 (total assets)  $61,500 (total liabilities)  $227,000 (total stockholders’ equity) The equity of $227,000 does not mean that the business is worth $227,000. Remember that many assets are not reported at current value. For example, although the land is reported at its cost of $95,000, it could worth more. Similarly, the business likely has unrecorded resources such as its brand name and customer base. In a contrary fashion, the business may face business risks or pending litigation that might restrict its value. Thus, accounting statements are important in investment and credit decisions, but they are not the sole source of information for evaluating a business. Sources of Capital Clearview Window Washers reported total equity of $227,000. What was the source of that capital? One would generally conclude that it was invested by the company’s shareholders. However, there is another important source of capital to consider, and that is the earnings of the business. Hopefully, over time, a business will prove to be profitable for its owners. The shareholders might receive periodic dividends; however, much of the income will likely be left in the business and reinvested in additional business assets. Thus, equity arises from two principal sources: capital investments and retained earnings. Before proceeding further, it is important to consider concepts of business income. Income can be thought of as the enhancement to the business as a result of providing goods and services to its customers. Mathematically, it is the result of subtracting expenses from revenues. Revenues are the gross inflows from customers, and expenses are the costs incurred in the process of producing those revenues. It is important to note that income and revenue are not synonymous. Very simply, income is revenues minus expenses. Some refer to revenue as the top line and income as the bottom line. You have already seen a balance sheet for Clearview Window Washers. Exhibit 1.2 is an income statement. Note, in particular, the date range shown on the income statement. It is important to identify carefully the period of time during which the revenues and expenses were generated. Exhibit 1.2: Income statement for Clearview Window Washers Clearview Window Washers Income Statement For the Month Ending December 31, 20X3 Revenues Services to customers $ 40,000 Expenses $ 7,000 Wages Supplies 3,000 10,000 Total expenses $ 30,000 Net income Perhaps it goes without saying that a business can also lose money. In other words, expenses can exceed revenues. When this happens, the business is said to have a net loss, and this will reduce retained earnings. Severe losses can erode owner investments and result in negative retained earnings, or accumulated deficit. 9 waL80144_01_c01_001-026.indd 9 8/29/12 2:43 PM CHAPTER 1 Section 1.4 The Financial Reporting Model When a business pays dividends to stockholders, such amounts are not reported as expenses. Granted, they are an outflow from the business, but they are reported separate from the income statement. Dividends are a distribution of income, not a reduction in income. Often, a statement of retained earnings is prepared. This statement builds a bridge between the retained earnings that existed at the beginning and end of a particular period. Exhibit 1.3 is an example of the statement of retained earnings for Clearview Window Washers. Exhibit 1.3: S tatement of retained earnings for Clearview Window Washers Clearview Window Washers Statement of Retained Earnings For the Month Ending December 31, 20X3 Assumed Beginning balance – December 1, 20X3 Plus: Net income $ 140,000 30,000 $ 170,000 Less: Dividends Ending balance – December 31, 20X3 5,000 $ 165,000 If you take time to review the financial statements for a public company that you are familiar with (they are often found on a company’s website under “Investor Relations”), you might find an expanded statement of stockholders’ equity in lieu of the statement of retained earnings. The expanded statement explains not only the periodic change in retained earnings but also shows all other sources of changes in equity. Examples include issuing additional shares of stock, dividends paid in shares of stock, and other unique events. These topics will be covered in a later chapter. For now, let’s stick with the basic statement of retained earnings. It is important to note that the income statement, statement of retained earnings, and balance sheet mesh together in a self-balancing fashion. Exhibit 1.4 shows how income flows from the income statement into the statement of retained earnings. Additionally note how the ending retained earnings from the statement of retained earnings also appear in the balance sheet. This final tie-in causes the balance sheet to balance. 10 waL80144_01_c01_001-026.indd 10 8/29/12 2:43 PM CHAPTER 1 Section 1.4 The Financial Reporting Model Exhibit 1.4: Flow of income Quartz Corporation Balance Sheet December 31, 20X9 Assets Cash $ 192,000 Accounts receivable 128,000 Inventories 120,000 Land 300,000 Building 100,000 Equipment 50,000 Other assets 10,000 Total assets $ 900,000 Liabilities $ 34,000 Salaries payable 166,000 Accounts payable $ 200,000 Total liabilities Stockholders’ equity $ 220,000 Capital stock 480,000 Retained earnings Total stockholders’ equity 700,000 Total liabilities and equity $ 900,000 How the articulation of the income statement, statement of retained earnings, and balance sheet occurs may at first seem mysterious, but the following illustration for Clearview Window Washers will begin to clarify the logic of the self-balancing nature of the core financial statements. Comprehensive Illustration A primary objective of this chapter is to examine business transactions using the accounting equation. You now have a basis for meeting this objective. Recognize that every business transaction has the potential to impact the assets, liabilities, and equity of a business. That impact will not undermine the self-balancing nature of the accounting equation. The reason should become apparent as you review the following example for Clearview Window Washers. The following example includes a summary of transactions and events for Clearview for the month of December, followed by a spreadsheet showing how each transaction impacts the overall accounting equation. The beginning-of-month amounts are all assumed, and the ending balances were used to prepare the financial statements illustrated earlier. Table 1.2 lists December’s transactions. 11 waL80144_01_c01_001-026.indd 11 8/29/12 2:43 PM CHAPTER 1 Section 1.4 The Financial Reporting Model Table 1.2: December’s transactions for Clearview Window Washers Description Amount Discussion of How Balance Is Maintained Provided window-washing services for cash. $10,000 Cash (an asset) and Revenues both increase; revenues increase income, which increases equity. Provided services on account to customers. $30,000 The asset, Accounts Receivable (representing amounts due from customers for work already rendered), is increased, which is matched with an increase in Revenues, which impacts Income and Equity. Collected amounts due from customers for work previously rendered. $20,000 Cash is increased and Accounts Receivable is decreased, resulting in no change in total assets. $3,000 Supplies Expense increases (which impacts Income and Equity); Supplies Inventory decreases. Bought additional supplies on account. $ 2,500 Supplies increase, as does the Accounts Payable liability account. Paid amounts due on outstanding Accounts Payable. $ 6,000 Cash and Accounts Payable are both decreased. Issued additional shares of stock. $12,000 Cash and the Capital Stock account are both increased by the same amount. Purchased land for cash ($20,000) and incurred a $55,000 loan. $75,000 Land (an asset) goes up by $75,000. This is offset by a $20,000 reduction in Cash. The balancing amount of $55,000 is reflected as an increase in the liability account Loan Payable. Paid wages to employees. $ 7,000 Cash is decreased, as is Income/Equity via the recording of Wages Expense. Paid dividends to shareholders. $ 5,000 Cash is decreased and the Dividends account is increased by the same amount (which causes a decrease in Retained Earnings and Equity). Used supplies on hand You should carefully each transaction’s impact within the spreadsheet shown in Exhibit 1.5. This will not be immediately intuitive; you will need to think carefully and slowlabout each entry, noting in particular how (1) the transaction impacts the various accounts and (2) how the equality of the fundamental accounting equation is preserved. CHAPTER 1 Section 1.4 The Financial Reporting Model Exhibit 1.5: S preadsheet for Clearview Window Washers for December Assets Cash Description Assumed Beginning balances $ 50,000 Services for cash + Liabilities Accounts Receivable Supplies $ 125,000 $ 5,000 Accounts payable $ 20,000 $ 8,000 Stockholders’ Equity Loan payable $ 2,000 Capital stock (increase equity) $ 50,000 Dividends Revenues Expenses (decrease equity) 20,000 + 30,000 30,000 – (20,000) Record use of supplies – (3,000) Buy supplies on account + 2,500 + 3,000 + 2,500 – (6,000) – (6,000) Additional investment + (decrease income, thus equity) + 10,000 + Collect account + (increase income, thus equity) Retained Earnings $140,000 10,000 Services on account Pay on account Land + 12,000 12,000 Buy land with cash and loan – (20,000) Pay wages – (7,000) Dividends – (5,000) – – – – – – + 5,000 – – Ending balance $ 54,000 $ 135,000 $ 4,500 $ 95,000 $ 4,500 $ 57,000 $ 62,000 $ 5,000 $ 40,000 $ 10,000 + 75,000 + 55,000 + 7,000 $30,000 Net Income $30,000 – $5,000 = $25,000 Increase in retained earnings Plus beginning retained earnings $140,000 Ending retained earnings $165,000 $288,500 Total Assets $61,500 Total Liabilities $227,000 Total Equity One challenge of accounting is to evaluate each transaction correctly and make sure that it is properly recorded into the accounts. If recording is not done correctly, the fundamental accounting equation will be violated, and it will not be possible to prepare logically “balanced” financial statements. The ability to evaluate and record transactions becomes routine—with practice—much like learning to play a musical instrument. Don’t fret that it is at first a bit confusing. In addition, an actual business would not want to rely on the spreadsheet in Exhibit 1.5 as the heart of its accounting system. Such a system suffers from a number of limitations, which are described in Chapter 2. That chapter will introduce a much better way to record transactions and process them into correct financial statements. Statement of Cash Flows: A Fourth Financial Statement In addition to a balance sheet, income statement, and statement of retained earnings, some businesses will also prepare and present a statement of cash flows. This statement is intended to show how cash is generated and expended during a specific period of 13 waL80144_01_c01_001-026.indd 13 8/29/12 2:43 PM Section 1.5 Usefulness of Accounting in Careers and Life CHAPTER 1 time. Recall that some transactions, such as providing services to customers on account, can impact income without producing any immediate cash effects. Although assessing a business’s income is important, it is sometimes important to also monitor periodic cash flows. Thus, the statement of cash flows identifies cash that is generated by operations. In addition, a comprehensive cash flows statement provides additional disclosures about cash generated or consumed through investing and financing activities. Understanding a statement of cash flows is usually predicated on knowing a number of other accounting subjects. As such, coverage of this important statement is deferred until later. For now, simply begin to appreciate that cash flows and income are not necessarily synonymous, and financial statement users need to be keenly aware of both. 1.5 Usefulness of Accounting in Careers and Life Y ou have probably heard that accounting is a great subject to study, maybe because it is one of the better academic pathways to a good job. In addition, the skills you will learn will prove helpful in managing your personal finances and investments. These are lifelong skills that will continue to serve you for many years to come. If you decide to become an accountant, you will find that there are many specialty areas. Many accountants specialize in public accounting, which involves providing audit, tax, and consulting services to the general public. To specialize in public accounting usually requires licensing. Individual states issue a license called a certified public accountant (CPA). Auditing involves the examination of transactions and systems that underlie an organization’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically and include such diverse activities as information systems engineering and evaluating production methods. Many accountants are privately employed by small and large businesses (i.e., industry accounting) and nonprofit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may serve as internal auditors, who look at controls and procedures in use by their employer. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations. It probably goes without saying that many accountants also work in the governmental sector, whether at the local, state, or national level. Many accountants are employed at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commission, and even the Federal Bureau of Investigation (Table 1.3). 14 waL80144_01_c01_001-026.indd 14 8/29/12 2:43 PM CHAPTER 1 Section 1.6 The Importance of Ethics Table 1.3: Examples of careers in accounting Public-sector accounting Audit and assurance services Tax preparation and planning Business consulting and systems design Private-sector accounting Staff accountant Controller Chief financial officer Tax manager Information technology manager Internal auditor Federal government Internal Revenue Service General Accounting Office Securities and Exchange Commission Federal Bureau of Investigation Nonprofit and state, local governmental sector Staff accountant Tax auditor Chief accounting officer/director Budget officer 1.6 The Importance of Ethics I nvestors and creditors greatly rely on financial statements in making their investment and credit decisions. It is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion. To help ensure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, governmental oversight, and the ever-vigilant plaintiff’s attorney all serve a vital role in providing additional safeguards against the errant accountant. Those who are preparing to enter the accounting profession should do so with the intention of behaving with honor and integrity. Others will likely rely on accountants in some aspect of their personal or professional lives. They have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, they will be entrusting them with financial resources and confidential information. Being ethical can sometimes be more challenging than you might presume. Accounting tasks naturally relate to money. This is especially true for public companies that have share prices prone to fluctuate based on reported income numbers. Sometimes millions of dollars are ultimately at stake based on what the accountants ultimately report. It is easy for accountants to fall into a trap of trying to cover what is seen as a temporary shortfall in income by some type of accounting gimmick. These stories usually end badly because participants tend to get sucked into an ever-worsening pattern of financial deception. In retrospect, participants in these schemes usually report that they initially acted in haste and under pressure. Nevertheless, the consequences tend to be career ending and worse. You must prepare yourself for ethical challenges in advance, so be firm and ready to act in an appropriate manner at all times. Accountants are fiduciaries for others and must act accordingly. 15 waL80144_01_c01_001-026.indd 15 8/29/12 2:43 PM CHAPTER 1 Concept Check In closing, many students cannot envision themselves as accountants. That’s okay. There are two important things to remember. First, accountants often move on to significant business leadership roles. This is true because their accounting training and experience provide the foundation for understanding and being successful in business. Second, people in business often remark that they wish they had studied more and knew more about accounting. In business, they quickly discover that accounting knowledge is essential— indeed paramount. Accounting truly is the language of business. Concept Check The following questions relate to several issues raised in the chapter. Test your knowledge of these issues by selecting the best answer. (The answers appear on p. 235.) 1. The principle of historical cost a. holds that acquisitions of goods and services should be entered in the accounting records at acquisition cost. b. results in the development of subjective financial statements. c. is ideal for use in periods of high inflation. d. is not acceptable when constructing general-purpose financial statements. 2. Apex  Company had owner’s equity of $32,000 on January 1, 20X2. During January, owner investments and withdrawals amounted to $15,000 and $9,000, respectively. In addition, the company generated revenues of $50,000 and expenses of $48,000. What was the amount of owner’s equity on January 31? a. $ 8,000 b. $36,000 c. $40,000 d. $58,000 3. John  Davis recently withdrew $1,000 cash from the Davis Repair Shop, a sole proprietorship. This transaction would a. decrease both assets and liabilities. b. decrease both assets and owner’s equity. c. decrease assets and increase owner’s equity. d. increase both assets and owner’s equity. 4. A  company’s ending accounts receivable balance and the period’s advertising expense would be found on which financial statements, respectively? a. Balance sheet and statement of owner’s equity b. Balance sheet and income statement c. Income statement and balance sheet d. Income statement and statement of owner’s equity 5. X  Company had revenues, expenses, owner investments, and owner with-drawals of $45,000, $35,000, $4,000, and $1,000, respectively. What was the firm’s net income? a. $ 9,000 b. $10,000 c. $13,000 d. $14,000 16 waL80144_01_c01_001-026.indd 16 8/29/12 2:43 PM CHAPTER 1 Key Terms Key Terms assets The economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangibles such as patents and other legal rights and claims. financial accounting Targeted toward reporting financial information about a business to external users such as the owner(s) and creditors. Financial Accounting Standards Board (FASB) A private-sector group primarily responsible for developing the rules that form the foundation of financial reporting. auditing The examination of transactions and systems that underlie an organization’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. GAAP See generally accepted accounting principles. generally accepted accounting principles (GAAP) General-purpose standards intended to be equally useful for all user groups. balance sheet A basic financial statement, it reveals the assets, liabilities, and equity of a business at a particular time. historical cost The concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions. certified public accountant (CPA) A license issued by states that allows an accountant to specialize in public accounting. IASB See International Accounting Standards Board. comparability The ability to make relative assessments of companies. IFRS See international financial reporting standards. consistency A concept that relates performance assessments over time. income The enhancement to the business as a result of providing goods and services to its customers; mathematically, it is the result of subtracting expenses from revenues. corporation A legally created entity that is owned by one or more persons. CPA See certified public accountant. income statement A statement that reports income for a particular time period. dividends Distributions to shareholders as a return on their investment. expenses The costs incurred in the process of producing revenues. internal auditors Those professionals who look at controls and procedures in use by their employer. FASB See Financial Accounting Standards Board. International Accounting Standards Board (IASB) The international counterpart to the FASB, the IASB and FASB work cooperatively on many projects. fair value An assessment based on current worth. 17 waL80144_01_c01_001-026.indd 17 8/29/12 2:43 PM CHAPTER 1 Critical Thinking Questions retained earnings Earnings of a business that are not distributed. international financial reporting standards (IFRS) The effort to establish consistency in global financial reporting. revenues The gross inflows from customers. liabilities The amounts owed to others, such as obligations to loans, extensions of credit, and others that occur in the normal course of business. sole proprietorship A business owned by one person. statement of cash flows A statement intended to show how cash is generated and expended during a specific period of time. managerial accounting Information intended to serve the specific needs of management. net assets Another term for owner’s equity. statement of retained earnings A statement that builds a bridge between the retained earnings that existed at the beginning and end of a particular period. owner’s equity The owner’s “interest” in the business, the equivalent to assets minus liabilities. statement of stockholders’ equity An expanded statement that explains not only the periodic change in retained earnings but also shows all other sources of changes in equity. partnership A type of business considered to exist when there is co-ownership of a business activity carried on with the objective of making a profit. relevance The degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance. tax services Provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. reliability The degree that accounting information is truthful and free from bias, or neutral. Critical Thinking Questions 1. 2. 3. 4. How does financial accounting differ from managerial accounting? What are several limitations of accounting information? How does bookkeeping differ from accounting? Paul Martin is contemplating an investment in the Indiana Company. He has secured the firm’s audited financial statements, which have been examined by a certified public accountant. How can Martin be satisfied that the statements do not present false and incorrect information to purposely mislead investors? 5. Discuss the use of historical cost in the accounting process. Why is historical cost used, and what is one of its chief limitations? 6. Consider the income statement, the statement of owner’s equity, and the balance sheet. Which of these statements cover(s) a period of time as opposed to a specific date? 18 waL80144_01_c01_001-026.indd 18 8/29/12 2:43 PM CHAPTER 1 Exercises Exercises 1. Basic  concepts. Jean’s Marine Supply specializes in the sale of boating equipment and accessories. Identify the items that follow as an asset (A), liability (L), revenue (R), or expense (E) from the firm’s viewpoint. a. The inventory of boating supplies owned by the company b. Monthly rental charges paid for store space c. A loan owed to Citizens Bank d. New computer equipment purchased to handle daily record keeping e. Daily sales made to customers f. Amounts due from customers g. Land owned by the company to be used as a future store site h. Weekly salaries paid to salespeople 2. Basic  computations. The following selected balances were extracted from the accounting records of Rossi Enterprises on December 31, 20X3: Accounts Payable Accounts Receivable Auto Expense Building Cash Fee Revenue $ 3,200 Interest Expense 14,800 $ 2,500 Land 18,000 1,900 Loan Payable 40,000 30,000 Tax Expense 3,300 Utilities Expense 4,100 7,400 56,900 Wage Expense 37,500 a. Determine Rossi’s total assets as of December 31. b. Determine the company’s total liabilities as of December 31. c. Compute 20X3 net income or loss. 3. Impact  of business transactions. The following items describe the impact of a business transaction or event on the components of the accounting equation. Present an example of a transaction or event that correctly matches the described impact. a. Increase an asset and increase a liability. b. Increase one asset and decrease another asset. c. Increase an asset and increase in owner’s equity from a transaction or event not related to income-producing activities. d. Increase an asset and increase in owner’s equity from a transaction or event related to income-producing activities. e. Decrease an asset and decrease a liability. f. Decrease an asset and decrease in owner’s equity from a transaction or event not related to income-producing activities. 19 waL80144_01_c01_001-026.indd 19 8/29/12 2:43 PM CHAPTER 1 Exercises 4. Analysis of transactions. Set up the following headings across a piece of paper: Assets  Liabilities  Owner’s Equity Using “-” and “+,” indicate the effect of each of the following transactions on total assets, liabilities, and owner’s equity: a. Processed a $5,000 cash withdrawal for the owner. b. Recorded the receipt of May’s utility bill, to be paid in June. c. Provided services to customers on account. d. Paid the current month’s advertising charges. e. Purchased a $27,000 delivery truck by paying $5,000 down and securing a loan for the remaining balance. f. Received $11,000 cash from the owner as an investment in the business. g. Returned a new computer and printer purchased earlier in the month on account. The bill had not as yet been paid. h. Paid the utility bill recorded previously in part (b). 5. Accounting  equation; analysis of owner’s equity. Sportscar Repair revealed the following financial data on January 1 and December 31 of the current year. January 1 Assets Liabilities $45,000 $20,000 49,000 31,000 December 31 a. Compute the change in owner’s equity during the year by using the accounting equation. b. Assume that there were no owner investments or withdrawals during the year. What is the probable cause of the change in owner’s equity from part (a)? c. Assume that there were no owner investments during the year. If the owner withdrew $17,000, determine and compute the company’s net income or net loss. Be sure to label your answer. d. If owner investments and withdrawals amounted to $13,000 and $2,000, respectively, determine whether the company operated profitably during the year. Show appropriate calculations. 6. Balance  sheet preparation. The following data relate to Preston Company as of December 31, 20XX: Building $44,000 Accounts Receivable $24,000 Cash 17,000 Loan Payable 30,000 J. Preston, Capital 65,000 Land 21,000 Accounts Payable ? Prepare a balance sheet in good form as of December 31, 20XX. 20 waL80144_01_c01_001-026.indd 20 8/29/12 2:43 PM CHAPTER 1 Exercises 7. I ncome statement concepts. Evaluate the following comments as being true or false. If the comment is false, briefly explain why. a. An income statement reveals the net income or net loss of an entity for a period of time as opposed to a specific date. b. Withdrawals are properly classified as an expense of doing business. c. If a company has $50,000 of revenues for March, it stands to reason that cash receipts for March must total $50,000. d. If expenses exceed revenues, a net loss has been generated. e. A computer acquired late in the year for use in the business should be disclosed on a firm’s income statement. 8. F  inancial statement relationships. The following information appeared on the financial statements of the Altoona Repair Company: Income statement Total expenses $ 64,900 Net income 7,200 Statement of owner’s equity Beginning owner’s equity balance $ 113,200 Owner withdrawals 61,300 Ending owner’s equity balance 70,800 Balance sheet Total liabilities $ 97,000 By picturing the content of and the interrelationships among the financial statements, determine the following: a. Total revenues for the year b. Total owner investments c. Total assets 9.  Financial statement presentation. The accounting records of Hickory Enterprises revealed the following selected information for the year ended December 31, 20X6. Cash investments by the owner $ 59,000 Services rendered to customers 86,000 Cash withdrawals by the owner 12,000 Total year-end assets 177,800 Salaries, advertising, and utilities for the year totaled $68,500. The year-end asset total included a parcel of land that had cost the company $45,000. Hickory’s accountant used this amount for valuation purposes rather than the land’s current market value of $75,000 (as determined by a recent real estate appraisal). 21 waL80144_01_c01_001-026.indd 21 8/29/12 2:43 PM CHAPTER 1 Problems a. Determine the net income to be disclosed on the company’s income statement. b. Compute the increase or decrease in owner’s equity during 20X6. On which financial statement would this information appear? c. Determine and justify the proper valuation for Hickory’s year-end assets. Problems 1. Identification of transactions. The following tabulation summarizes several transactions of the Hartford Company: Assets Cash  $5,000  ccounts A 1 Computer Receivable $13,000 $29,000  Liabilities  Owner’s Equity Accounts Payable  (Investments 2 Withdrawals)  (Revenues 2 Expenses) $17,000 $30,000 Balances a. 2800 b. 1,900 c. 22,000 d. 23,000 e. 2800* 21,900 22,000 10,000 7,000 11,500 f. 11,500* 2,500 g. 2,500 1900 $1,100 $12,600 $41,500 $24,900 2900* $30,300 Transactions in the Owner’s Equity column designated with an asterisk (*) were caused by the company’s income-producing activities. The $2,000 and $2,500 figures are unrelated to such activities. Instructions Write a brief explanation of each transaction. 2. Basic transaction processing. On November 1 of the current year, Richard Parker established a sole proprietorship. The following transactions occurred during the month: 1: Received $19,000 from Parker as an investment in the business. 2: Paid $9,000 to acquire a used minivan. 22 waL80144_01_c01_001-026.indd 22 8/29/12 2:43 PM CHAPTER 1 Problems 3: Purchased $1,800 of office furniture on account. 4: Rendered $2,100 of consulting services on account. 5: Paid $300 of repair expenses. 6: Received $800 from clients who were previously billed in item 4. 7: Paid $500 on account to the supplier of office furniture in item 3. 8: Received a $150 electric bill, to be paid next month. 9: Processed a $600 withdrawal for Parker. 10: Received $250 from clients for consulting services rendered. 11: Returned a $450 office desk to the supplier. The supplier agreed to reduce the balance due. Instructions a. Arrange the following asset, liability, and owner’s equity elements of the accounting equation: Cash, Accounts Receivable, Office Furniture, Van, Accounts Payable, Investments/Withdrawals, and Revenues/Expenses. b. Record each transaction on a separate line. After all transactions have been recorded, compute the balance in each of the preceding items. c. Answer the following questions for Parker. (1) H  ow much does the company owe to its creditors at month-end? On which financial statement(s) would this information be found? (2) D  id the company have a “good” month from an accounting viewpoint? Briefly explain. 3.  Statement preparation. The following information is taken from the accounting records of Grimball Cardiology at the close of business on December 31, 20X1. Accounts Payable $ 14,700 Surgical Expenses 80,000 Cash Surgical Equipment 37,000 Office Equipment Salaries Expense 30,000 Rent Expense 15,000 135,000 Loan Payable 10,300 Accounts Receivable Utilities Expense Surgery Revenue $175,000 60,000 118,000 5,000 All equipment was acquired just prior to year-end. Conversations with the practice’s bookkeeper revealed the following data: Rose Grimball, capital (January 1, 20X1) $300,000 19X1 owner investments 2,000 19X1 owner withdrawals 22,000 23 waL80144_01_c01_001-026.indd 23 8/29/12 2:43 PM CHAPTER 1 Problems Instructions a. Prepare the income statement for Grimball Cardiology in good form. b. Prepare a statement of owner’s equity in good form. c. Prepare Grimball’s balance sheet in good form. 4.  Transaction analysis and statement preparation. The transactions that follow relate to Frisco Enterprises for March 20X1, the company’s first month of activity. 3/1:  eceived $20,000 cash from Joanne Burton, the owner, as an investment R in the business. 3/4: Rendered $2,400 of services on account. 3/7: Acquired a small parcel of land by paying $6,000 cash. 3/12: Received $700 from a client, who was billed previously on March 4. 3/15:  aid $800 to the Journal Herald for advertising that ran during the first P half of the month. 3/18:  cquired $9,000 of equipment from Park Central Outfitters by paying A $7,000 down and agreeing to remit the balance owed within the next 2 weeks. 3/22: Received $300 cash from clients for services performed on this date. 3/24:  aid $1,500 on account to Park Central Outfitters in partial settlement P of the balance due from the transaction on March 18. 3/28:  ented a car from United Car Rental for use on March 28. Total charges R amounted to $75, with United billing Frisco for the amount due. 3/31: Paid $900 for March wages. 3/31: Processed a $600 cash withdrawal from the business for Joanne Burton. Instructions a. Determine the impact of each of the preceding transactions on Frisco’s assets, liabilities, and owner’s equity. Use the following format: Assets 5 Liabilities 1 Owner’s Equity Accounts Cash Receivable Land Equipment Accounts Payable () Investments () Revenues (2) Withdrawals (2) Expenses Record each transaction on a separate line. Calculate balances only after the last transaction has been recorded. b. Prepare an income statement, a statement of owner’s equity, and a balance sheet in good form. 24 waL80144_01_c01_001-026.indd 24 8/29/12 2:43 PM CHAPTER 1 Problems 5.  Financial statement preparation. On October 1, 20X6, Susan Thompson opened Thompson Decorating Services, a sole proprietorship. Susan began operations with $50,000 cash, 60% of which was acquired via an owner investment. The remaining amount was obtained from a bank loan. A review of the accounting records for October revealed the following: • Asset purchases: Van, $16,000; office equipment, $4,000; and decorator (household) furnishings, $17,000. These amounts were paid in cash except for $2,100 that is still owed for the furnishings acquisition. • Services performed: Total billings on account, $18,300. Clients have remitted a total of $14,200 in settlement of their balances due. • Expenses incurred: Salaries, $8,700; advertising, $2,500; taxes, $150; postage, $1,800; utilities, $100; interest, $450; and miscellaneous, $200. These amounts had been paid by month-end with the exception of $700 of the advertising expenditures. Further information revealed that Thompson withdrew $5,500 of cash from the business on October 31. Instructions a. Prepare an income statement for the month ending October 31, 20X6. b. Prepare a statement of owner’s equity for the month ending October 31, 20X6. c. Prepare a balance sheet as of October 31, 20X6. 25 waL80144_01_c01_001-026.indd 25 8/29/12 2:43 PM CHAPTER 1 Problems 6.  Identification of income statement errors. The following income statement was prepared by Action Tree Service’s bookkeeper: ACTION TREE SERVICE Income Statement June 30, 20XX Revenue Services rendered Accounts receivable 34,900 6,100 Owner investments 41,000 6,000 Total revenue $57,000 Less: Salaries expense 15,600 Advertising expense 3,400 Down payment on truck 1,000 Utilities expense Rent expense Tree-trimming equipment Loan payment (includes $600 interest) Miscellaneous expense 900 1,200 15,000 1,900 12,000 Supplies used Owner withdrawals 800 2,000 Total deductions 40,300 Net loss $16,700 Instructions Identify and explain the errors in Action’s income statement. Tell what should be done to correct the errors. (Note: A corrected income statement is not required.) 26 waL80144_01_c01_001-026.indd 26 8/29/12 2:43 PM
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