Accounting Basics

Important Disclaimer
Important Note: The text in this chapter is intended to clarify business-related concepts. It is not intended nor can it replace formal legal advice. Before taking any actions relating to your business, always consult your accountant or a business law/tax attorney.

The Need for Accounting

Every organization needs to maintain good records to track how much money they have, where it came from, and how they spend it. These records are maintained by using an accounting system.

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These records are essential because they can answer such important questions as: Am I making or losing money from my business? How much am I worth? Should I put more money in my business or sell it and go into another business? How much is owed to me, and how much do I owe? How can I change the way I operate to make more profit?

Even if you do not own or run a business, as an accountant you will be asked to provide the valuable information needed to assist management in the decision making process. In addition, these records are invaluable for filing your organizations tax returns. The modern method of accounting is based on the system created by an Italian monk Fra Luca Pacioli. He developed this system over 500 years ago. This great and scientific system was so well designed that even modern accounting principles are based on it. In the past, many businesses maintained their records manually in books hence the term bookkeeping came about. This method of keeping manual records was cumbersome, slow, and prone to human errors of translation. A faster, more organized, and easier method of maintaining books is using Computerized Accounting Programs. With the decrease in the price of computers and accounting programs, this method of keeping books has become very popular.

Accounting and Business

Accounting is the system a company uses to measure its financial performance by noting and classifying all the transactions like sales, purchases, assets, and liabilities in a manner that adheres to certain accepted standard formats. It helps to evaluate a Companys past performance, present condition, and future prospects.

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A more formal definition of accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof.

What Accountants Do
We have said that accounting consists of these functions: Recording Classifying Summarizing Reporting and evaluating the financial activities of a business

Before any recording can take place, there must be something to record. In accounting, the something consists of a transaction or event that has affected the business. Evidence of the transaction is called a document. For example: A sale is made, evidenced by a sales slip. A purchase is made, as evidenced by a check and other documents such as an invoice and a purchase order. Wages are paid to employees with the checks and payroll records as support. Accountants do not record a conversation or an idea. They must first have a document.

In almost any business, these documents are numerous and their recording requires some sort of logical system. Recording is first carried out in a book of original entry called the journal. A journal is a record, listing transactions in a chronological order. At this point, we have a record of a great volume of data. How can this data best be used? Aside from writing down what has occurred for later reference, what has been accomplished? The answer is, of course, that the accountant has only started on his task. This great

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volume of data in detailed listings must be summarized in a meaningful way. When asked, the accountant must turn to these summaries to answer questions like: What were total sales this month? What were the total expenses and what were the types and amounts of each expense? How much cash is on hand? How much does the business owe? How much are the accounts receivable?

The next task after recording and classifying is summarizing the data in a significant fashion. The records kept by the accountant are of little value until the information contained in the records is reported to the owner(s) or manager(s) of the business. These records are reported to the owners by preparing a wide variety of financial statements. The accountant records, classifies, summarizes, and reports transactions that are mainly financial in nature and affect the business. The reporting, of course, involves placing his interpretation on the summarized data by the way he arranges his reports. Every business has a unique method of maintaining its accounting books. However, all accounting systems are similar in the following manner: Business documents representing transactions that have taken place. (A business transaction occurs when goods are sold, a contract is signed, merchandise is purchased, or some similar financial transaction has occurred). Various journals where the documents are recorded in detail and classified Various ledgers where the details recorded in the journals are summarized Financial reports where the summarized information is presented

Where variations exist, they have to do with the way the business transaction is assembled, processed, and recorded.
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These methods are partly arbitrary. First, you must understand certain simple principles of accounting. When you have a firm grasp of the fundamentals you can deal with any kind of accounting problem.

Advantages of Computerized Accounting

Some of the advantages of using a computerized accounting system are: The arithmetic of adding up debits and credits columns is done automatically and with total accuracy by the computer. Audit trails or details are automatically maintained for you. Produce financial statements simply by selecting the appropriate menu item. A computerized system lets you retrieve the latest accounting data quickly, such as todays inventory, the status of a clients payment, or sales figures to date. Data can be kept confidential by taking advantage of the security password systems that most accounting programs provide.

Computerized accounting programs usually consist of several modules. The principal modules commonly used are: General Ledger Inventory Order Entry Accounts Receivable Accounts Payable Bank Manager Payroll

In a good accounting system, the modules are fully integrated. When the system is integrated, the modules share common data. For example, a client sales transaction can be entered in as an invoice, which automatically posts to the General Ledger module without reentering any data. This is one of the greatest advantages of a

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computerized accounting system you need to enter the information only once. As a result of this: Data entry takes less time. There is less chance that errors will occur. You do not have to re-enter data for posting.

Types of Business Organizations

Three principal types of organizations have developed as ways of owning and operating business enterprise. In general, business entity or organizations are: Sole proprietorship Partnerships Corporations

Let us discuss these concepts starting with the simplest form of business organization, the single or sole proprietorship.

Sole Proprietorship
A sole proprietorship is a business wholly owned by a single individual. It is the easiest and the least expensive way to start a business and is often associated with small storekeepers, service shops, and professional people such as doctors, lawyers, or accountants. The sole proprietorship is the most common form of business organization and is relatively free from legal complexities. One major disadvantage of sole proprietorship is unlimited liability since the owner and the business are regarded as the same, from a legal standpoint.

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Partnerships
A partnership is a legal association of two or more individuals called partners and who are co-owners of a business for profit. Like proprietorships, they are easy to form. This type of business organization is based upon a written agreement that details the various interests and right of the partners and it is advisable to get legal advice and document each persons rights and responsibilities. There are three main kinds of partnerships General partnership Limited partnership Master limited partnership

General Partnership
A business that is owned and operated by 2 or more persons where each individual has a right as a co-owner and is liable for the businesss debts. Each partner reports his share of the partnership profits or losses on his individual tax return. The partnership itself is not responsible for any tax liabilities. A partnership must secure a Federal Employee Identification number from the Internal Revenue Service (IRS) using special forms. Each partner reports his share of partnership profits or losses on his individual tax return and pays the tax on those profits. The partnership itself does not pay any taxes on its tax return.

Limited Partnership
In a Limited Partnership, one or more partners run the business as General Partners and the remaining partners are passive investors who become limited partners and are personally liable only for the amount of their investments. They are called limited partners because they cannot be sued for more money than they have invested in the business.

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Limited Partnerships are commonly used for real-estate syndication.

Master Limited Partnership

Master Limited Partnerships are similar to Corporations trading partnership units on listed stock exchanges. They have many advantages that are similar to Corporations e.g. Limited liability, unlimited life, and transferable ownership. In addition, they have the added advantage if 90% of their income is from passive sources (e.g. rental income), then they pay no corporate taxes since the profits are paid to the stockholders who are taxed at individual rates.

Corporations
The Corporation is the most dominant form of business organization in our society. A Corporation is a legally chartered enterprise with most legal rights of a person including the right to conduct business, own, sell and transfer property, make contracts, borrow money, sue and be sued, and pay taxes. Since the Corporation exists as a separate entity apart from an individual, it is legally responsible for its actions and debts. The modern Corporation evolved in the beginning of this century when large sums of money were required to build railroads and steel mills and the like and no one individual or partnership could hope to raise. The solution was to sell shares to numerous investors (shareholders) who in turn would get a cut of the profits in exchange for their money. To protect these investors associated with such large undertakings, their liability was limited to the amount of their investment. Since this seemed to be such a good solution, Corporations became a vibrant part of our nations economy. As rules and regulations evolved as to what a Corporation could or could not do, Corporations acquired most of the legal rights as those of people in that it could receive, own sell and transfer property, make contracts, borrow money, sue and be sued and pay taxes.

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The strength of a Corporation is that its ownership and management are separate. In theory, the owners may get rid of the Managers if they vote to do so. Conversely, because the shares of the company known as stock can sold to someone else, the Companys ownership can change drastically, while the management stays the same. The Corporations unlimited life span coupled with its ability to raise money gives it the potential for significant growth. A Company does not have to be large to incorporate. In fact, most corporations, like most businesses, are relatively small, and most small corporations are privately held. Some of the disadvantages of Corporations are that incorporated businesses suffer from higher taxes than unincorporated businesses. In addition, shareholders must pay income tax on their share of the Companys profit that they receive as dividends. This means that corporate profits are taxed twice. There are several different types of Corporation based on various distinctions, the first of which is to determine if it is a public, quasipublic or Private Corporation. Federal or state governments form Public Corporations for a specific public purpose such as making student loans, building dams, running local school districts etc. Quasi-public Corporations are public utilities, local phones, water, and natural gas. Private Corporations are companies owned by individuals or other companies and their investors buy stock in the open market. This gives private corporations access to large amounts of capital. Public and private corporations can be for-profit or non-profit corporations. For-profit corporations are formed to earn money for their owners. Non-profit Corporations have other goals such as those targeted by charitable, educational, or fraternal organizations. No stockholder shares in the profits or losses and they are exempt from corporate income taxes. Professional Corporations are set up by businesses whose shareholders offer professional services (legal, medical, engineering, etc.) and can set up beneficial pension and insurance packages.

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Limited Liability Companies (LLCs as they are called) combine the advantages of S Corporations and limited partnerships, without having to abide by the restrictions of either. LLCs allow companies to pay taxes like partnerships and have the advantage of protection from liabilities beyond their investments. Moreover, LLCs can have over 35 investors or shareholders (with a minimum of 2 shareholders). Participation in management is not restricted, but its life span is limited to 30 years.

Subchapter S Corporation
Subchapter S Corporation, also known as an S Corporation is a cross between a partnership and a corporation. However, many states do not recognize a Subchapter S selection for state tax purposes and will tax the corporation as a regular corporation. The flexibility of these corporations makes them popular with smalland medium-sized businesses. Subchapter S allows profits or losses to travel directly through the corporation to you and to the shareholders. If you earn other income during the first year and the corporation has a loss, you may deduct against the other income, possibly wiping out your tax liability completely subject to the limitations of Internal Revenue Service tax regulations. Subchapter S corporations elect not to be taxed as corporations; instead, the shareholders of a Subchapter S corporation include their proportionate shares of the corporate profits and losses in their individual gross incomes. Subchapter S corporations are excellent devices to allow small businesses to avoid double taxation. If your company does produce a substantial profit, forming a Subchapter S Corporation would be wise, because the profits will be added to your personal income and taxed at an individual rate. These taxes may be lower than the regular corporate rate on that income. To qualify under Subchapter S, the corporation must be a domestic corporation and must not be a member of an affiliated group. Some of the other restrictions include that it must not have more than 35 shareholders all of who are either individuals or estates. Subchapter S corporations can have an unlimited amount of passive income from rents, royalties, and interest. For more information on the rules that apply to a Subchapter S corporation, contact your local IRS office.
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Limited Liability Company

Limited Liability Companies (LLCs as they are called) combine the advantages of S Corporations and limited partnerships, without having to abide by the restrictions of either. LLCs allow companies to pay taxes like partnerships and have the advantage of protection from liabilities beyond their investments. Moreover, LLCs can have over 35 investors or shareholders (with a minimum of 2 shareholders). Participation in management is not restricted, but its life span is limited to 30 years.

The Business Entity Concept

It is an important accounting principle that the business is treated as an entity separate and distinct from its owners and any other people associated with it. This principle is called the Business Entity Concept. It simply means that accounting records and reports are concerned with the business entity, not with the people associated with the business. Now, lets us review the two main accounting methods.

Types of Accounting
The two methods of tracking your accounting records are: Cash Based Accounting Accrual Method of Accounting

Cash Based Accounting

Most of us use the cash method to keep track of our personal financial activities. The cash method recognizes revenue when payment is received, and recognizes expenses when cash is paid out. For example, your personal checkbook record is based on the cash

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method. Expenses are recorded when cash is paid out and revenue is recorded when cash or check deposits are received.

Accrual Accounting
The accrual method of accounting requires that revenue be recognized and assigned to the accounting period in which it is earned. Similarly, expenses must be recognized and assigned to the accounting period in which they are incurred. A Company tracks the summary of the accounting activity in time intervals called Accounting periods. These periods are usually a month long. It is also common for a company to create an annual statement of records. This annual period is also called a Fiscal or an Accounting Year. The accrual method relies on the principle of matching revenues and expenses. This principle says that the expenses for a period, which are the costs of doing business to earn income, should be compared to the revenues for the period, which are the income earned as the result of those expenses. In other words, the expenses for the period should accurately match up with the costs of producing revenue for the period. In general, there are two types of adjustments that need to be made at the end of the accounting period. The first type of adjustment arises when more expense or revenue has been recorded than was actually incurred or earned during the accounting period. An example of this might be the pre-payment of a 2-year insurance premium, say, for $2000. The actual insurance expense for the year would be only $1000. Therefore, an adjusting entry at the end of the accounting period is necessary to show the correct amount of insurance expense for that period. Similarly, there may be revenue that was received but not actually earned during the accounting period. For example, the business may have been paid for services that will not actually be provided or earned until the next year. In this case, an adjusting entry at the end of the accounting period is made to defer, that is, to postpone, the recognition of revenue to the period it is actually earned.

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Although many companies use the accrual method of accounting, some small businesses prefer the cash basis. The accrual method generates tax obligations before the cash has been collected. This benefits the Government because the IRS gets its tax money sooner.

Cash versus Accrual Accounting

Accounts Receivable is an asset that is owed to you but you do not have money in the bank or property to show you own something - it is intangible, on paper. It grows or accumulates as you issue invoices; therefore, Accounts Receivable is part of an accrual accounting system. Double-entry accounting is the most accurate and best way to keep your financial records. With a computer, you dont have to fully understand all the accounting details. Basically, in double entry accounting each transaction affects two or more categories or accounts, so everything stays in balance. Therefore, if you change an asset balance by issuing an invoice some other category balance changes as well. In this case, when you issue an invoice, the category that balances the asset called Accounts Receivable is an income or a sales account. When you bill your client, there is an increase in income (on paper) and hence an increase in Accounts Receivable. When you are paid, the paper asset turns into money you put in the bank a tangible asset. Through a process of recording the payment and the deposit, Accounts Receivable decreases and the bank balance increases. This accounting program takes care of all the accounting details. This paper income can be confusing if you dont understand that it is the total of all invoiced work, both paid and unpaid. If you have invoiced clients for a total of $10,000 but only $2,000 has been paid, your income will be $10,000 and your Accounts Receivable balance will be $8,000, and your bank account has increased by the $2,000 you received. An accountant would call this an accrual accounting method. A cash accounting method only counts income when money is received, and it does not keep track of Accounts Receivable.

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However, in real life, small businesses tend to use both methods without realizing the difference until income tax time. This program can handle both accrual and cash based accounting. You can use the G/L Setup option in the G/L module to select either Cash or Accrual based accounting. We recommended that you consult with your accountant to determine which system will work best for you.

Accounts
The accounting system uses Accounts to keep track of information. Here is a simple way to understand what accounts are. In your office, you usually keep a filing cabinet. In this filing cabinet, you have multiple file folders. Each file folder gives information for a specific topic only. For example you may have a file for utility bills, phone bills, employee wages, bank deposits, bank loans etc. A chart of accounts is like a filing cabinet. Each account in this chart is like a file folder. Accounts keep track of money spent, earned, owned, or owed. Each account keeps track of a specific topic only. For example, the money in your bank or the checking account would be recorded in an account called Cash in Bank. The value of your office furniture would be stored in another account. Likewise, the amount you borrowed from a bank would be stored in a separate account. Each account has a balance representing the value of the item as an amount of money. Accounts are divided into several categories like Assets, Liabilities, Income, and Expense accounts. A successful business will generally have more assets than liabilities. Income and Expense accounts keep track of where your money comes from and on what you spend it. This helps make sure you always have more assets than liabilities.

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Account Types
In order to track money within an organization, different types of accounting categories exist. These categories are used to denote if the money is owned or owed by the organization. Let us discuss the three main categories: Assets, Liabilities, and Capital.

Assets
An Asset is a property of value owned by a business. Physical objects and intangible rights such as money, accounts receivable, merchandise, machinery, buildings, and inventories for sale are common examples of business assets as they have economic value for the owner. Accounts receivable is an unwritten promise by a client to pay later for goods sold or services rendered. Assets are generally listed on a balance sheet according to the ease with which they can be converted to cash. They are generally divided into three main groups: Current Fixed Intangible

Current Asset
A Current Asset is an asset that is either: Cash includes funds in checking and savings accounts Marketable securities such as stocks, bonds, and similar investments Accounts Receivables, which are amounts due from customers Notes Receivables, which are promissory notes by customers to pay a definite sum plus interest on a certain date at a certain place. Inventories such as raw materials or merchandise on hand Prepaid expenses supplies on hand and services paid for but not yet used (e.g. prepaid insurance)

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In other words, cash and other items that can be turned back into cash within a year are considered a current asset.

Fixed Assets
Fixed Assets refer to tangible assets that are used in the business. Commonly, fixed assets are long-lived resources that are used in the production of finished goods. Examples are buildings, land, equipment, furniture, and fixtures. These assets are often included under the title property, plant, and equipment that are used in running a business. There are four qualities usually required for an item to be classified as a fixed asset. The item must be: Tangible Long-lived Used in the business Not be available for sale

Certain long-lived assets such as machinery, cars, or equipment slowly wear out or become obsolete. The cost of such as assets is systematically spread over its estimated useful life. This process is called depreciation if the asset involved is a tangible object such as a building or amortization if the asset involved is an intangible asset such as a patent. Of the different kinds of fixed assets, only land does not depreciate.

Intangible Assets
Intangible Assets are assets that are not physical assets like equipment and machinery but are valuable because they can be licensed or sold outright to others. They include cost of organizing a business, obtaining copyrights, registering trademarks, patents on an invention or process and goodwill. Goodwill is not entered as an asset unless the business has been purchased. It is the least tangible of all the assets because it is the price a purchaser is willing to pay for a companys reputation especially in its relations with customers.

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Liabilities
A Liability is a legal obligation of a business to pay a debt. Debt can be paid with money, goods, or services, but is usually paid in cash. The most common liabilities are notes payable and accounts payable. Accounts payable is an unwritten promise to pay suppliers or lenders specified sums of money at a definite future date.

Current Liabilities
Current Liabilities are liabilities that are due within a relatively short period of time. The term Current Liability is used to designate obligations whose payment is expected to require the use of existing current assets. Among current liabilities are Accounts Payable, Notes Payable, and Accrued Expenses. These are exactly like their receivable counterparts except the debtor-creditor relationship is reversed. Accounts Payable is generally a liability resulting from buying goods and services on credit Suppose a business borrows $5,000 from the bank for a 90-day period. When the money is borrowed, the business has incurred a liability a Note Payable. The bank may require a written promise to pay before lending any amount although there are many credit plans, such as revolving credit where the promise to pay back is not in note form. On the other hand, suppose the business purchases supplies from the ABC Company for $1,000 and agrees to pay within 30 days. Upon acquiring title to the goods, the business has a liability an Account Payable to the ABC Company. In both cases, the business has become a debtor and owes money to a creditor. Other current liabilities commonly found on the balance sheet include salaries payable and taxes payable. Another type of current liability is Accrued Expenses. These are expenses that have been incurred but the bills have not been received

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for it. Interest, taxes, and wages are some examples of expenses that will have to be paid in the near future.

Long-Term Liabilities
Long-Term Liabilities are obligations that will not become due for a comparatively long period of time. The usual rule of thumb is that long-term liabilities are not due within one year. These include such things as bonds payable, mortgage note payable, and any other debts that do not have to be paid within one year. You should note that as the long-term obligations come within the one-year range they become Current Liabilities. For example, mortgage is a long-term debt and payment is spread over a number of years. However, the installment due within one year of the date of the balance sheet is classified as a current liability.

Capital
Capital, also called net worth, is essentially what is yours what would be left over if you paid off everyone the company owes money to. If there are no business liabilities, the Capital, Net Worth, or Owner Equity is equal to the total amount of the Assets of the business.

Key Accounting Concepts

The two fundamental accounting concepts which were developed centuries ago but remain central to the accounting process are: The accounting equation Double-entry bookkeeping

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The Accounting Equation

Now let us discuss the accounting equation, which keeps all the business accounts in balance. We will create this equation in steps to clarify your understanding of this concept. In order to start a business, the owner usually has to put some money down to finance the business operations. Since the owner provides this money, it is called Owners equity. In addition, this money is an Asset for the company. This can be represented by the equation:

ASSETS = OWNERS EQUITY

If the owner of the business were to close down this business, he would receive all its assets. Lets say that owner decides to accept a loan from the bank. When the business decides to accept the loan, their Assets would increase by the amount of the loan. In addition, this loan is also a Liability for the company. This can be represented by the equation:

Assets = Liabilities + Owners Equity

Now the Assets of the company consist of the money invested by the owner, (i.e. Owners Equity), and the loan taken from the bank, (i.e. a Liability). The companys liabilities are placed before the owners equity because creditors have first claim on assets. If the business were to close down, after the liabilities are paid off, anything left over (assets) would belong to the owner.

The Double Entry System

As we had mentioned earlier that todays accounting principles are based on the system created by an Italian Monk Fra Luca Pacioli. He developed this system over 500 years ago. Pacioli had devised this method of keeping books, which is today known as the Double Entry system of accounting. He explained that every time a transaction took place whether it was a sale or a collection there were two

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offsetting sides. The entry required a two-part give-and-get entry for each transaction. Here is a simple explanation of the double entry system. Say you took a loan from the bank for $5,000. Now if you can recall in an earlier discussion we had mentioned that:

ASSETS = LIABILITIES + OWNERS EQUITY

Since the company borrowed money from the bank, the $5,000 is a liability for the company. In addition, now that the company has the extra $5,000, this money is an asset for the company. If we were to record this information in our accounts, we would put $5,000 in an account called Loan Taken from the Bank, and $5,000 in an account called Cash Saved in the Bank. The former account will be a Liability and the second account would be an Asset. As you can see, we created two entries. The first one is to show from where the money was received (i.e. the source of the money). The second entry is to show where the money was sent (i.e. the destination of the money received). In a double entry accounting system, every transaction is recorded in the form of debits and credits. Even for the simplest double entry, transaction there will be a debit and a credit. In simpler terms, a debit is the application of money, and credit is the source of money. Let us discuss some examples to help you understand the concept of debits and credits:

Example 1
Lets say you wrote a check for $100 to purchase some stationary. This transaction would be recorded as a Credit of $100 to the Cash in Bank account, and a Debit of $100 to the Stationary account. In this case, we made a credit to the Cash in Bank, as it was the source of the money. The Stationary account was debited, as it was the application of the money.

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Example 2
Lets say you received $200 cash for services rendered to a client. This transaction would be recorded as a Credit of $200 to the Income from Services account, and a Debit of $200 to the Cash in Bank account. In this case, we made a credit to the Income from Services, as it was the source of the money. The Cash in Bank account was debited, as it was the application of the money.

Example 3
Lets say you received a $10,000 loan from a bank. This transaction would be recorded as a Credit of $10,000 to the Loan Payable account, and a Debit of $10,000 to the Cash in Bank account. In this case, we made a credit to Loan Payable, as it was the source of the money. The Cash in Bank account was debited, as it was the application of the money.

Example 4
Lets say you made out a payroll check to an employee for $300. This transaction would be recorded as a Credit of $300 to the Cash in Bank account, and a Debit of $300 to the Payroll Expense account. In this case, we made a credit to the Cash in Bank, as it was the source of the money. The Payroll Expense account was debited, as it was the application of the money.

Example 5
Lets say you invested $10,000 in starting a new business. This transaction would be recorded as a Credit of $10,000 to the Owners equity account, and a Debit of $10,000 to the Cash in Bank account. In this case, we made a credit to the Owners equity, as it was the source of the money. The Cash in Bank account was debited, as it was the application of the money. You may remember from our discussion earlier that in order to start a business, the owner usually has to put some money down to finance the business operations. Since the owner provides this money, it is called Owners Equity.

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Overview
The previous examples illustrated some of the transactions that are recorded in a double entry accounting system. These transactions are also referred to as Journal Entries. Your accounting application automatically creates the journal entries for you. In example 1 above, you would create a check in the system, and on the check you would give the expense account number for stationary. The checkbook program would then automatically credit the cash account, and debit the stationary expense account.

Journals
Looking at the ledger account alone, it is difficult to trace back all the accounts that were affected by a transaction. For this reason, another book is used to record each transaction as it takes place and to show all the accounts affected by the transaction. This book is called the General Journal, or Journal. Each transaction is first recorded in the journal and then the appropriate entries are made to the accounts in the G/L. Because the journal is the first place a transaction is recorded it is called the book of original entry. The advantage of the journal is that it shows all the accounts that are affected by a transaction, and the amounts the appropriate accounts are debited and credited, all in one place. Also included with each transaction is an explanation of what the transaction is for. Transactions are recorded in the journal as they take place, so the journal is a chronological record of all transactions conducted by the business. There is a standard format for recording transactions in the journal. A journal transaction usually consists of the following: Journal Transaction Number Transaction Date Journal Type (General Journal, Sales Journal etc.) Actual Journal entries adjusting the account balances

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In addition to the General Journal, other specialized journals contain entries from other accounting modules to track sales, purchases, and the disbursement of cash. Some of the important journals are: Invoice Journal Report The Cash Receipts Report The Purchases Journal A/P Journal (Transactions & Payments) Reports

This program comes with sample chart of accounts already installed. If you prefer, you can modify these accounts or create your own chart of accounts. In addition, all the Debits, Credit, and Journals are automatically maintained for you. When you create invoices, checks and other transactions in the system all the journal entries are created for you automatically. It is that easy!

Managing Your Business

We have covered the areas of accounts, debits, credits, and the accounting equation. In order to control your business you must manage key areas. These areas are Cash, Sales, Income, Expenses, Assets, Inventory, and Payroll. We will discuss each of these areas in the following sections.

Managing Cash
Bank Reconciliation
Typically, a business will use a bank checking account to help control the flow of cash. Cash received during the day is deposited periodically in the bank account and checks are written on the account whenever cash is paid out. When the bank account is opened, each authorized person signs a signature card. The bank can use the signature card at any time to

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make sure that the signature on the check is authentic and that money can be paid out of that account. When cash is deposited into the account, a deposit ticket is filled out listing the check number and the amount of each check and any additional currency. As the business makes payments, it will write checks on the bank account and record each check payment in the checkbook or on the check stub. Every month, the bank will send the business a bank statement, along with the cancelled checks paid that month. The bank statement shows the balance at the beginning of the month, it lists each check paid, each deposit, any other charges or credits to the account, and it shows the balance at the end of the month. Usually the ending balances on the bank statement will not match the current cash account balance shown in the checkbook. This is because there may be checks that have been written and recorded in the checkbook but have not yet been processed and paid by the bank. There may also be service or other charges the bank has deducted from the bank statement balance but which have not yet been recorded and deducted from the checkbook balance. For this reason, it is necessary at the end of each month to reconcile your bank statement. This is simply the process of making the proper adjustments to both the bank statement balance and to the checkbook balance to prove that they do in fact balance. There are three steps to reconcile your bank statement. Step 1: Compare the deposits shown in the checkbook with those shown on the bank statement. Any deposits not yet shown on the bank statement are deposits in transit, that is, they are not yet received and recorded by the bank. Subtract the total of the deposits in transit from the final balance in your checkbook. Compare the canceled checks as shown on the bank statement with those recorded as written in the checkbook. Checks that have been written but not yet

Step 2:

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processed and paid by the bank are called outstanding checks. Add the total of the outstanding checks to the final balance in your checkbook. Step 3: Now look at the bank statement and see if there are any service charges or credits that are not yet recorded in the checkbook. Add the credits and subtract the charges from the final balance of your checkbook. The adjusted balances of your checkbook will now be equal to the ending balance on the bank statement.

All the checks and deposits entered in this program automatically list on the checkbook reconciliation screen. This saves time and makes the reconciliation process quick and easy.

Petty Cash
As we had discussed earlier, the principal method for maintaining internal control of cash is using a checking account. However, a business usually has minor expenses, such as postage or minor purchases of supplies that are easier to pay for with currency rather than with a check. To handle these minor expenses, a petty cash fund is set up. A small amount of money, like $100, is placed in a petty cash box or drawer and an individual is given responsibility for the funds. This individual is the petty cashier. When money is needed for an expense, the cashier prepares a pettycash ticket, which shows the date, amount, and purpose of the expense and includes the signature of the person receiving the money. This ticket is then placed in the petty cash box. At any time, the total amount of cash in the box plus the total amount of all tickets should equal the original fixed amount of cash originally placed in the box. As expenditures are made, the petty cash fund will eventually need to be replenished. This is usually done by writing a check to bring the amount in the fund back to the original amount of $100.

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Managing Sales
Sales made by businesses can be broken down into the following main categories: Cash sales Sales on account

Cash Sales
Some businesses sell merchandise for cash only, while others sell merchandise either for cash or on account. A variety of practices are followed in the handling of cash sales. If such transactions are numerous, it is probable that one or more types of cash registers will be used. In this instance, the original record of the sales is made in the register. Often, registers have the capability of accumulating more than one total. This means that by using the proper key, each amount that is punched in the register can be classified by type of merchandise, by department, or by salesperson. Where sales tax is involved, the amount of the tax may be separately recorded. In accounting terms, a cash sale means that the asset Cash is increased by a debit and the income account Sales and a liability account Sales Tax Payable are credited. This displays in the table below:
Debit Credit

Cash Sales Sales Tax Total

110.00 100.00 10.00 110.0 110.00

In many retail establishments, the procedure in handling cash sales is for the sale clerks to prepare sale tickets in triplicate. Sometimes the preparation of the sales tickets involves the use of a cash register that prints the amount of the sale directly on the ticket. Modern electronic cash registers serve as input terminals that are online with computers, that is, in direct communication with the central
30 Accounting Basics Accounting for Windows

processor. At the end of each day, the cash received is compared with the record that the register provides. The receipts may also be compared with the total of the cash-sales tickets, if the system makes use of the latter.

Sales on Account
Sales on account are often referred to as charge sales because the seller exchanges merchandise for the buyers promise to pay. In accounting terms, this means that the asset Accounts Receivable of the seller is increased by a debit or charge, and the income account sales is increased by a credit. Selling goods on account is common practice at the retail level of the distribution process. Firms that sell goods on account should investigate the financial reliability of their clients. A business of some size may have a separate credit department whose major function is to establish credit policies and decide upon requests for credit from persons and firms who wish to buy goods on account. Seasoned judgment is needed to avoid a credit policy that is so stringent that profitable business may be refused, or a credit policy that is so liberal that uncollectable account losses may become excessive. Generally, no goods are delivered until the salesclerk is assured that the buyer has established credit - that there is an account established for this client with the company. In the case of many retail businesses, clients with established credit are provided with credit cards or charge plates, which provide evidence that the buyer has an account. These are used in mechanical or electronic devices to print the clients name and other identification on the sales tickets. In the case of merchants who commonly receive a large portion of their orders by mail or by phone, this confirmation of the buyers status can be handled as a matter of routine before the goods are delivered.

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Managing Expenses
The Expense Authorization system is a commonly used method to keep track of and control expenses. It is based upon the use of tickets. These tickets are written authorizations prepared for each expense. With this system, before a check is written, a ticket is prepared authorizing payment. This system provides an excellent control over expenses. It does this by making sure that each expense is justified and by requiring more than one person to be responsible for preparing and authorizing the payment. A ticket is prepared for every transaction that results in an expense. When an invoice for a purchase is received, it is attached to a ticket, which is then filled out and signed. The information that goes on the front side of the ticket verifies the information on the invoice. Once the information is verified, an approval signature is required to authorize the expense. Once the ticket is approved, it is recorded in an expense register. Tickets are recorded in the register in date order. Once recorded, the ticket is put into an Unpaid Ticket File where it remains until it is paid. The tickets are filed according to the date they should be paid in order to take advantage of discounts. When it comes time to pay a ticket, it is removed from the Unpaid Tickets File and a check is issued. The check number and payment date is recorded on the ticket and in the Ticket Register next to that ticket entry. Each ticket is paid by check. As each ticket is paid, the payment is recorded in a Check Register. With the ticket system, the Check Register is the book of original entry for recording payments and it takes the place of a cash payments journal. In a computerized accounting system, the function for controlling expenses is controlled by the Accounts Payable program. You would enter, track and pay your invoices with Accounts Payable.

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Managing Inventory
Merchandise Inventory
Merchandise inventories are the goods that are on hand for the production process or available for sale to final customers. There are two basic methods for determining inventory: Perpetual inventory method Periodic inventory method

With the perpetual inventory method, the cost of each item in the inventory is recorded when purchased. When an item is sold, its cost is deducted from the inventory. This results in a perpetual record of exactly what is in inventory. The perpetual inventory method is best suited for those businesses that have a relatively low number of sales each day and whose merchandise has a high unit value. For example, a car dealer might use the perpetual inventory method to keep track of inventory because it is easy to keep track of each item as it is purchased by the business and then resold. This program uses the perpetual method and automatically tracks your inventory value. This program makes it easy for businesses such as department and grocery stores that have a large number of sales each day to track inventory value on a real-time basis. For businesses that manually maintain track inventory value, it wouldnt be practical to adjust the cost of inventory each time an item is sold. Instead, these types of business use the periodic inventory method, which involves periodically taking a physical count of the merchandise on hand, usually once a year at the end of the accounting period. Once the physical count is done, the exact quantity of merchandise on hand is known. The costs of all items on hand are then totaled to give a total cost of the inventory on hand at the end of the year.

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Calculating Inventory Value

A company can raise or lower its earnings by changing the way it calculates the cost of goods sold. As inventory items are purchased during the accounting period, their unit cost may vary. A costing method is a way of calculating the cost of goods sold. The first time you purchase a product, the value is whatever you paid. Once you receive more stock at a different price, it is necessary to use one of the three standard methods to determine the value of what you sell. The three most popular methods used to determine the value of the ending inventory are: First in, First out (FIFO) Last in, First out (LIFO) Average cost

Important Note: You should consult your accountant regarding the method that best suits your needs.

First in, First out (FIFO) This method assumes that the first item to come into the inventory are the first items sold, so the most recent unit cost is used to determine the inventorys value. FIFO assumes that the oldest stock you have is sold first. At a time when your cost is constantly increasing, the first items sold are the least expensive ones, therefore your cost of goods sold is low and your income is greater. Last in, First out (LIFO) This method assumes that the last item to come into the inventory are the first items sold, so the oldest unit cost is used to determine the inventorys value. With LIFO, the newest stock is sold first. An inventory value should generally reflect the replacement cost of your stock and that is what LIFO does. When prices are increasing LIFO will calculate cost of goods sold at the most recent price, resulting in a higher cost of goods and lower income. Average Cost This method uses the average unit cost for all items that were available for sale during the accounting period. The Average method
34 Accounting Basics Accounting for Windows

is the total cost of all goods divided by the number in stock. This has the effect of leveling out price fluctuations, providing a constant cost of goods and income. Let us discuss an example that will clarify this concept. For example, suppose you sell Boxes. On August 1, you purchase 100 Boxes for $1.00 each for a total cost of $100. On August 2, you purchase another 100 Boxes, this time at $1.25 per box for a total cost of $125. You now have purchased 200 Boxes for $225. On August 3, you sell 50 Boxes for $1.50 each for a total of $75. Depending which costing method you are using, your income will be different: FIFO: This method would assume the 50 boxes you sold were from the first 100 boxes you bought (at $1 each). Your cost of goods would be $50 and your profit would be $25. LIFO: It is assumed that the 50 boxes sold were from the last 100 boxes you purchased (at $1.25 each). Your cost of goods is then $62.50 for a profit of $12.50. Average: This method will consider only that you bought 200 boxes for $225, for an average cost of $1.125 each. Your cost for the 50 boxes sold is $56.25 and you will have a profit of $18.75. When the income statement is prepared, the cost of inventory on hand is subtracted from the Cost of Goods Available for Sale during the year. This yields the Cost of Goods Sold for the year. You should check with your accountant to determine which method suits your needs.

Break-Even Point
One of the first steps in evaluating a business is determining your break-even point. This is the number of units of your product, which must be sold for income to equal all expenses incurred in producing the merchandise. Logic would dictate that if you are in a high rent area and need to sell half your stock of art objects each month in order to break even, you have started a losing business.

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Assuming your product or service is a worthwhile one, the control of your overhead is the key to your profit. Overhead consists of fixed costs, such as rent, insurance, and payment on bank notes, etc., which will not vary if your production increases. It also includes variable and semi-variable costs. Variables mean such items as commissions to salespeople, purchases of raw materials; and other overhead, which increase in direct proportion to changes in production volume. That is to say, if a company that has been making 10,000 snow shovels per month, for example, doubled production to the 20,000 level, then purchase of raw materials, sales commissions, and other expenses would also increase. Semi-variable costs will vary with volume, but not in direct proportion. The cost of lighting and power will increase with greater production. Each unit produced should provide some margin for fixed costs and profits. Or expressed a different way, at no point should the direct cost, not the fixed cost, of producing a unit be greater than its sales price. Your fixed cost per unit will vary inversely with changes in volume. Since your fixed overhead will not increase as a result of greater production, and semi-variable costs will increase by a percentage considerably lower than the rate of increased production, it follows that your cost per unit will lessen as greater quantities are produced. The experienced businessman uses his break-even charts to indicate profit margins at a given rate of production. However, the chart is useful only when fixed costs remain the same, when variable percentage can be plotted with reasonable accuracy, and when a company produces only one item.

Managing Payroll
Payroll Records
An employer, regardless of the number of employees, must maintain all records pertaining to payroll taxes (income tax withholding, Social Security, and federal unemployment tax)

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There are several different kinds of employment records that must be maintained to satisfy federal requirements. These records are summarized below: Income-Tax-Withholding Records Name, address, and Social Security number of each employee Amount and date of each payment of compensation Amount of wages subject to withholding in each payment Amount of withholding tax collected from each payment Reason that the taxable amount is less than the total payment Statement relating to employees non-resident alien status Market value and date of non-cash compensation Information about payments made under sick-pay plans Withholding exemption certificates Agreements regarding the voluntary withholding of extra cash Dates and payments to employees for non-business services Statements of tips received by employees Requests for different computation of withholding taxes

Social Security (FICA) Tax Records Amount of each payment subject to FICA tax Amount and date of FICA tax collected from each payment Explanation for the difference, if any

Unemployment and Disability Records Total amount paid during calendar year Amount subject to unemployment tax Amount of contributions paid into the state unemployment fund Any other information requested on the unemployment tax return State disability contributions

Financial Statements
In order to manage your business effectively you need reports that tell you how your business is performing. For example, you may want to know the value of your assets like, Cash you have on hand,

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Cash in bank, and Inventory in stock. In addition, you would like to know the value of your liabilities, loans, income earned, and expenses incurred. Accountants prepare financial statements that summarize these transactions. Two of the most important reports for managing your business are Income Statement and the Balance Sheet.

Income Statement
An Income Statement is also called a Profit and Loss Report. In addition, the word Revenue is often used in place of the word Income. An Income Statement is used to inform you about the income earned, expenses incurred, and the total profit or loss in a particular period. Two common periods for creating an income statement are monthly and annually. This report summarizes all Income (or sales), the amounts that have been or will be received from customers for goods delivered or services rendered to them, and all expenses, the costs that have arisen in generating revenues. To show the actual profit or loss of a company, the expenses are subtracted from the revenues to show the Net Income profit or the bottom line. Income Accounts: These accounts are used to track income earned during the process of operating your business. The income of a business comes from sales to customers or fees for services or both. Some of the common names for income accounts are: Income from Sales Income from Freight Other Income

Expense Accounts: These accounts are used to track expenses incurred during the process of operating your business. Expenses include both the costs directly associated with creating products and general operating expenses. Some of the common names for expense accounts are: Cost of Sales Office Supplies Utilities

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Payroll Expenses Tax Expenses

A very simple form of an income statement displays in the following example: Joes Bicycle Company 123 Main Street Any Town CA 99999 Income Statement Income Income from Sales Income from Freight Other Income Total Income Expenses Cost of Sales Office Supplies Telephone Expense Utilities Consulting Fees Maintenance Insurance Miscellaneous Expenses Travel & Entertainment Bank Charges Payroll Expense Tax Expense Total Expenses Net Income/Loss 2,000.00 250.00 500.00 100.00 750.00 300.00 250.00 375.00 650.00 25.00 4,000.00 2,500.00 11,700.00 4,550.00

15,000.00 1,000.00 250.00 16,250.00

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Accounting Basics 39

Balance Sheet
A Balance sheet is like a snapshot that gives you the overall picture of the financial health of a company at one moment in time. This report lists the assets, liabilities, and owners equity in the business. Unlike the income statement, this report is always created to show the financial status as of a certain date. Two common ending periods to create a balance sheet are the end of a month and the end of the year. The Balance Sheet has two sections. The first section lists all the Asset accounts and their balances. At the end of the list, the totals of all assets are listed. In the second section, the Liability and Owners Equity accounts are listed. There are two sub-totals for the Liability and the Equity accounts. At the end, there is a combined total of the Liabilities and Owners Equity. As discussed earlier in the accounting equation, the Assets equal the sum of the Liabilities and the Equities. You will also notice that the Profit from the income statement is listed in the Equity section of the balance sheet. Some of the important accounts in the balance sheet are: Current Assets: Current assets are always listed first and include cash and other items that can be converted into cash within the following year. This includes funds in checking and savings accounts. Accounts Receivable: Accounts Receivable represents money owed to the business. These usually result from the sale of merchandise or performance of services for a client on account. The phrase On Account indicates that on the date the goods were sold to the client, or the service performed for him, the business did not receive full payment. However, it did obtain an asset the right to collect payment for merchandise sold or Services performed. The claim a business has against a credit client is referred to as an Account Receivable. It is an asset because it represents a legal claim to cash. Inventory: Inventories may represent merchandise purchased for resale as well as the raw materials acquired by a manufacturing firm to put into the product. In the case of a manufacturer, the term inventories also includes manufacturing supplies, purchased parts, the work that is in process, and finished goods. Inventory is also an asset account.

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Accounts Payable: When you purchase goods or services on account, you are usually required to pay within a fixed period of time. These amounts you owe for the goods or services purchased are called accounts payable. The payment of these purchases is usually due within a relatively short period of time. Usually this period is one year or less. Typical periods are thirty to sixty days. The payment for these short-term liabilities requires the use of existing resources like the Cash or The Checking Account. A very simple form of a balance sheet displays in the following example: Joes Bicycle Company 123 Main Street Any Town CA 99999 Balance Sheet Assets Checking Account Investments Inventory Accounts Receivable Machinery & Equipment Investments Total Assets Liabilities & Equity Accounts Payable Loans Payable Salaries Payable Taxes Payable Total Liabilities Owners Equity Profit/Loss Total Equity Total Liabilities & Equity 15,000.00 60,450.00 75,000.00 2,500.00 152,950.00 100,000.00 4,550.00 104,550.00 _ 257,500.00 25,000.00 75,000.00 25,000.00 10,000.00 22,500.00 100,000.00 257,500.00

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Accounting Basics 41

This program automatically creates the Balance Sheet and the Income Statements for you. All the accounts are automatically updated when you create invoices, checks, and transactions in the system. To create a Balance Sheet or an Income Statement all you have to do is to select the report from the menu and print it.

Linking the Income and Balance Sheet

Generally, a balance sheet and an income statement are prepared and issued together because in a way they are twin reports, the income statement showing what happened over a period of time and the balance sheet showing the resulting condition at the end of that period. Since these statements are usually studied in relation to one another, it is highly desirable for them to tie together with one common figure. You will see that the Net Profit/Loss on the bottom of the income statement discussed earlier was $4,550.00. If you look at the Equity section of the balance sheet shown earlier, you will notice that the $4,550.00 Profit/Loss lists as a part of the total equity. This ties the income statement to the balance sheet report.

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E145/STS173 Workshop A Basics of Accounting

Professors Tom Byers and Randy Komisar Stanford University
With special thanks to: Roma Jhaveri, Ben Hallen, Filipe Santos, Yosem Companys

Copyright 2004 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be reproduced for educational purposes only.

Goals of the Workshop

Review main accounting documents and financial analysis Balance Sheet Income Statement (Statement of Operations) Statement of Cash Flows
Please refer also to the handout: How to Read a Financial Report

How Does It All Add Up

When you get paid for a product or service

Income

Expenses
When you buy something

Assets

Assets often generate income

Liabilities

Liabilities often generate expenses

The value of anything you own

The value of anything you borrow

Some Accounting Principles

Accounting items are classified into accounts according

to their nature, translated into monetary units, and organized in statements

Basic Accounting formula:

Assets = Liabilities + Equity

What the company owns How the ownership of assets was financed (By third parties or by the owners)

Accounting vs. Market Value

Equity: Ownership of a company is divided in certificates called

common shares
Accounting Value (or Book Value) = Equity = Assets Liabilities

Accounting Value is different from Market Value !!!

Market Value = Share Price * Number of Common Shares Outstanding

Income Statement

Reports the economic results of a company over a time period. It shows the derivation of earnings or losses.
Income Statement of XXX Corp. year 2000 + Revenues - Cost of Revenue (product cost or COGS) = Gross Margin - Sales and Marketing - General and Administrative - Research & Development - Depreciation and Amortization = Operating Income (EBIT) + Interest Income(expense) net = Net Income before Taxes - Income Tax Provision - Extraordinary Items = Net Income
$ % Rev.

Income Statement - Analysis

When does a transaction affect income? - When it changes the economic value of the company for the owners Some Profitability Measures:

Gross Margin (%) = Gross Profit / Sales Operating Margin = Operating Income / Sales Return on Sales = Net Income / Sales Return on Equity = Net Income / Shareholders Equity

Other Important Measures

Earnings Per Common Share (EPS) = Net Income / Common Shares Price Earnings Ratio (P/E) = Market Price / Earnings Per Share

Income Statement - Example

From Kimmel et. al. Financial Information For Decision Making

The following information was taken from the 2001 financial statements of Kellogg Company. Dollar amounts are in millions. Cost of goods sold Selling & admin. expenses Interest expense Other expense Net sales Income tax expense $ 4,128.5 3,523.6 351.5 54.0 8,853.3 322.1

Income Statement - Example

KELLOG COMPANY Income Statement For the Year Ended December 31, 2001 Net sales Cost of goods sold Gross Profit Selling & admin. expense Income from Operations Interest expense Other expense Net Income Before Taxes Income tax expense Net Income $ 8,853.3 4,128.5 4,724.8 3,523.6 1,201.2 351.5 54.0 795.7 322.1 $ 473.6

Balance Sheet

It is a financial snapshot of a company at a given point in time

Balance Sheet of XXX Corp. - 31 December of 2000 (in thousand $)
Cash and Equivalents Accounts Payable

Current Assets
(liquid in less than a year)

Accounts Receivable Inventories Property, plant and equipment (minus Depreciation) Intangibles (minus depreciation)

Current Liabilities
(payable in less than a year)

Accrued Expenses Short Term debt

Long-Term Liabilities (bonds issued, bank loans)

Common Stock

Fixed Assets

Shareholders Equity

Additional Paid-in Capital Retained Earnings

Other Assets

Investment Securities

Total Assets

= Total Liabilities + Shareholders Equity

Balance Sheet - Analysis

Working Capital: measure of the amout of cash available in the short-term;

Also, indication of the funds needed operate within a given business size = Current Assets Current Liabilities

Liquidity ratios: measures of the ability to meet short term financial obligations
Current Ratio: Current Assets / Current Liabilities Acid-test: (Cash + Accounts receivable) / Current Liabilities

Operational Efficiency Measures

Inventory Turnover = Cost of Sales per year / Current Inventory Accounts Receivable Collection Period = accounts receivable / sales Accounts Payable Collection Period = accounts payable / cost of sales

Balance Sheet - Example

From Kimmel et. al. Financial Information For Decision Making

These financial statement items are for Tweeter Entertainment Group at year-end on September 30, 2001. (in millions) Accounts payable Property, plant & equipment Receivables Other current liabilities Stockholders equity Cash Long-term debt Inventories Accrued expenses Other current assets Other liabilities Other assets $ 38.6 109.1 31.3 23.3 332.4 3.3 36.7 129.2 38.9 7.5 10.5 200.0

Balance Sheet - Example

TWEETER HOME ENTERTAINMENT GROUP Balance Sheet (in millions) September 30, 2001
Assets Current assets Cash $ 3.3 Receivables 31.3 Inventories 129.2 Other current assets 7.5 Total current assets 171.3 Property, plant & equipment 109.1 Other assets 200.0 Total assets $ 480.4 Liabilities and Stockholders Equity Current liabilities Accounts payable Accrued expenses Other current liabilities Total current liabilities Long-term debt Other liabilities Total liabilities Stockholders equity Total liab. & stock. equity $ 38.6 38.9 23.3 100.8 36.7 10.5 148.0 332.4 $ 480.4

Statement of Cash Flows

The Statement of Cash Flows reports cash receipts and payments over a period, separating operational, investing and financing activities.
Statement of Cash Flows of XXX Corp. 2000 $

+ Cash Flow from operating activities (reconciled from income statement)

= income - net changes in working capital (except cash and equivalents) + depreciation and amortization

+ Cash Flow from investing activities + Cash Flow from financing activities = Net Change in Cash or Equivalents + Cash or Equivalents at beginning of period = Cash or Equivalents at end of period

Statement of Cash Flows - Analysis

CFIMITYM !!!
(Cash Flow is More Important Than Your Mother!! ) Especially for an entrepreneurial firm...

How is cash flow different from income?

Income accrual is not necessarily linked to cash transactions (e.g.,

depreciation, sales by credit) Some activities affect cash flows but not income (e.g., investments in fixed assets, additional capital from shareholders)

Growth often absorbs cash flow because of a higher need for working capital and fixed investments (Entrepreneurial firms with negative income and high growth can have a very fast cash burn rate)

Statement of Cash Flows - Example

From Kimmel et. al. Financial Information For Decision Making
SIERRA CORPORATION Statement of Cash Flows For the Month Ended October 31, 2004 Cash flows from operating activities Cash receipts from operating activities Cash payments for operating activities Net cash provided by operating activities Cash flows from investing activities Purchased office equipment Net cash used by investing activities Cash flows from financing activities Issuance of common stock Issued note payable Payment of dividend Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period $ 11,200 (5,500) $ 5,700 (5,000) (5,000) 10,000 5,000 500 14,500 15,200 0 15,200

Learning Goal 15: Identify and Prepare a Balance Sheet

S1

SOLUTIONS
LG 15-1.

Learning Goal 15

David Running-Elk, M.D. Balance Sheet July 31, 2008 Assets Cash Accounts receivable Supplies Prepaid insurance Equipment $ 8,500 3,100 700 750 35,000 Liabilities Accounts payable Unearned fees revenue Note payable Total liabilities Owners Equity Total assets $48,050 David Running-Elk, Capital Total liabilities and owners equity 37,450 $48,050 $ 1,100 500 9,000 10,600

Notes Owners equity is verified as $48,050 total assets $10,600 total liabilities = $37,450. $ signs are generally used at the top of a column and at the total of the column. Always double check to be sure that the title is correctly written and especially that the date is correct.

LG 15-2. To prepare this balance sheet, you have to calculate the following:
Supplies: This is $1,000 (March 31 balance) + $7,000 purchased $4,000 used = $4,000 (April 30 balance). Accounts Receivable: To calculate this, we need to know the total assets. Because the balance sheet is based on the accounting equation A = L + OE, we know that total assets equal the total liabilities and owners equity of $41,000. If total assets are $41,000, we can subtract $25,000 for cash, $4,000 for supplies, and $10,000 for equipment. What is left must be accounts receivable of $2,000. Don Chen, Capital: If total liabilities and owners equity equal $41,000 and we know the only liability is accounts payable of $12,000, then Don Chen, Capital must be $41,000 $12,000 = $29,000.
Fulton Avenue Company Balance Sheet April 30, 2008 Assets Cash Accounts receivable Supplies Equipment Total assets $25,000 2,000 4,000 10,000 $41,000 Accounts payable Owners Equity Don Chen, Capital Total liabilities and owners equity 29,000 $41,000 Liabilities $12,000

Format note: Because there is only one liability, we do not have to write total liabilities and repeat the number.

Learning Goal 14: Identify and Prepare a Statement of Owners Equity

S1

SOLUTIONS

Learning Goal 14

LG 14-1. Statement of owners equity:

David Running-Elk, M.D. Statement of Owners Equity For the Month Ended July 31, 2008 David Running-Elk, Capital, July 1, 2008 Add: Initial investment by owner Net income Subtotal Less: Withdrawals David Running-Elk, Capital, July 31, 2008 $ 0 $37,000 1,450 38,450 (1,000) $37,450

(The statement of owners equity explains the David Running-Elk, Capital, balance of $37,450 on the balance sheet.)

LG 14-2. As before, with any missing information nancial statement problem, there are two good ways to set up the problem and identify what you need to do. You can either:
a. Prepare a statement using the amounts available, so you can identify what is missing, or . . . b. You can use the formula relationship that the statement is based on. a. A statement using the amounts available:
West Valley Company Statement of Owners Equity For the Year Ended December 31, 2008 Lucy Palangian, Capital, January 1, 2008 Add: Investment by owner Net income/loss Subtotal Less: Withdrawals Lucy Palangian, Capital, December 31, 2008 $ 3,800 $15,000 ? (5,300) $?

b. Use the formula that the statement is based on: beginning balance + (net income/(loss) + investments withdrawals) = ending balance. Filling in what you know: $3,800 + net income/ (loss) + $15,000 $5,300 = ending balance. Reviewing the information, you see that because you know total assets and total liabilities on December 31, you can calculate the balance of owners capital as A L = OE, or $41,000 $37,000 = $4,000 on December 31.

S2

Section IV The Essential Financial Statements

SO L U T ION S
LG 14-2, continued

Learning Goal 14, continued

When you know the ending balance, you can complete the statement by lling in the difference as a net loss on the statement or by calculating it in the formula as: $3,800 + X + $15,000 $5,300 = $4,000. Therefore, X = 9,500 (a net loss).
West Valley Company Statement of Owners Equity For the Year Ended December 31, 2008 Lucy Palangian, Capital, January 1, 2008 Add: Investment by owner Less: Withdrawals Net (Loss) Subtotal Lucy Palangian, Capital, December 31, 2008 (5,300) (9,500) (14,800) $ 4,000 $ 3,800 15,000

Learning Goal 13: Identify and Prepare an Income Statement

S1

SOLUTIONS
LG 13-1. Income statement:

Learning Goal 13

David Running-Elk, M.D. Income Statement For the Month Ended July 31, 2008 Revenues Fees earned Expenses Rent expense Wages expense Interest expense Utilities expense Total expenses Net income $4,250 $1,500 850 300 150 2,800 $1,450

LG 13-2. There are two good ways to nd the missing information for a nancial statement problem:
a. One good way is to actually prepare the statement using the amounts available and then ll in or calculate the amounts you identied as missing. This helps you visually identify what you need to do. b. A second, and faster, way is simply to use the relationships that exist on the income statement. This is always: revenues expenses = net income. Using the rst method:
De Anza Operating Company Income Statement For the Year Ended December 31, 2008 Revenues Service revenue earned Expenses Rent expense Wages expense Advertising expense Utilities expense Supplies expense Total expenses Net income $? $12,000 7,500 3,000 2,000 ? $10,000

S2

Section IV . The Essential Financial Statements

SO L U T ION S
LG 13-2, continued

Learning Goal 13, continued

Supplies Expense is the supplies used up: $3,000 (balance on January 1) + $4,000 purchased X used up = $5,000 (balance on December 31). Therefore, $7,000 X = $5,000. The supplies used up is $2,000. Service Revenue Earned is the sum of net income plus the total expenses. Now that you know Supplies Expense, you can calculate the total expenses as $26,500. Therefore, total revenue is $10,000 + $26,500 = $36,500. If you use the second method: R (12,000 + 7,500 + 3,000 + 2,000 + S) = 10,000. After you calculate Supplies Expense, you have: R 26,500 = 10,000. Therefore, revenue is $36,500. Whichever method you use, you can now complete the income statement.

De Anza Operating Company Income Statement For the Year Ended December 31, 2008 Revenues Service revenue earned Expenses Rent expense Wages expense Advertising expense Utilities expense Supplies expense Total expenses Net income

$36,500 $12,000 7,500 3,000 2,000 2,000 26,500 $10,000

LG 13-3. The income statement shows the effect of operations on the owners equity. The owners equity is changed by the operational effects of (a) revenues and (b) expenses. Revenues increase owners equity and expenses decrease owners equity.

Learning Goal 12: Describe the Financial Statements

S1

SOLUTIONS
Multiple Choice 1. b 2. c 3. a 4. c 5. d 6. c 7. a 8. d 9. a 10. d 11. b 12. d

Learning Goal 12

S2

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
LG 11-1.

Learning Goal 11

Assets Cash Increase

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (Bal.) 17,140 250 550 400 340 1,200 250 1,000 1,500 650 1,500 900 750 1,500 250 120 800 3,300 1,100 15,000 1,200 210 210 1,200

=
Supplies Increase Decrease Equipment Increase Decrease

Accounts Receivable Increase Decrease

Decrease

Learning Goal 11: Begin to Record

S3

SOLUTIONS

Learning Goal 11, continued

Liabilities + Owners Equity Accounts Payable Decrease Increase Unearned Revenue Decrease Increase Edgar Mendoza, Capital Decrease Increase
15,000

3,300 1,100 800 750 250 120 1,500 900 750 550 550 1,650 Advertising expense Revenue Supplies expense Revenue Withdrawal 750 Rent expense Revenue Legal expense

2,000

2,000

Revenue

550 250 1,300 17,530 Net Income: 3,430

S4

Section III . TransactionsBasic Recording Concepts

SO L U T ION S

Learning Goal 11, continued

LG 11-2. Sugar Eclairs Gym September transactions.

a. Example: Supplies of $100 are purchased for cash.
Assets $40,020
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) A (New Bal.)

10,300 100 10,200

4,100

620 100

25,000

4,100

720

25,000

b. The club collects $2,000 cash from the accounts receivable.

Assets $40,020
Cash
Increase Decrease

Accounts Receivable
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) B (New Bal.)

10,200 2,000 12,200

4,100 2,000 2,100

720

25,000

720

25,000

c. The club prepays a nine-month re insurance policy for $1,500.

Assets $40,020
Cash
Increase Decrease

Accounts Receivable
Increase Decrease

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) C (New Bal.)

12,200 1,500 10,700

2,100 1,500 2,100 1,500

720

25,000

720

25,000

Learning Goal 11: Begin to Record

S5

SOLUTIONS

Learning Goal 11, continued

Liabilities + Owners Equity $40,020

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200

39,820

200

39,820

Liabilities + Owners Equity $40,020

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200

39,820

200

39,820

Liabilities + Owners Equity $40,020

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200

39,820

200

39,820

S6

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
LG 11-2, continued

Learning Goal 11, continued

d. The club receives member dues of $5,300.

Assets $45,320
Cash
Increase Decrease

Accounts Receivable
Increase Decrease

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) D (New Bal.)

10,700 5,300 16,000

2,100

1,500

720

25,000

2,100

1,500

720

25,000

e. The club sends out bills to members for dues for $2,900.
Assets $48,220
Cash
Increase Decrease

Accounts Receivable
Increase Decrease

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) E (New Bal.)

16,000

2,100 2,900

1,500

720

25,000

16,000

5,000

1,500

720

25,000

f. The club receives and pays the utilities bill of $550.

Assets $47,670
Cash
Increase Decrease

Accounts Receivable
Increase Decrease

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) F (New Bal.)

16,000 550 15,450

5,000

1,500

720

25,000

5,000

1,500

720

25,000

Learning Goal 11: Begin to Record

S7

SOLUTIONS

Learning Goal 11, continued

Liabilities + Owners Equity $45,320

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200

39,820 5,300 5,300 5,300

200

45,120

Liabilities + Owners Equity $48,220

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200

45,120 2,900

5,300 2,900 8,200

200

48,020

Liabilities + Owners Equity $47,670

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200 550 200

48,020 550 47,470 550

8,200

8,200

S8

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
LG 11-2, continued

Learning Goal 11, continued

g. The club receives but does not pay the telephone bill of $185.
Assets $47,670
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) G (New Bal.)

15,450

5,000

1,500

720

25,000

15,450

5,000

1,500

720

25,000

h. The club pays $200 of the accounts payable.

Assets $47,470
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) H (New Bal.)

15,450 200 15,250

5,000

1,500

720

25,000

5,000

1,500

720

25,000

i. The club borrows $50,000 from the 5th National Bank and signs a 15-year note.
Assets $97,470
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) I (New Bal.)

15,250 50,000 65,250

5,000

1,500

720

25,000

5,000

1,500

720

25,000

Learning Goal 11: Begin to Record

S9

SOLUTIONS

Learning Goal 11, continued

Liabilities + Owners Equity $47,670

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

200 185 385 185

47,470

550 185

8,200

47,285

735

8,200

Liabilities + Owners Equity $47,470

Accounts Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

385 200 185

47,285

735

8,200

47,285

735

8,200

Liabilities + Owners Equity $97,470

Accounts Payable
Decrease Increase

Notes Payable
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

185 50,000 185 50,000

47,285

735

8,200

47,285

735

8,200

S10

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
LG 11-2, continued

Learning Goal 11, continued

j. Cash of $590 is received from members who prepay next months dues.
Assets $98,060
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) J (New Bal.)

65,250 590 65,840

5,000

1,500

720

25,000

5,000

1,500

720

25,000

k. Sugar withdraws $2,000 from the business for personal living expense.
Assets $96,060
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) K (New Bal.)

65,840 2,000 63,840

5,000

1,500

720

25,000

5,000

1,500

720

25,000

l. The business purchases $500 of supplies and $1,000 of equipment on credit.

Assets $97,560
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) L (New Bal.)

63,840

5,000

1,500

720 500

25,000 1,000 26,000

63,840

5,000

1,500

1,220

Note: Neither the supplies nor the equipment have been used yet, so there is no expense. The assets have been purchased, but not used up.

Learning Goal 11: Begin to Record

S11

SOLUTIONS

Learning Goal 11, continued

Liabilities + Owners Equity $98,060

Accounts Payable
Decrease Increase

Notes Payable
Decrease Increase

Unearned Revenue
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

185

50,000 590

47,285

735

8,200

185

50,000

590

47,285

735

8,200

Liabilities + Owners Equity $96,060

Accounts Payable
Decrease Increase

Notes Payable
Decrease Increase

Unearned Revenue
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

185

50,000

590 2,000

47,285

735

8,200

185

50,000

590

45,285

735

8,200

Liabilities + Owners Equity $97,560

Accounts Payable
Decrease Increase

Notes Payable
Decrease Increase

Unearned Revenue
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

185 1,500 1,685

50,000

590

45,285

735

8,200

50,000

590

45,285

735

8,200

S12

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
LG 11-2, continued

Learning Goal 11, continued

m. Air conditioning repairs are required for $900. The bill will be paid later.
Assets $97,560
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) M (New Bal.)

63,840

5,000

1,500

1,220

26,000

63,840

5,000

1,500

1,220

26,000

(Notice that repair services are a resource consumed, so this is an expense. The decrease in cash will occur later when the bill is paid.)

n. Sugar spends the $2,000 she withdrew for new furniture for her home.
Assets $97,560
Accounts Receivable
Decrease Increase Decrease

Cash
Increase

Prepaid Insurance
Increase Decrease

Gym Supplies
Increase Decrease

Gym Equipment
Increase Decrease

(Bal) N (New Bal.)

63,840

5,000

1,500

1,220

26,000

63,840

5,000

1,500

1,220

26,000

This is a personal transaction of the owner. It is not recorded by the business!

Learning Goal 11: Begin to Record

S13

SOLUTIONS

Learning Goal 11, continued

Liabilities + Owners Equity $97,560

Accounts Payable
Decrease Increase

Notes Payable
Decrease Increase

Unearned Revenue
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

1,685 900 2,585

50,000

590 900

45,285

735 900

8,200

50,000

590

44,385

1,635

8,200

Liabilities + Owners Equity $97,560

Accounts Payable
Decrease Increase

Notes Payable
Decrease Increase

Unearned Revenue
Decrease Increase

Sugar Eclair, Capital

Decrease Increase Exp. Rev.

2,585

50,000

590

44,385

1,635

8,200

2,585

50,000

590

44,385

1,635

8,200

What are the total revenues that the club received during September? $8,200 What are the total expenses of the club during September? $1,635 Calculate the clubs net income or loss during September. $8,200 1,635 = $6,565 net income

S14

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
LG 11-3.

Learning Goal 11, continued

Assets
Increase a. A business collects $1,000 of accounts receivable from a customer. b. A business pays a bill to a vendor. c. A business purchases supplies on account. d. A business makes a sale on account. e. A business uses up some supplies. f. A business buys a $5,000 computer, pays $1,000 cash, and signs a note. g. A business receives an advance payment from a customer. h. The owner removes some cash and supplies from her business. i. A business prepays rent for 3 months in the amount of $1,500. j. The owner buys a new car for herself. k. A business pays the wages to its employees. l. One month has passed since the rent was prepaid in item i, above. m. A business receives a bill from the telephone company. n. The business performs services for the customer who prepaid in item G, above. o. A business that incurred a liability pays the liability. p. A customer pays a business for an amount owed. Cash Cash Accounts Receivable Cash Prepaid Rent $500 Prepaid Rent $1,500 Ofce Equipment $5,000 Cash Supplies Accounts Receivable Supplies Cash $1,000 Cash Decrease Accounts Receivable Cash

Liabilities
Decrease Increase

Owners Equity
Decrease Increase

Accounts Payable Accounts Payable Revenue Supplies Expense Notes Payable $4,000 Unearned Revenue

Cash Supplies Cash $1,500 Not a business transaction.

Withdrawals (or drawing)

Wages Expense Rent Expense $500 Accounts Payable Unearned Revenue Accounts Payable Telephone Expense Fees Revenue

Learning Goal 10: Explain the Accounting Process

S1

SOLUTIONS
Multiple Choice 1. a 2. d 3. b 4. a 5. b 6. c 7. c 8. d 9. a 10. b 11. d 12. c

Learning Goal 10

S2

Section III . TransactionsBasic Recording Concepts

SO L U T ION S
Reinforcement Problems LG 10-1.

Learning Goal 10, continued

Assets Affected? Event a. On April 30, a count of supplies shows $400 of supplies used up. b. The owner invested $5,000 in his business on May 7. c. $500 was collected from accounts receivable on October 12. d. On June 1, received $2,700 from a tenant for 3 months ofce rent beginning on June 1. e. On December 31, purchased $1,900 of supplies and will pay later. f. Provided $750 services to customer on December 31. Customer will pay later. g. On August 3, purchased $9,500 of equipment by paying $3,000 cash and signing a 2-month note payable. h. On January 5, received $300 bill from the telephone company for telephone services up to December 31. i. The owner wrote a $2,500 check to himself from the business checking account on November 23. j. It is now June 30, the end of the rst month after item d above. k. On October 3, borrowed $6,500 on a new long-term note and used the money to pay off the note in g. R April 30 C Supplies V (400)

Liabilities Affected? C V

Owners Equity Affected? C Supplies Expense Owners equity V (400)

May 7 Oct. 12

Cash Cash Acct. Rec. Cash

5,000 + 500 + (500) 2,700 + Unearned Revenue 2,700 +

5,000 +

June 1

Dec. 31

Supplies

1,900 +

Accounts Payable

1,900 +

Dec. 31

Acct. Rec.

750 +

Service Revenue Notes Payable 6,500 +

750 +

Aug. 3

Cash Equipment

(3,000) 9,500 +

Dec. 31

Accounts Payable

300 +

Telephone Expense

(300)

Nov. 23

Cash

(2,500)

Withdrawal

(2,500)

June 30

Unearned Revenue Notes Payable

(900)

Rent Revenue

900 +

Oct. 3

(6,500) 6,500 +

Learning Goal 10: Explain the Accounting Process

S3

SOLUTIONS
LG 10-1, continued

Learning Goal 10, continued

Comments: (1) Event h: Did you nd this one to be a little tricky? This example shows that the timing for the recognition date is not always obvious. Because the bill was for telephone services up to end of December (not for January!), the item should be recorded with a December 31 date. We will study this timing issue much more in Volume 2. (2) Event j: A timing and valuation issue, because one-third of the rent revenue has been earned by the end of June. This means that one-third of the revenue should be recorded in June. (3) Event k: The Total Notes Payable does not change because the new note payable replaces the old one for the same amount.

LG 10-2.
Event a. On March 11, the owner invested $10,000 cash and $2,000 of supplies in her business. b. On December 31, a business counts the supplies inventory and determines that the amount of supplies have decreased by $900 during the last quarter. Financial statements are quarterly. c. On September 4, a business performs $3,000 of services and sends the bill to the customer. No cash is received. d. On November 12, a business pays $5,000 cash to buy some computer equipment. The invoice is not received until November 23. e. On May 3, a commercial trade school receives a donation of 20 computers. Although the school can use the computers, it would be difcult to sell them because they are obsolete. f. On January 23, the local bank calls and offers to loan our business $25,000 no later than 7 days from today. g. A computer that had cost $1,500 suddenly stops functioning on June 23. It is not worth repairing. h. On October 27, $50,000 of merchandise inventory is destroyed by a re. i. On November 23, a business hires a new employee at a salary of $80,000 per year. j. On July 16, the owner of business withdraws $5,000 cash from the business. k. On August 9, our business used a consulting service and incurred $2,000 of consulting expense. A bill arrived, but we will pay it later. Classication Cash Supplies Owners Equity Supplies Owners Equity Valuation $ 10,000 $ 2,000 $12,000 $900 $900 Timing March 11

Dec. 31

Accounts Receivable Owners Equity Equipment Cash Computer Equip. Owners Equity

$3,000 $3,000 $5,000 $5,000 Unknown need to determine value, if any Noneno transaction $1,500 $1,500 $50,000 $50,000 Noneno transaction $5,000 $5,000 $2,000 $2,000

Sept. 4 Nov. 12

May 3

Noneno transaction Computer Equip. Owners Equity Merchandise Inventory Owners Equity Noneno transaction Cash Owners Equity Owners Equity Accounts Payable

Noneno transaction June 23 Oct. 27

Noneno transaction July 16 Aug. 9

LG 10-3. Mr. Clavati refers to the three essential elements for analyzing an eventto determine if or how the event will affect a business: Classication, Valuation, and Timing.

Learning Goal 9: Analyze the Cumulative Effect of Transactions

S1

SOLUTIONS

Learning Goal 9

Note: Bold numbers mean a calculated amount. Reinforcement Problems

LG 9-1.
Cumulative Change: Assets + $5,000 = Liabilities + $15,000 + Owners Equity $10,000

The company borrowed $15,000 in resources; during the same time, the combination of operations and owners drawing decreased owners equity by $10,000 (not a good business plan).

LG 9-2.
Cumulative Change: Assets + $40,000 = Liabilities + $20,000 + Owners Equity + $20,000

The company borrowed $20,000 and also increased resources by $20,000 from operations and/or owners investments.

LG 9-3.
Cumulative Change: Assets + $16,000 = Liabilities $9,000 + Owners Equity + $25,000

This company used $9,000 of resources to pay debts. These resources were more than replaced by a $25,000 combination of operations and/or owner investments. These are good changes.

LG 9-4.
Assets January 1: Cumulative Change: December 31: + $12,000 $95,000 = Liabilities $ 15,000 $25,000 + Owners Equity $43,000 (70,000 27,000) + $27,000 [12,000 (15,000)] $70,000 (95,000 25,000)

This is similar to what happened to Diablo Valley Services in LG 9-3, above.

LG 9-5.
June 1: Cumulative Change: June 30: Assets $90,000 + $12,000 = Liabilities $15,000 + $22,000 $37,000 + Owners Equity $75,000 (L = 90,000 75,000) $10,000 [L = 12,000 (10,000)] (L = 15,000 + 22,000)

This is similar to what happened to Vermont Street Surf Shop in LG 9-1, above.

S2

Section II . TransactionsAnalyzing and Visualizing

SO L U T I O N S

Learning Goal 9, continued

LG 9-6. First, calculate the January 1 equation and owners equity: (A) $400,000 = (L) $300,000 + (OE) $100,000.
a. b. c. d. e. Still $300,000 because assets and owners equity have each gone up by the same amount. (OE) $105,000 (A) $395,000 (OE) $145,000 (L) $290,00

LG 9-7.
Assets January 1: Cumulative Change: December 31: 51,000 644,000 = Liabilities 256,000 (18,000) 238,000 + Owners Equity 69,000 406,000 L = 238,000 + 18,000 L = 51,000 69,000 L = 644,000 406,000

LG 9-8.
July 1: Cumulative Change: September 30: Assets 305,000 (95,000) 210,000 = Liabilities 96,000 (41,000) + Owners Equity (54,000) A = 41,000 + 54,000 A = 305,000 + (95,000)

LG 9-9.
Assets September 1: Cumulative Change: September 30: = Liabilities + Owners Equity (81,000) 2,000 (79,000) OE = (79,000) 2,000 OE = 19,000 6,000 11,000 OE = 241,000 320,000

241,000

320,000

LG 9-10.
January 1: Cumulative Change: December 31: Assets 957,000 (64,000) 893,000 = Liabilities (27,000) 295,000 + Owners Equity (37,000) 598,000 A = 893,000 + 64,000 A = (27,000) + (37,000) A = 598,000 + 295,000

LG 9-11.
Cumulative Change: Assets (7,000) = Liabilities (45,000) + Owners Equity 38,000 OE = 19,000 + 28,000 9,000 L = (7,000) 38,000

Learning Goal 8: Explain the Four Basic Changes in Owners Equity

S1

SOLUTIONS
Reinforcement Problems

Learning Goal 8

LG 8-1. No. Paying a liability reduces a creditors claim, never the owners claim. An expense is a reduction in the owners claim because of consuming resources to add value and make sales (operations). It has nothing to do with paying liabilities.

LG 8-2.
1. An increase in owners equity caused by either an increase in assets or a decrease in liabilities as a result of performing services or selling products is called (i) Revenue. 2. Items such as paper, pencils, binders, staples, solvents, and paper towels are called (b) Supplies. 3. An asset created when a sale is made to a customer on account (that is, no cash is received at the time of sale) is (c) Accounts Receivable. 4. A liability that is created on the books of the seller when a customer prepays before the service or product is provided to the customer is called (h) Unearned Revenue. 5. An asset that is created for the recipient when a formal written promise to pay a certain amount is signed is called a (d) Note Receivable. 6. A liability that is created for the payor when a formal written promise to pay a certain amount is prepared and signed is called a (g) Note Payable. 7. The owner transferring personal assets into a business is called (l) Owner Investment. 8. A decrease in owners equity caused by a decrease in assets or an increase in liabilities resulting from the process of operating the business is an (m) Expense. 9. An obligation to pay money (normally in 3090 days) to a supplier is an (f) Account Payable. 10. Currency that a business has on hand and the amounts in the checking and savings accounts that can be withdrawn on demand is called (a) Cash. 11. A short-term asset created when a business pays for goods or services before it receives them or uses them up is a (e) Prepaid Expense. 12. The owners withdrawal of assets from the business for personal use is called a (k) Withdrawal.

S2

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S
LG 8-3.

Learning Goal 8, continued

Transaction a. An accountant performs $2,000 of accounting services and is paid in cash.

Assets increased or liabilities decreased? Yes (The asset Cash increases.)

Revenue? Yes

Why is it a revenue or not a revenue? Assets increase because services are performed for a customer, so it is a revenue transaction. Assets increase because of a loan, so it is not a revenue transaction. Assets increase as a result of a liability, so it is not a revenue (revenue not earned yet). Services were performed, so revenue was earned.

OE

b. The accountant borrows $2,000 from her bank. c. An accountant receives a $2,000 cash advance from a client as a prepayment for future services. d. The accountant fully performs all the services for the client who prepaid her in (c) above. e. The accountant invests an additional $5,000 in her business.

Yes (The asset Cash increases.) Yes (The asset Cash increases.)

No

No

Yes (The liability Unearned Revenue decreases.) Yes (The asset Cash increases.)

Yes

No

Owners equity increases, but not because of a sale of services or goods. Investment is not revenue. Accounting services were performed.

f. In September, the accountant performs $2,500 of services on account.

Yes (The asset Accounts Receivable increases.)

Yes

Learning Goal 8: Explain the Four Basic Changes in Owners Equity

S3

SOLUTIONS
LG 8-3, continued

Learning Goal 8, continued

Transaction g. The accountant collects $2,000 cash from the accounts receivable.

Assets increased or liabilities decreased? Yes (The asset Cash increases and the asset Accounts Receivable decreases.) Yes (The liability Unearned Revenue decreases.) Yes (The asset Cash increases.)

Revenue? No

Why is it a revenue or not a revenue? Simply an exchange of one kind of asset for another kind of asset.

OE

h. A magazine publisher mails magazines to its subscribers who prepaid subscriptions. i. A computer consultant is paid $1,000 immediately after nishing a job.

Yes

Merchandise is delivered when the magazines are mailed out to customers. Assets increased because services were performed.

Yes

LG 8-4. No sale has been made. A revenue must meet two requirements: (1) it must increase owners equity, and (2) it must be caused by making a sale of services or goods. None of the examples meet both requirements. Except for owners investment, none of the transactions affect owners equity. The investment increases owners equity but not because of a sale being made.

LG 8-5. None of the transactions involve operations. An expense must meet two requirements: (1) it must decrease owners equity, and (2) it must be caused by operations. None of the examples meet both requirements. Except for owners drawing, none of the transactions affect owners equity. The withdrawal does decrease owners equity but not because of operations.

S4

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S
LG 8-6.

Learning Goal 8, continued

Transaction a. The business pays off a loan of $10,000. b. $1,500 of supplies are used up. c. A business pays off an account payable of $1,500. d. A business pays employees $1,500 in wages as soon as they are earned. e. A business receives a $750 repair bill for this months computer repair services. The bill is not paid immediately.

Assets decreased or liabilities increased? Yes (The asset Cash decreases.) Yes (The asset Supplies is used up.) Yes (The asset Cash decreases.)

Expense? No

Why is it an expense or not an expense? Only creditors equity is affected, not the owners. A direct using up of resources in operations. Paying a liability is never an expense; it affects the creditors equity, not the owners. Asset used up in operations to pay for employee services. A new claim is placed on existing assets because of a service consumed and not paid for.

OE

Yes

No

Yes (The asset Cash decreases.)

Yes

Yes (The liability Accounts Payable increases.)

Yes

Learning Goal 8: Explain the Four Basic Changes in Owners Equity

S5

SOLUTIONS
LG 8-6, continued

Learning Goal 8, continued

Transaction f. The owner pays himself a salary and withdraws $1,000 in cash. g. A business pays this months telephone bill of $300 as soon as it is received. h. A business owes its employees $15,000 in wages but will not pay them until next Monday. i. Next Monday, the business pays the wages owing to the employees.

Assets decreased or liabilities increased? Yes (The asset Cash decreases.)

Expense? No

Why is it an expense or not an expense? Drawing is never an expense; it is not part of business operations. Cash decreases immediately as a result of operations. A new claim is placed on existing assets because of a service consumed and not paid for.

OE

Yes (The asset Cash decreases.)

Yes

Yes (The liability Wages Payable increases.)

Yes

Yes (The asset Cash decreases.)

No

Payment of debt is never an expense.

S6

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S
LG 8-7.

Learning Goal 8, continued

Transaction a. The business borrows $10,000 and records a liability to Fifth National Bank. b. The business owes its employees $8,500 for this weeks wages and records it as a new liability by classifying it as Wages Payable. c. The business receives a bill for this months utilities. d. The business receives a bill for this months accounting services. e. The business purchases $700 of supplies on account. f. The $700 of supplies is consumed.

Expense? No

Liabilities increased? Yes (The liability Notes Payable increases.) Yes (The liability Wages Payable increases.) Yes (The liability Accounts Payable increases.) Yes (The liability Accounts Payable increases.) Yes (The liability Accounts Payable increases.) No (Liabilities are not affected.)

Did event happen as part of revenue-earning operations? No (Borrowing money is not part of revenue-earning operations.) Yes (Employee services were used.)

Yes

Yes

Yes (Utility services were consumed.) Yes (Accounting services were consumed.) No (A resource has not been consumed in operations.) Yes (This is to remind you that the expense occurs when the supplies are consumed, even though the $700 liability for the purchase of the supplies happened in example f.) No (A resource has not been consumed in operations.) Yes (Repair services were consumed.) No (A resource has not been consumed in operations.)

Yes

No

Yes

g. The business purchases $4,000 of equipment on account. h. The business receives a $1,000 bill for this months computer repair services. i. The business receives a $500 prepayment from a customer for services to be performed next month.

No

Yes (The liability Accounts Payable increases.) Yes (The liability Accounts Payable increases.) Yes (The liability Unearned Revenue increases.)

Yes

No

Learning Goal 8: Explain the Four Basic Changes in Owners Equity

S7

SOLUTIONS
LG 8-8.

Learning Goal 8, continued

Transaction affecting owners equity a. An accountant prepares a tax return and collects $500 from a client. b. An owner invests $10,000 cash in her business. c. Ofce supplies are used up. d. A business receives a bill for consulting services payable on account. e. The same accountant as in (a) above prepares another tax return for $400 and sends the bill to the client. f. A real estate company receives and pays its current bill for advertising. g. A law rm receives its current bill from the telephone company but does not immediately pay it. h. An owner withdraws $500 worth of supplies from his business. i. An airline company provides a ight to a customer who purchased the ticket three months ago. j. The accountant receives a bill for computer repair services for this month for $950. k. An owner pays a debt of his business by writing a check on his personal checking account (not a good business practice).

Type of change to owners equity Revenue Owners investment Expense Expense

Owners equity increase or decrease? Increase Increase Decrease Decrease

Asset or liability affected? Asset (Cash) Asset (Cash) Asset (Supplies) Liability (Accounts Payable) Asset (Accounts Receivable) Asset (Cash) Liability (Accounts Payable) Asset (Supplies) Liability (Unearned Revenue) Liability (Accounts Payable) Liability (Debt decreased)

Increase or decrease? Increase Increase Decrease Increase

Revenue

Increase

Increase

Expense Expense

Decrease Decrease

Decrease Increase

Owners drawing Revenue

Decrease Increase

Decrease Decrease

Expense

Decrease

Increase

Owners investment

Increase

Decrease

S8

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S
LG 8-9.

Learning Goal 8, continued

a. Assets increase, but not as a result of revenue-earning operations. Only creditors equity is affected. b. The advance payment is not the result of a sale, so owners equity is not affected. c. Again, only creditors equity is affected. Paying a debt is never an expense. d. Assets increase, but not as a result of revenue-earning operations or owners investment. Only creditors equity is affected. e. There is no change in total assets. Cash increases but accounts receivable decrease. Collection of a receivable is not part of revenue-earning operations. (The revenue was earned previously, when the receivable was created.)

Learning Goal 7: Identify Common Assets and Liability

S1

SOLUTIONS
Reinforcement Problems

Learning Goal 7

LG 7-1.
Name of the Item a. A formal written promise by someone else to pay cash to our business b. Amounts owing suppliers or service providers, usually due in 3090 days c. Items needed for the daily operation of a business and consumed in a year or less d. Money that is collectible in addition to a note receivable e. Currency on hand, plus amounts in checking and savings accounts f. A formal written promise by our business to pay someone else g. Amounts owed to us by our customers, usually due in 3090 days h. Money that is owed because of item (f), above, but is not yet paid i. A payment to a provider of services or goods before they are received j. The receipt of a prepayment from a customer before providing goods or services to that customer Note receivable Accounts payable Supplies Interest receivable Cash Note payable Accounts receivable Interest payable Prepaid expense Unearned revenue

LG 7-2. An account receivable is money that is receivable from a customer as a result of making a sale and is normally due in 3090 days. A note receivable is a formal written promise to pay money to your business by someone else. A note receivable is normally due any time from several months to many years depending on the terms of the particular note. Interest is the cost of borrowing money. (You could think of it as the rental charge for money.) Interest receivable is the interest that the holder of the note is expecting to receive from the borrower for the use of the money for a particular period of time that has elapsed.

LG 7-3. Ofce supplies are assets that are consumed quickly (in less than a year) in the normal course of business (such as paper, pens and pencils, paper clips, and copy machine toner). Ofce equipment is a category of assets that have a much longer useful life (greater than a year) and are used up slowly (such as desks, le cabinets, and computers).

Learning Goal 6: Analyze Individual Transactions

S1

SOLUTIONS
Multiple Choice 1. b
A = L + OE

Learning Goal 6

2. d
A = L + OE

3. d
A = L + OE

L (+) A (+) OE (+) A ()

L A () OE

L ()

OE

4. c
A = L + OE

5. c
A = L + OE
(+) L (+) OE (+) A () OE

6. c
A = L + OE

L A (+)

L A () OE ()

7. c
A = L + OE

8. d
A = L + OE

L () A () OE
(+) A ()

OE

Reinforcement Problems

LG 6-1.
a. Borrowing money; purchasing assets on credit; receiving a prepayment from a customer. b. Purchasing an asset for cash; using an asset to exchange for a different asset; collecting an account receivable. c. Expense: An asset is used up while operating the business, such as using up supplies; the owner withdraws cash or other assets. d. Not possible. (Notice that the accounting equation would not balance.) e. A bill for services is received but not immediately paid, such as telephone expense; wages are owed to employees. f. A bill is paid; a loan is repaid. g. The business performs services for a customer from whom it had previously received an advance payment.

S2

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S
LG 6-2.

Learning Goal 6, continued

A Step 1: Are assets affected? $10,000 $5,000

L Step 2: Are liabilities affected? No $5,000

OE Step 3: Is owners equity affected? $10,000 No

Transaction a. The owner of Ellisville Enterprises invests $10,000 in his business. b. Senatobia Company borrowed $5,000. c. Youngstown Service Company earned $1,000 of revenue that had already been prepaid by a customer last month.

No $1,000 $1,000 (The liability decreases because the business provided services to the customer who had paid in advance, which is a liability (see page 126). $5,000 $5,000 $2,500 $$$ No No No No $2,500 No $2,500 $$$ $2,500

d. Canton Corporation used $5,000 of cash to purchase supplies. e. Brownsville Company provided $2,500 of consulting services to a customer on credit. f. Harlingen Partnership received a telephone bill and paid it at once. g. Chula Vista Corporation used $2,500 of consulting services and did not pay for them immediately. h. Redding Company purchased $10,000 of equipment by paying $2,000 cash and borrowing $8,000. i. Shasta Company collects $1,000 owed by a customer on account.

$10,000 $2,000

$8,000

No

$1,000 $1,000

No

No

LG 6-3.
a. The business performed services for a customer from whom it had previously received an advance payment. b. The business paid a debt of some kind. c. The business used up assets as part of operationsan expense. d. The owner withdrew assets for personal use. e. Cash was used to purchase an asset; one asset was exchanged for a different asset; an account receivable was collected. f. A bill for services was received which was not immediately paidan unpaid expense. g. The business performed services for customers and received cash or accounts receivable, or any other asset. h. The owner made an investment in the business. i. The business borrowed money or purchased assets on credit. j. If there was a transaction, it was one that had nothing to do with the business, so assets, liabilities, and owners equity were all unaffected.

Learning Goal 6: Analyze Individual Transactions

S3

SOLUTIONS
LG 6-4.

Learning Goal 6, continued

b. Either the owner has invested $5,000 in the business, or the business has earned $5,000 of revenue and received cash or another asset. c. $6,000 of liabilities were paid, using up $6,000 of assets (probably cash). d. The business provided services for a customer that had made an advance payment, thereby increasing the owners equity and eliminating the obligation to the customer. e. Assets are decreased either by being used up as part of business operations (an expense) or being withdrawn by the owner (a draw). f. Given that there has to be at least one business transaction, then probably an asset was reduced while another was increased, such as using cash to buy supplies. This would keep the total assets unchanged at $8,000. g. $4,000 worth of services were consumed and not immediately paid for (example: wages owed to employees).

LG 6-5. b. Assets
$1,000 + $1,000

= Liabilities $ _______

+ Owners Equity $ ________

c.

Assets + $1,000

= Liabilities + $1,000

+ Owners Equity $ ________

Ext, Ex

(+) $1,000 A () $1,000 OE

L (+) $1,000

Ext, Ex

A (+) $1,000 OE

d.

Assets + $5,000

= Liabilities $ _______

+ Owners Equity + $5000

e.

Assets $1,200

= Liabilities $ _______

+ Owners Equity $1,200

(+) $5,000

() $1,200

Ext, Ex

A (+) $5,000 OE

Ext, Ex

A () $1,200 OE

S4

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S
LG 6-5, continued
f.
Assets $750 = Liabilities $750

Learning Goal 6, continued

g.
Assets $250 = Liabilities $ _______ + Owners Equity $250

+ Owners Equity $ ________

Ext, Ex

L () $750 A () $750 OE

() $250

Int, N-Ex

A () $250 OE

h.

Assets $ _____

= Liabilities + $150

+ Owners Equity $150

i.

Assets + $1,200

= Liabilities + $1,200

+ Owners Equity $ ________

L (+) $150

Ext, Ex

A () $150 OE

Ext, Ex

L (+) $1,200 A (+) $1,200 OE

Learning Goal 6: Analyze Individual Transactions

S5

SOLUTIONS

Learning Goal 6, continued

k.
Assets $1,000 = Liabilities $ _______ + Owners Equity $1,500

LG 6-5, continued j. Assets = Liabilities + Owners Equity

$ _____ $1,200 + $1,200

L () $1,200

() $1,500

Ext, Ex

A (+) $1,200 OE

Int, N-Ex

A () $1,500 OE

l.

Assets $ _____

= Liabilities $ _____

+ Owners Equity $ _____

m.

= Liabilities Assets + $3,500 $2,500 $1,000

+ Owners Equity $ _____

L A OE

Ext, Ex

+$3,500 Equipment A $1,000 Cash

+$2,500 Note Payable L

OE

Note: This is not a Hot Spots transaction. This is a personal expenditure.

S6

Section II . TransactionsAnalyzing and Visualizing

SO L U T ION S

Learning Goal 6, continued

LG 6-6. Refer to the six illustrations on page 134.

LG 6-7.
Item a. Step 1: Are assets affected? The asset equipment increases $8,000 and the asset Cash decreases $2,000. Step 2: Are liabilities affected? A liability increase of $6,000 occurs. Step 3: Is owners equity affected? No Correct Recording in Equation A = L + OE 6,000 6,000

The recording was incorrect because the equation was not in balance and because assets should have shown a net increase of $6,000. This was the equipment increase of $8,000 less the cash decrease of $2,000. b. Cash increases by $900 and accounts receivable decrease by $900. No No A = L + OE 900 900

The recording was incorrect because the revenue was already earned in a previous period when the account receivable was recorded. Here, the receivable is simply eliminated when the cash is received. c. Ofce Supplies increase by $2,000 and cash decreases by $2,000. No No A = L + OE 2,000 2,000

The recording was incorrect because there is no expenseone asset (Cash) is being given up to obtain another asset (Ofce Supplies). An expense would have occurred only if there had been a net decrease in assets because they were used up in the operations. d. Cash decreases by $750. Accounts Payable decrease by $750. No A = L + OE 750 750

The recording was incorrect because there is no expense. Paying a debt is a reduction in a creditors claim on assets; the cash is not being used in operations, so there is no expense. e. No Accounts Payable increase. Owners equity decreases because of telephone expense. A = L + OE 200 200 (expense)

Not recording the event was incorrect because an expense happens the moment a resource is consumed. In this case, when the telephone service was used the expense occurred and should have been recorded along with a liability, because the company did not immediately pay for the service. f. Cash increases. Unearned Revenue increases. No A = L + OE 500 500

The recording was incorrect because there is no revenuethe services have not been provided yet. An advance payment from a customer creates a liability to either return the money or perform the services.

Learning Goal 6: Analyze Individual Transactions

S7

SOLUTIONS
LG 6-8.

Learning Goal 6, continued

Transaction a. The owner invested $5,000 in her business. b. Paid a repair bill immediately upon receipt. c. Purchased supplies but did not pay the bill immediately. d. Purchase equipment for $10,000 by making a cash payment of $4,000 and signing a note payable. e. Received an advance payment from a customer. f. Received an advertising services bill but did not pay it immediately. g. Borrowed money from the bank and signed a note payable. h. Paid the employee wages. i. Performed consulting services and billed the client who will pay later. j. Received payment from the client for the amount owed one month later. k. The owner withdraws $1,500 cash from the business. l. Performed consulting services and collected the amount in full from the client upon completion of the job.

A C+ C S+ C Eq + C+ _______ C+ C AR + AR C+ C C+

L _______ _______ AP + NP + UR + AP + NP + _______ _______ _______ _______ _______

OE I+ Exp _______ _______ _______ Exp _______ Exp Rev + _______ W Rev +

Learning Goal 5: Define Entity and Identify Different Types

S1

SOLUTIONS

Learning Goal 5

Multiple Choice 1. b The partners are personally liable for all partnership debts and together have legal ownership of the assets. 2. d 3. d 4. d No nancial activity takes place that needs to be reported for the Wednesday night group. 5. b 6. a 7. d The equation applies to every economic entity. 8. c There is no personal liability for this potentially dangerous product.

S2

Section I . What Is a Business?

SO L U T ION S
Reinforcement Problems

Learning Goal 5, continued

LG 5-1.
a. How many owners form a proprietorship? b. What document brings a corporation into existence? c. What is the length of life of a partnership? d. What entity is most difcult to form? e. What entity is technically easy to form but for practical purposes has many potential complications? One owner The charter The lesser of the existing group of partners or the term written in the partnership agreement. A corporation A partnership (A partnership technically can be formed with a verbal agreement and by individuals behaving as partners, but this is very unwise.) A corporation A corporation A proprietorship or general partnership A proprietorship A proprietorship (1) No personal liability, (2) potentially greater resources, (3) often easier to transfer ownership than a partnership Two or more One or more (One person can own all the stock.) Unlimited life (1) Personal liability, (2) limited resources This is called a withdrawal or a drawing. (It is not a salary expense of the business.) Common stock A corporation

f. What entity is a legal person that incurs liability separate from the owners of the entity? g. The owners of what business are called stockholders or shareholders? h. As an owner, you will have personal liability if you form what type of entity? i. What is the most common form of business? j. What form of business is easiest to create? k. What are the three biggest advantages of a corporation?

l. How many owners form a partnership? m. How many owners form a corporation? n. What is the length of life of a corporation? o. What are the main disadvantages of a proprietorship? p. The owner of a proprietorship writes herself a check from the business bank account. What is this payment called? q. What indicates ownership in a corporation? r. What is the type of entity that potentially can obtain the most money from investors?

Learning Goal 4: Use the Accounting Equation to Show the Condition

S1

SOLUTIONS
Reinforcement Problems

Learning Goal 4

LG 4-1.
Total Assets = Total Liabilities + Owners Equity a. Mohawk Company (June 30, 2008) b. Nez Perce Company (December 31, 2008) c. Lakota Company (October 31, 2007) d. Modoc Company (March 31, 2007) e. Cherokee Company (April 30, 2008) f. Seminole Company (December 31, 2008) $251,000 A L OE (A $40,700) $50,000 A L OE (A $225,000) $200,000 $815,000 $200,000 $18,500 A OE L (L $15,000) $45,000 $251,000 A OE L (L $170,000) A L OE (OE $51,000) $22,200 $35,000 $180,000 A L OE (OE $51,000) $645,000

Meaning of situation (e): Yes, this is not unusual. It means that a business has consumed so many assets that there are not enough assets left to pay the creditors. This negative owners equity means that the owner will have to invest $51,000 more so the business can pay all the liabilities, if the business were to be terminated today.

S2

Section I . What Is a Business?

SO L U T ION S
LG 4-2.
Item a. Money owed to a supplier b. Cash c. Ofce supplies

Learning Goal 4, continued

A, L, or OE L A A L OE None (perhaps some undetermined legal obligation, but no nancial liability to creditor.) A A L A None (It doesnt meet the denition of asset.) None (Somebody else owns the building.) A

d. Money owed to the bank for a loan e. The amount of assets that would go to the owner after the all creditors are paid f. A signed contract requiring us to provide services next month

g. A computer h. Computer software i. A bill from the telephone company for this months service j. Land k. An employee l. An ofce building our company is renting m. Money owed to us by our customers

LG 4-3. Any business consists of three fundamental nancial elements: Assets, Liabilities, and Owners Equity. They are always related to each other in this way: A = L + OE, so this relationship will always explain the essential nancial condition of any business.

LG 4-4. This feature is sometimes written into business loans. If $80,000 is the only debt, then $80,000 is 40% of what amount? $80,000 /.4 = $200,000 amount of assets. So if the assets were $200,000 and the liabilities were $80,000, then owners equity would be $120,000.

Learning Goal 3: Define and Identify the Two Claims on Assets

S1

SOLUTIONS
Reinforcement Problems

Learning Goal 3

LG 3-1.
a. Creditors and the owner(s). They provide property and services. b. The creditors have provided resources to the business for which the business has not paid them. The owner also provided resources and has the legal right to claim the value of the assets, except for the amount needed to pay the creditors. c. Because the owners management efforts will cause the total business assets (wealth) to increase or decrease, and this changes the owners claim. d. Owner services do not have a xed dollar value like wages. Owner services are an investment of time and effort. This value shows up as the increase or decrease in the wealth of the business, which changes the owners claim. (However, this is different in a corporation, where an owner can also be an employee; see Learning Goal 5.)

LG 3-2.
a. b. c. d. Yes. $800. Yes. Initially $500, and then the claim is reduced to $400 after the payment is made. Yes. The owners claim increases by $5,000. The effect of the owners services can only be measured by the change in the wealth of the business as a result of business operations. Owners services are not wagesthe owner is not an employee of himselfso the $30 per hour is irrelevant.

LG 3-3. Owners equity is the owners claim on the assets. It is secondary to the creditors claim.

LG 3-4. Liabilities are debts of the business. They have the rst claim on assets. Some examples are wages owed to employees, debts to vendors, and unpaid bank loans.

LG 3-5. While it is true that the creditors and the owner directly provide assets to a business, they also provide services. Both liability and owners claims on the assets arise not only for the assets provided, but also for services provided. (The owners good or bad management services indirectly change the owners claim.)

LG 3-6. No. Priority means: (A) all business debts must be paid when they are due, regardless of what the owner might want, and (B) when a business is terminated and liquidated, all existing debts have priority over the owners claim on assets. The owner can withdraw assets at any time. However, debts still have to be paid in the manner stated above, and if the owner withdraws too much, he is legally obligated to reinvest enough money to make sure the debts are paid.

S2

Section I . What Is a Business?

SO L U T ION S
LG 3-7.

Learning Goal 3, continued

Description of Equity Characteristic a. It always has the rst claim on assets. b. It is increased by owners hard work and risk-taking. c. It is usually called liabilities. d. It is known as a residual claim on assets. e. They are the debts of the business. f. It is increased when the owner invests in his/her business. g. It is created when someone other than the owner provides assets or services to the business that are not immediately paid for. h. Together they always add up to the total amount of assets.

Creditors Equity

Owners Equity

Learning Goal 2: Define and Identify Assets

S1

SOLUTIONS
Reinforcement Problems

Learning Goal 2

LG 2-1. An asset is property that is owned by a business. Every asset must be able to provide a future benet to the business to which it belongs. The asset must be owned by the business as a result of a past event.

LG 2-2. The everyday, nontechnical meaning of the word asset is anything that has a benecial quality or trait.

LG 2-3. The two essential qualities of a business asset are: (a) It must provide future benets to a business, and (b) it must be owned as a result of a past event.

LG 2-4. Your answer will be different from this answer. Nevertheless, notice how the everyday example of an asset excludes some of the necessary qualities of a business asset, and the business example includes all of the necessary qualities. You should look for this in your own examples.
Everyday Asset: I love my bicycle! I found it sometime last summer in a park (a past event), so I did not pay anything for it, and Im not even sure what it would cost. It looks old, is rusting, is slow, and has only one speed, but people like to look at it and ask questions because its an antique! Thats how they become my friends. And the bike gives me pleasure because while I slooowwwly pedal it, I notice more owers and trees. And by doing all this pedaling, I have lost eight pounds. In this story, the bicycle provides the benets of pleasure and a way to make new friends, but these are not business benets. Also, we cannot be certain of who really owns the bicycle. There was never any kind of dollar value transaction that took place to acquire it, nor do we know what date it was acquired. Business Asset: We use a bicycle in our business to provide fast, inner-city delivery of documents. Our business bought the bicycle on August 10 for $800. The employee assigned to use the bicycle can make deliveries in half the time of a professional courier service. In this story, both qualities of a business asset are set forth: the business benets it provides (speedy delivery); it is owned by the business as the result of a past event. Notice also that there will be objective evidence and an identiable historical cost.

LG 2-5.
Business item an asset a. The supervisors of a business b. Ofce supplies c. Cash in the checking account It is . . . not an asset Missing quality Future benets Owned as a result of a past event

S2

Section I . What Is a Business?

SO L U T ION S
LG 2-5, continued
Business item

Learning Goal 2, continued

It is . . . an asset not an asset

Missing quality Future benets Owned as a result of a past event

d. The legal right to collect $500 that customers owe the business e. The new airport to be built next year, ve miles from your business f. A 12-year-old computer that is no longer functional g. An expensive French impressionist painting purchased to hang in the lobby of your ofce h. A building that your company rents from Multnomah Company i. A prepaid $700 re insurance policy j. The business owners masters degree Note: this is not something owned by the business k. The computer that your business rents and uses to produce marketing brochures l. A promise by a good customer to buy $10,000 of merchandise from your business

Note: not a past event; certain legal details aside, your company has nothing but a promise m. The $5,000 increase in value of the French painting your business bought six years ago. ?

Note: any increase in value is only an estimate, so future benets are not really meaurable n. A mission statement explaining company goals that managers prepared o. The employees of a business p. A budgeted amount to buy ofce equipment q. Money that your business owes to vendors

Note: This is DEBT, which is the claim of someone else on the business assets! Were you fooled? Dont worry, we discuss more about debts and assets in the next learning goal.

Learning Goal 2: Define and Identify Assets

S3

SOLUTIONS
LG 2-6.
Item

Learning Goal 2, continued

Property

Service

a. The aircraft of a commercial airline company b. A medical examination by your doctor c. The medical equipment in the doctors ofce d. The gasoline in your car e. The cash in a savings account f. The classroom lecture from your accounting instructor g. The rental of a computer to a business that does not own one h. A six-month re insurance policy paid in advance

Note: Anything prepaid is property, even prepayment of a service as in this case. A prepayment is owned by whomever made the prepayment, and the benet is the right to receive future re insurance coverage. We will talk more about prepaid items in later sections of this volume and in Volume 2.

LG 2-7.
a. Because the machine has a market value and can be sold for $250, it is still an assetthe $250 represents potential future benets that can be received. b. Because the machine is still functional and is able to provide operational benets, it is still an asset to the business that is using itdespite the fact that no one would buy it. The historical cost of the item will be the dollar amount used to keep the item in the accounting records. c. No, it is not an asset. The equipment no longer provides any kind of benetseither future sales price or operational cash ow. When property loses all future benets to a business, the item is no longer an asset, even if it has some kind of functionality. d. Yes, an item can be an asset even though it is acquired at no costfor example, a donation of land by a local city to attract a new business. However, the item must have some measurable value or it cannot be recorded, even if it otherwise would qualify as an asset. In the case of an asset acquired at no cost, the usual method is to use its appraised value. The best approach would be to use one or more certied appraisers. Another example: A business locates an old machine that no one wants and obtains it without cost. The machine is in some particular way useful to the operations of the business, so it provides some future benets. The business would record the machine at its appraised value. Summary: In addition to being owned as the result of a past event, an item must provide some kind of future benets to qualify as an asset. As well, for the asset to be recorded it must also be able to be valued at some measurable amounteither at historical cost, appraised value, or some other reliable valuation. Comment: Valuation issues are among the most tricky and difcult issues in accounting. How to determine the best valuation is the subject of frequent debate and controversy among professional accountants and academics. We return to the subject of valuation again in other learning goals.

Learning Goal 1: Explain What a Business Is and What It Does

S1

SOLUTIONS

Learning Goal 1

Multiple Choice 1. b 2. d 3. a 4. b Revenue is a word that confuses many people. Usually they think revenue is the same thing as wealth (like cash, or some other valuable thing). Revenue is not a thing. Revenue is a measure of what customers paid for something the business sold. Revenue conrms the added value of what the business is offering. 5. d A business does not really know the total added value created by consuming resources until a sale is made. Making a sale does not mean there is a prot. 6. b Expenses are resources that are used up in operations and reduce wealth. Whether or not expenses will add value depends on how the resources are used. 7. c 8. c 9. a Notice that (d) is incorrect because a business can be adding value and still have a loss. This is because it is not adding enough value! 10. c Customers do not want cookie prices increased because of resources consumed by waste and loss.

S2

Section I . What Is a Business?

SO L U T ION S
Reinforcement Problems

Learning Goal 1, continued

LG 1-1.
a. A meal is created using various resources such as labor, food, and equipment. The meal provides valuable pleasure and energy to the customer, who pays for it. b. Information is made available that will inform people of the availability of new services and low-cost loans. People will want this information and want to borrow money, for which the bank will charge. c. The automobiles are made safer, which customers will perceive as adding to the total value of the automobile, making it more desirable. At a minimum, the cost of testing resources will be added to the price of the new car. The customer will probably pay itand probably much morevery willingly. d. People are willing to pay more for better, safer surgery.

LG 1-2.
a. Unless you think that people will like liver-avored toothpaste (personally, I nd it revolting), I would say that the total added value of the toothpaste is zero (unless it might be sold as a joke novelty) because I think no one will buy it at any price. So, the cost of the resources used to produce it will be lost, because thousands of tubes of the toothpaste will have to be disposed of, probably in a toxic-waste site. b. This is a difcult question, but typical of the uncertainty managers have to deal with. First, my feeling is that the exercise and child-care facilities will probably add more value than the value received from using four new trucks, depending upon how many other trucks are available and the need for the new ones. This is because healthy employees and employees with peace of mind will be far more careful and creative. They will produce and create quality things that ultimately increase the total added value (revenue). Second, cost of production will probably decline, employee turnover and training costs will be reduced, and company loyalty might be created. Thus, total expenses will also probably be reduced. This reduces the amount of resources used, even if total added value is not changed at all.

LG 1-3.
a. This is a combination business. It is both a service (veterinary service) and a merchandising (pet-care products) business. However, it is primarily a service business. b. The clinic adds value primarily by providing veterinary medical care, which people need and are willing to pay for. Secondarily, the clinic adds value by offering a selection of pet-care merchandise, which people also need and will pay for. Two new resources are being created: (1) veterinary medical services, and (2) pet-care merchandise selection. c. Total added value conrmed by the revenue was $40,700 ($38,500 + $2,200). Based on the initial prices, the clinic apparently thought the merchandise had an added value of $2,500, instead of $2,200 it actually sold for. d. (1) Service resources consumed: $25,900 ($21,200 + $2,000 + $450 + $1,100 + $400 + $750) (2) Property resources consumed: $2,800 ($2,000 + $800) e. The value chain includes consuming both services and property. Wages, rent, utilities, repairs, supplies, advertising, accounting and management, and cost of merchandise sold are the items that we know about. Total expenses in the value chain were $28,700.

Learning Goal 1: Explain What a Business Is and What It Does

S3

SOLUTIONS
LG 1-3, continued

Learning Goal 1, continued

f. No. The repairs to the damaged equipment caused by poor training did not add value. Also, I have some doubts about the wages of the poorly trained employee adding much value in the future. g. The wealth of the business increased by $12,000 during the month ($40,700 $28,700). Because the business had this $12,000 net income, I would say that last month was successful. Note: Using the $10,000 cash to purchase equipment does not diminish wealth; it simply changes form from cash into equipment. The merchandise, which is a resource purchased at some previous time, is now consumed because it was sold to customers.

LG 1-4.
a. An account receivable is a legal right to collect money that the business owns as the result of making a sale. Even though you cannot touch it (like a desk or a computer) a legal right is property. Property that does not have physical substance, such as a legal right, is called intangible property. We discuss this more in Volume 2. Cash is not the same as accounts receivable. They are different kinds of property. b. This is a tricky question because it is not clear that any wealth (only services) is actually being received. However, each business is still accumulating wealth as a result of being in business! Example: suppose that Business A provides consulting service to Business B. Then Business B provides advertising service to Business A. Business B has now received consulting services without paying. Business A has now received advertising service without paying. Obtaining any valuable resource without paying for it (money saved) has exactly the same effect on total wealth as receiving the same amount of money from a sale. Note: This concept assumes that the exchange of services is a genuine transaction in which each company is consuming resources as it provides real servicesthat no fraud or fake transactions are involved.

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S1

SOLUTIONS

Learning Goal 17

Multiple Choice 1. d 2. c 3. d Choice c is incorrect because it says: . . . at a specic date. Revenues and expenses are over a period of time. 4. c An expense either decreases an asset or increases a liability (see Learning Goal 6 on page 94). 5. b A revenue either increases an asset or decreases a liability (see Learning Goal 6 on page 94). 6. d Revenues and expenses are combined as the net income or net loss taken from the income statement. 7. b 8. d 9. d 10. c 11. c 12. c 13. d You could also nd out the cash balance from the statement of cash ows. 14. c 15. a Because Revenues Expenses = Net Income. So, R 50,000 = (7,000). R = 43,000. 16. a Because Beginning Balance + (10,000 12,000 + 5,000) = 90,000. So, Beginning Balance = 107,000. 17. a Total owners equity increased by $20,000. There are three possible changes on the statement of owners equity (net income/(loss), investments, and drawing), but there was no drawing. Therefore, net income is the $20,000 increase minus the increase caused by the investment of $5,000 = $15,000. 18. c 19. c 20. a

Discussion Questions and Brief Exercises for Learning Goals 1217 1. The correct format is:
Name of Company Name of Financial Statement Date (or Period, if a change statement)

2. For change statements (income statement, statement of owners equity, and statement of cash ows), the date should identify the period of time and the date on which it ends. For example, Month Ended December 31, 2008. Period Ended is not acceptable because it does not identify the exact period of time. For a balance sheet, the exact date should be used. For example, December 31, 2008. 3. Revenue: The dollar amount of sales of goods or services. This increases owners equity. Expense: The dollar amount of goods or services used up in operations. This decreases owners equity. 4. Assets: Business property, the wealth of the business Liabilities: Debts owed, the rst claim on the business wealth Owners equity: The residual claim on the wealth left to the owner after all debts are paid 5. The purpose of the income statement is to explain the change in owners equity, for a specic period of time, that has resulted only from the business operations. This is accomplished by identifying revenues and expenses and subtracting the total expenses from the total revenues.

S2

Section IV The Essential Financial Statements

SO L U T ION S

Learning Goal 17, continued

6. The purpose of the statement of owners equity is to explain, for a specic period of time, the entire change in owners equity. This is accomplished by combining the net income or net loss (from the income statement) with the owners investments and withdrawals. 7. The purpose of the balance sheet is to show the business wealth and the claims on that wealth. This is accomplished by listing all the assets with dollar amounts, the debts owed and their amounts, and then recording the difference between the two totals as owners equity. 8. The purpose of the statement of cash ows is to explain, for a specic period of time, the change in the amount of cash shown on the balance sheet. 9. The statements are connected. This connection is called articulation. Specically:
The net income on the income statement is also included on the statement of owners equity to explain the amount of the change in owners equity that was caused by the business operations (compared to other changes in owners equity caused by owner investments or withdrawals). The statement of owners equity explains all the changes in owners equity during a period. The ending balance of owners equity on the statement of owners equity is also exactly the same amount of owners equity that appears on the balance sheet. The balance sheet and the income statement are also related. Every item of revenue or expense on the income statement will affect some asset or liability item on the balance sheet by the same amount. Income statement: Revenue increases, and therefore net income increases. Statement of owners equity: Net income increases, and therefore the ending balance of owners equity increases. Balance sheet: The asset Cash increases, and owners equity increases. Income statement: An expense increases, and therefore net income decreases. Statement of owners equity: Net income decreases, and therefore the ending balance of owners equity decreases. Balance sheet: The asset Supplies decreases, and owners equity decreases. Change in owners equity during September: $259,000 $250,000 = $9,000 decrease. $15,000 withdrawals $9,000 total decrease = $6,000 difference to account for. This is the net income from the income statement. The owners withdrawal reduced the owners equity by $15,000, but this decrease of owners equity was partially offset by $6,000 of net income, so the total decrease was only $9,000. OR: 259,000 + X 15,000 = 250,000. x = 6,000. The change statements are the income statement, the statement of owners equity, and the statement of cash ows. The condition statement is the balance sheet, which shows wealth and claims on wealth (the nancial condition) at a point in time. Four important qualities are:

10.

11.

12.

13. 14.

reliability relevance consistency comparability

The qualities of reliability and relevance are most important. If information is not reliable and not relevant, it will never be useful, regardless of other qualities.

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S3

SOLUTIONS
Reinforcement Problems

Learning Goal 17, continued

LG 17-1.
Balance Sheet depends on method Income Statement Statement of Owners Equity Statement of Cash Flows

Item Ofce Supplies Service Revenue Accounts Payable Net Loss Withdrawals (Drawing) Financing Activities Bill Jones, CapitalMay 31 Wages Expense Net Income Accounts Receivable Operating Activities Investing Activities Rent Expense Bill Jones, CapitalMay 1 Unearned Revenue Wages Payable Cash Prepaid Rent Expense

S4

Section IV The Essential Financial Statements

SO L U T ION S
LG 17-2.

Learning Goal 17, continued

Income Statement Revenue a. Cash b. Accounts Payable c. Interest Revenue d. Interest Receivable e. Fees Earned f. Unearned Revenue g. Notes Receivable h. Wages Payable i. j. l. Ofce Supplies Ofce Equipment Prepaid Insurance Expense Asset

Balance Sheet Liability Capital

k. Ofce Supplies Expense m. Dee Markowitz, Capital

LG 17-3.
Transaction a. The owner invests $7,500 in his business. b. The business earns service revenue and receives $500 cash. c. The business buys $100 of ofce supplies on account. d. The business buys $2,000 of equipment for cash. e. The business pays rent expense of $1,500. f. The business earns service revenue for $1,000 on account (accounts receivable). g. The business pays the $100 account payable for the purchases of supplies. h. The owner withdraws $200 cash. i. The business collects $1,000 cash from the account receivable. Effect + + NE NE + NE NE

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S5

SOLUTIONS
LG 17-4.

Learning Goal 17, continued

Balance Sheet
Asset Liability Owners Equity

Income Statement
Revenue Expense

Statement of Owners Equity

Net Income/ Investment (Net Loss/ Withdrawal)

Statement of Cash Flows

Source of Cash (Use of Cash)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16)

$40,000 1,800 (1,100) 1,100 3,300 2,850 1,650 700 (200) (820) (2,100) (1,700) 1,700 (1,140) (700) (700) 3,100 $39,170 $45,780 $6,610 $39,170 $6,090 $4,820 3,100 1,140 2,850 1,650 $700 200 820 $3,300 $1,800

$40,000

$40,000 ($1,100)

2,850 1,650 (200) (2,100) 1,700 (700) 1,270 $46,200 ($4,100) (2,100)

The owners equity is $45,780 $6,610 = $39,170 The net income is $6,090 $4,820 = $1,270 The net change in the cash balance is $46,200 $4,100 = $42,100

S6

Section IV The Essential Financial Statements

SO L U T ION S
LG 17-5.

Learning Goal 17, continued

Balance Sheet Errors

Income Statement Errors

Statement of Owners Equity Errors

Assets are in the wrong order. Accounts receivable and supplies should come after cash. Addition error. Assets total $27,125. The correct terminology to use for a nancial statement is liabilities, not debts. Total is used instead of Total Assets and Total Liabilities. Capital is misspelled with an o. The owners equity cannot be $24,485 if the balance sheet balances but the assets were added incorrectly. Dollar signs should only be used for the rst number in a column and a nal total in a column.

Date is incorrect. The income statement is for a period, and the date should read For the Month Ending November 30, 2008. (Making a mistake in the title does not look good!) Unearned revenues is a liability, not a revenue. The $3,500 should be part of the liabilities on the balance sheet. Prepaid expenses are an asset, not an expense. The $4,100 should be an asset on the balance sheet. Prot is not the correct terminology for an income statement. The correct term is Net Income. The correct net income is $14,860.

The date is wrong again! The period ending . . . is not correct because a period can be any length of time, and this statement is for a month. It should read For the month ending . . . Net income of $14,620 is not the same number as the net income on the income statement. The difference is $360. The ending capital balance of $24,945 is not the same balance as the amount of $24,485 on the balance sheet. These numbers must be the same.

Why all these detail corrections? People must have total condence in the complete reliability of nancial statements. Financial statements must be useful and as easy as possible to read. This includes every detail, such as making sure that terminology and format are accurate, clear, and consistent. This takes practice, and now is a good time to begin with the basics. Final score? I count 14 mistakes! 30 possible 14 wrong = a nal score of 16.

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S7

SOLUTIONS
LG 17-6.

Learning Goal 17, continued

Mheta Tarsal Medical School JANUARY 1, 2008 Assets Liabilities Owners Equity DECEMBER 31, 2008 Assets Liabilities Owners Equity $120,000 $ 40,000 b. $ 80,000 $ 75,000 $ 15,000 a. $ 60,000

Lynne Guinni Cooking College

Pop Flies Baseball Clinic

Manuel Dexterity Acting Academy

$100,000 $ 20,000 d. $ 80,000

g. $ 46,000 $ 15,000 h. $ 31,000

$120,000 j. $ 28,000 k. $ 92,000

$112,000 e. $ 12,000 f. $100,000

$ 51,000 $ 1,000 i. $ 50,000

l. $ 72,000 $ 50,000 $ 22,000

CHANGE IN OWNERS EQUITY DURING 2008 Owner Investment Revenues Expenses Withdrawals c. $ 8,000 $ 12,000 $ 82,000 $ 71,000 $ 3,000 $ 0 $ 10,000 $ 98,000 $178,000 $ 0 $ 52,000 $ 35,000 $ 5,000 $ 49,000 $ 22,000 $ 8,000

LG 17-7.

Wendy Monahan Real Estate Company Income Statement For the Year Ended December 31, 200X Service revenue Expenses Wages expense Rent expense Telephone expense Interest expense Insurance expense Travel expense Total expenses Net income $221,800 $108,000 24,000 2,450 2,100 780 650 137,980 $83,820

S8

Section IV The Essential Financial Statements

SO L U T ION S
LG 17-7, continued

Learning Goal 17, continued

Wendy Monahan Real Estate Company Statement of Owners Equity For the Year Ended December 31, 200X W. Monahan, Capital January 1 Add: Investments Net income Less: Withdrawals W. Monahan, Capital December 31 $183,470 18,000 83,820 285,290 55,000 $230,290

Wendy Monahan Real Estate Company Balance Sheet December 31, 200X Assets Cash Accounts receivable Ofce supplies Prepaid insurance Computer equipment Ofce furniture Land Total assets Liabilities Wages payable Accounts payable Unearned revenue Notes payable Total liabilities Owners equity Wendy Monahan, Capital Total liabilities and Owners Equity 230,290 $290,210 $7,500 24,220 3,200 25,000 59,920 $37,100 47,500 2,000 3,660 9,000 5,750 185,200 $290,210

Note: You may have the liabilities in a different order. Also you might have put furniture before equipment on the asset side.

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S9

SOLUTIONS
LG 17-8.

Learning Goal 17, continued

Robert Jimenez Company Income Statement For the Year Ended December 31, 2008 Revenue Fees earned Expenses Rent expense Travel expense Utilities expense Insurance expense Total expenses Net income $84,000 $18,400 2,050 1,000 3,000 24,450 $59,550

Robert Jimenez Company Balance Sheet December 31, 2008 Assets Cash Accounts receivable Prepaid insurance expense Equipment $38,000 12,000 2,500 15,000 Liabilities Accounts payable Notes payable Unearned fees revenue Total liabilities Owners Equity Total assets $67,500 Robert Jimenez, Capital Total liabilities and owners equity 52,550 $67,500 $ 1,150 10,000 3,800 14,950

Notes Owners equity is calculated as $67,500 $14,950 = $52,550. $ signs are generally used at the top of a column and at the total of the column. Always double-check that the title is correctly written, and especially that the date is proper.

S10

Section IV The Essential Financial Statements

SO L U T ION S
LG 17-8, continued

Learning Goal 17, continued

Robert Jimenez Company Statement of Owners Equity For the Year Ended December 31, 2008 R. Jimenez, Capital, January 1, 2008 Add: Initial investment by R. Jimenez Net income Subtotal Less: Withdrawals R. Jimenez, Capital, December 31, 2008 $ 0 $10,000 59,550 $69,550 (17,000) $52,550

Robert could probably get a loan from a bank. The balance sheet shows about $50,000 of cash or items that will quickly turn into cash ($38,000 + $12,000), while there is a need for cash of only about $11,150 assuming that the note payable is due in the near future. Also, the business is very protable ($84,000 revenues and only $24,450 of expense) which indicates a reliable, continuing business in the future. A bank would probably loan Robert something in the range of 50% to 70% of the capital minus non-cash assets such as equipment or land.

LG 17-9.

Sanderson Ecology Services Company Income Statement For the Year Ended December 31, 2008 Revenue Fees earned Expenses Wages expense Rent expense Travel expense Advertising expense Utilities expense Supplies expense Total expenses (Net loss) $ 122,500 $104,300 16,500 8,150 3,300 1,400 750 134,400 $(11,900)

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S11

SOLUTIONS
LG 17-9, continued

Learning Goal 17, continued

Sanderson Ecology Services Company Balance Sheet December 31, 2008 Assets Cash Accounts receivable Supplies Prepaid insurance Ofce equipment $199,300 43,080 3,800 1,500 25,600 Liabilities Accounts payable Unearned fees revenue Total liabilities $23,750 12,300 36,050

Owners Equity Total assets $273,280 Dave Sanderson, Capital Total liabilities and owners equity 237,230 $273,280

Note: Owners equity has to be calculated as assets minus liabilities because no other information is available.

Sanderson Ecology Services Company Statement of Owners Equity For the Year Ended December 31, 2008 Dave Sanderson, Capital, January 1, 2008 Add: Initial investment by Dave Sanderson Less: Withdrawals Net (loss) (no prior balance) (ll in) (calculate as last number) (ll in) (870) (11,900) (12,770) $237,230 $ 0 250,000

Subtotal Dave Sanderson, Capital, December 31, 2008

(calculate from b/s totals)

Withdrawals can be calculated by lling in the items on the statement of owners equity and using the ending owners equity on the balance sheet for the ending owners equity on the statement of owners equity. (Of course, you must remember that information is missing hereotherwise, the statements would be prepared independently and used to verify each other.) The amount of the withdrawals can now be determined by calculating the difference between the $250,000 and the ending owners equity balance of $237,230 less the loss of 11,900. Or, you can make the statement of owners equity into the form of an equation: $0 + $250,000 X $11,900 = $237,230 X = $870 X = $870

S12

Section IV The Essential Financial Statements

SO L U T ION S
LG 17-10.

Learning Goal 17, continued

December 31, 2007 Cash Accounts Receivable Supplies Equipment Accounts Payable J. Duneld, Capital $25,000 $12,000 $4,000 $40,000 $5,000 $76,000 Cash

December 31, 2008 $39,000 $28,000 $5,000 $41,000 $20,000 $93,000 Accounts Receivable Supplies Equipment Accounts Payable J. Duneld, Capital

2007 owners equity: Total assets of $81,000 total liabilities of $5,000 = $76,000 owners equity. 2008 owners equity: 2007 owners equity of $76,000 + year 2008 income of $17,000 = $93,000. 2007 income is not relevant, because it was already part of the December 31, 2007 owners equity. 2008 Accounts Receivable: Total liabilities and owners equity = $20,000 + $93,000 = $113,000. Therefore, total assets must also be $113,000. A/R = $113,000 $39,000 $5,000 $41,000 = $28,000.

LG 17-11. a. (1) Correct classication was important because if any other items had been used for the $1,000, both the balance sheet and income statement would show incorrect balances in some of the items. This in turn will mislead whoever uses the nancial statements for making decisions.
Some examples of possible misclassications:

Some other asset could have been used instead of supplies. This would understate the other asset and overstate Supplies. This would also affect the income statement by showing the wrong type of expense item. Example: Cash or Accounts Receivable would be understated and Supplies overstated. A liability could have been used instead of supplies. To keep the equation in balance, this would cause liabilities to be overstated. Example: $1,000 of expense is shown on the income statement and Unearned Revenue is increased. Of course, this would be a very misleading error to a user of the nancial statements. The classication only involves assets. Therefore, the expense would be understated on the income statement, and the assets would be misstated on the balance sheet. Example: Supplies are decreased and Accounts Receivable are increased. The classication is between assets and liabilities. Again, the expense is understated on the income statement, and both the assets and liabilities on the balance sheet are incorrect. Example: Supplies decrease and Unearned Revenue decreases. The classication is between only income statement items. The effect would be to misstate the items on the income statement and the items on the balance sheet. Example: On the income statement Supplies expense is increased, and Fees Earned is increased by the same amount. This overstates both items and overstates the Supplies shown on the balance sheet.

Learning Goal 17: Compare, Contrast, and Connect All the Financial Statements

S13

SOLUTIONS
LG 17-11, continued

Learning Goal 17, continued

You can see that there are many possible misclassications and that they can seriously affect the nancial statements in many ways. Hopefully this emphasizes for you the importance of proper classication. (2) This valuation error would have a very serious result because it changes the amount of the expense and therefore net income or loss, and it also affects the assets. Specically, the Supplies Expense would now become $3,000 and the net loss would increase to $2,500! As well, the balance sheet would now show only $1,000 of Supplies. This is a big difference from what the proper amounts really are. (3) This is a timing issue. Intentionally reporting the supplies being used in January instead of December is a way to overstate the December net income and overstate the total assets on the balance sheet. In fact, on the income statement instead of a net loss of $500 there would be a net income of $500! This is because the Supplies Expense would not have been recorded. Also, the total assets on the balance sheet would be overstated by $1,000 because the Supplies would be overstated by $1,000. And in January the effect would be reversed, thereby creating errors in the January balance sheet and income statement. Timing can seriously affect both the income statement and the balance sheet! b. This involves both classication and valuation. By recording the item as Fees Earned, the revenue becomes overstated and changes the net loss into net income of $14,500. The valuation is also incorrect because we know that the correct value of the transaction was really $5,000.