What Is Accounting?

Learning Objective 1

Explain what accounting is.

What consistently ranks as one of the top career opportunities in business? What frequently rates among the most popular majors on campus? Accounting.¹ Why do people choose accounting? They want to acquire the skills needed to understand what is happening financially inside a company. Accounting is the financial information system that provides these insights. In short, to understand an organization of any type, you have to know the numbers.

Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. Let’s take a closer look at these three activities.

Essential terms are printed in blue when they first appear, and are defined in the end-of-chapter Glossary Review.

Three Activities

As a starting point to the accounting process, a company identifies the economic events relevant to its business. Examples of economic events are the sale of food and snacks by Unilever (GBR and NLD), the providing of telephone services by Chunghwa Telecom (TWN), and the manufacture of motor vehicles by Tata Motors (IND).

Once a company like Unilever identifies economic events, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in monetary units. In recording, Unilever also classifies and summarizes economic events.

Finally, Unilever communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, Unilever reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, Unilever accumulates all sales transactions over a certain period of time and reports the data as one amount in the company’s financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful.

A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendix A of this textbook shows the financial statements of Taiwan Semiconductor Manufacturing Company (TSMC) Ltd. (TWN). Appendix B illustrates the financial statements of Nestlé SA (CHE), and Appendix C includes the financial statements of Petra Foods Ltd. (SGP). We refer to these statements at various places throughout the textbook. (In addition, in the A Look at U.S. GAAP section at the end of each chapter, the U.S. company Apple Inc. is analyzed.) At this point, these financial statements probably strike you as complex and confusing. By the end of this course, you’ll be surprised at your ability to understand, analyze, and interpret them.

Illustration 1-1 summarizes the activities of the accounting process.

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

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

Who Uses Accounting Data?

The specific financial information that a user needs depends upon the kinds of decisions the user makes. There are two broad groups of users of financial information: internal users and external users.

Learning Objective 2

Identify the users and uses of accounting.

INTERNAL USERS

Internal users of accounting information are managers who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users must answer many important questions, as shown in Illustration 1-2.

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

EXTERNAL USERS

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

Financial accounting answers these questions. It provides economic and financial information for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities, such as the State Administration of Taxation in the People’s Republic of China (CHN), want to know whether the company complies with tax laws. Regulatory agencies, such as the Autorité des Marchés Financiers (FRA) or the Federal Trade Commission (USA), want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like Tesla Motors, Inc. (USA) will continue to honor product warranties and support its product lines. Labor unions, such as the German Confederation of Trade Unions (DEU), want to know whether the companies have the ability to pay increased wages and benefits to union members.

The Building Blocks of Accounting

Learning Objective 3

Understand why ethics is a fundamental business concept.

A doctor follows certain protocols in treating a patient’s illness. An architect follows certain structural guidelines in designing a building. Similarly, an accountant follows certain standards in reporting financial information. These standards are based on specific principles and assumptions. For these standards to work, however, a fundamental business concept must be at work—ethical behavior.

Ethics in Financial Reporting

People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t play the securities market if they think share prices are rigged. In recent years, the financial press has been full of articles about financial scandals at Enron (USA), Parmalat (ITA), Satyam Computer Services (IND), AIG (USA), and others. As the scandals came to light, mistrust of financial reporting in general grew. One article in the financial press noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent share prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting.

The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in business and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook:

1. A number of the Feature Stories and other parts of the textbook discuss the central importance of ethical behavior to financial reporting.
2. Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings.
3. Many of the People, Planet, and Profit Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues.
4. At the end of each chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case.

When analyzing these various ethics cases, as well as experiences in your own life, it is useful to apply the three steps outlined in Illustration 1-4.

Accounting Standards

Learning Objective 4

Explain accounting standards and the measurement principles.

In order to ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard-setting bodies. Presently, there are two primary accounting standard-setting bodies—the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). More than 130 countries follow standards referred to as International Financial Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is headquartered in London, with its 15 board members drawn from around the world. Most companies in the United States follow standards issued by the FASB, referred to as generally accepted accounting principles (GAAP).

As markets become more global, it is often desirable to compare the results of companies from different countries that report using different accounting standards. In order to increase comparability, in recent years the two standard-setting bodies made efforts to reduce the differences between IFRS and U.S. GAAP. This process is referred to as convergence. Because convergence is such an important issue, we provide at the end of each chapter a section called A Look at U.S. GAAP, to provide a comparison with IFRS.

Measurement Principles

• HELPFUL HINT
Relevance and faithful representation are two primary qualities that make accounting information useful for decision-making.

IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation. Relevance means that financial information is capable of making a difference in a decision. Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual.

Assumptions

Learning Objective 5

Explain the monetary unit assumption and the economic entity assumption.

Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption.

MONETARY UNIT ASSUMPTION

The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle.

This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company’s owner, the quality of service, and the morale of employees are not included. The reason: Companies cannot quantify this information in money terms. Though this information is important, companies record only events that can be measured in money. Throughout this textbook, we use a variety of currencies in our examples and end-of-chapter materials, such as those shown in Illustration 1-5.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

PROPRIETORSHIP A business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. Small service-type businesses (plumbing companies, beauty salons, and auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often proprietorships. Usually only a relatively small amount of money (capital) is necessary to start in business as a proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business. There is no legal distinction between the business as an economic unit and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner.

PARTNERSHIP A business owned by two or more persons associated as partners is a partnership. In most respects a partnership is like a proprietorship except that more than one owner is involved. Typically a partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, and chartered public accountants).

CORPORATION A business organized as a separate legal entity under corporation law and having ownership divided into transferable shares is a corporation. The holders of the shares (shareholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Shareholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be transferred without dissolving the corporation, the corporation enjoys an unlimited life.

Although the combined number of proprietorships and partnerships in the world significantly exceeds the number of corporations, the revenue produced by corporations is much greater. Most of the largest companies in the world—for example, ING (NLD), Royal Dutch Shell (GBR and NLD), Apple Inc. (USA), Fortis (BEL), and Toyota (JPN)—are corporations.

SHARE CAPITAL—ORDINARY

A corporation may obtain funds by selling ordinary shares to investors. Share capital—ordinary is the term used to describe the amounts paid in by shareholders for the ordinary shares they purchase.

RETAINED EARNINGS

Retained earnings is determined by three items: revenues, expenses, and dividends.

REVENUES Revenues are the gross increases in equity resulting from business activities entered into for the purpose of earning income. Generally, revenues result from selling merchandise, performing services, renting property, and lending money.

• HELPFUL HINT
The effect of revenues is positive—an increase in equity coupled with an increase in assets or a decrease in liabilities.

Revenues usually result in an increase in an asset. They may arise from different sources and are called various names depending on the nature of the business. Taipai Pizza, for instance, has two categories of sales revenues—pizza sales and beverage sales. Other titles for and sources of revenue common to many businesses are sales, fees, services, commissions, interest, dividends, royalties, and rent.

EXPENSES Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in equity that result from operating the business. Like revenues, expenses take many forms and are called various names depending on the type of asset consumed or service used. For example, Taipai Pizza recognizes the following types of expenses: cost of ingredients (flour, cheese, tomato paste, meat, mushrooms, etc.), cost of beverages, wages expense, utilities expense (electric, gas, and water expense), telephone expense, delivery expense (gasoline, repairs, licenses, etc.), supplies expense (napkins, detergents, aprons, etc.), rent expense, interest expense, and property tax expense.

• HELPFUL HINT
The effect of expenses is negative—a decrease in equity coupled with a decrease in assets or an increase in liabilities.

DIVIDENDSNet income represents an increase in net assets which is then available to distribute to shareholders. The distribution of cash or other assets to shareholders is called a dividend. Dividends reduce retained earnings. However, dividends are not expenses. A corporation first determines its revenues and expenses and then computes net income or net loss. If it has net income, and decides it has no better use for that income, a corporation may decide to distribute a dividend to its owners (the shareholders).

In summary, the principal sources (increases) of equity are investments by shareholders and revenues from business operations. In contrast, reductions (decreases) in equity result from expenses and dividends. These relationships are shown in Illustration 1-7.

Transaction Analysis

To demonstrate how to analyze transactions in terms of the accounting equation, we will review the business activities of Softbyte SA. As part of this analysis, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transactions on equity. Recall that equity is comprised of two parts: share capital—ordinary and retained earnings. Share capital—ordinary is affected when the company issues new ordinary shares in exchange for cash. Retained earnings is affected when the company earns revenue, incurs expenses, or pays dividends. Illustration 1-9 (page 16) shows the expanded accounting equation.

If you are tempted to skip ahead after you’ve read a few of the following transaction analyses, don’t do it. Each has something unique to teach, something you’ll need later. (We assure you that we’ve kept them to the minimum needed!)

• HELPFUL HINT
You will want to study these transactions until you are sure you understand them. They are not difficult, but understanding them is important to your success in this course. The ability to analyze transactions in terms of the basic accounting equation is essential in accounting.

TRANSACTION 1. INVESTMENT BY SHAREHOLDERS Ray and Barbara Neal decide to start a smartphone app development company that they incorporate as Softbyte SA. On September 1, 2017, they invest €15,000 cash in the business in exchange for €15,000 of ordinary shares. The ordinary shares indicates the ownership interest that the Neals have in Softbyte SA. This transaction results in an equal increase in both assets and equity.³

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

TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte SA purchases computer equipment for €7,000 cash. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes.

Observe that total assets are still €15,000. Share Capital—Ordinary also remains at €15,000, the amount of the original investment.

TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte SA purchases for €1,600 from Mobile Solutions Company headsets and other computer accessories expected to last several months. Mobile Solutions agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using the headsets and computer accessories, and liabilities increase by the amount due Mobile Solutions.

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

TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte SA receives €1,200 cash from customers for app development services it has performed. This transaction represents Softbyte’s principal revenue-producing activity. Recall that revenue increases equity.

The two sides of the equation balance at €17,800. Service Revenue is included in determining Softbyte’s net income.

Note that we do not have room to give details for each individual revenue and expense account in this illustration. Thus, revenues (and expenses when we get to them) are summarized under one column heading for Revenues and one for Expenses. However, it is important to keep track of the category (account) titles affected (e.g., Service Revenue) as they will be needed when we prepare financial statements later in the chapter.

TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte SA receives a bill for €250 from Programming News for advertising on its website but postpones payment until a later date. This transaction results in an increase in liabilities and a decrease in equity.

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

TRANSACTION 6. SERVICES PERFORMED FOR CASH AND CREDIT Softbyte SA performs €3,500 of app development services for customers. The company receives cash of €1,500 from customers, and it bills the balance of €2,000 on account. This transaction results in an equal increase in assets and equity.

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

TRANSACTION 7. PAYMENT OF EXPENSES Softbyte SA pays the following expenses in cash for September: office rent €600, salaries and wages of employees €900, and utilities €200. These payments result in an equal decrease in assets and equity.

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

TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte SA pays its €250 Programming News bill in cash. The company previously (in Transaction 5) recorded the bill as an increase in Accounts Payable and a decrease in equity.

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

TRANSACTION 9. RECEIPT OF CASH ON ACCOUNTSoftbyte SA receives €600 in cash from customers who had been billed for services (in Transaction 6). Transaction 9 does not change total assets, but it changes the composition of those assets.

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

TRANSACTION 10. DIVIDENDS The corporation pays a dividend of €1,300 in cash to Ray and Barbara Neal, the shareholders of Softbyte SA. This transaction results in an equal decrease in assets and equity.

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

Summary of Transactions

Illustration 1-10 summarizes the September transactions of Softbyte SA to show their cumulative effect on the basic accounting equation. It also indicates the transaction number and the specific effects of each transaction. Finally, Illustration 1-10 demonstrates a number of significant facts:

1. Each transaction must be analyzed in terms of its effect on:
   1. The three components of the basic accounting equation.
   2. Specific types (kinds) of items within each component.
2. The two sides of the equation must always be equal.
3. The Share Capital—Ordinary and Retained Earnings columns indicate the causes of each change in the shareholders’ claim on assets.

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

Financial Statements

Learning Objective 8

Understand the five financial statements and how they are prepared.

Companies prepare five financial statements from the summarized accounting data:

1. An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time.
2. A retained earnings statement summarizes the changes in retained earnings for a specific period of time.
3. A statement of financial position (sometimes referred to as a balance sheet) reports the assets, liabilities, and equity of a company at a specific date.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.
5. A comprehensive income statement presents other comprehensive income items that are not included in the determination of net income.

These statements provide relevant financial data for internal and external users. Illustration 1-11 shows the first four financial statements from the above list of Softbyte SA. (Illustration 1-11 assumes Softbyte has no other comprehensive income items.) A comprehensive income statement is presented on page 25 for Softbyte.

Note that the statements shown in Illustration 1-11 are interrelated:

• HELPFUL HINT
The income statement, retained earnings statement, statement of cash flows, and comprehensive income statement are all for a period of time, whereas the statement of financial position is for a point in time.

1. Net income of €2,750 on the income statement is added to the beginning balance of retained earnings in the retained earnings statement.
2. Retained earnings of €1,450 at the end of the reporting period shown in the retained earnings statement is reported on the statement of financial position.
3. Cash of €8,050 on the statement of financial position is reported on the statement of cash flows.

Also, explanatory notes and supporting schedules are an integral part of every set of financial statements. We illustrate these notes and schedules in later chapters of this textbook.

Be sure to carefully examine the format and content of each statement in Illustration 1-11. We describe the essential features of each in the following sections.

Income Statement

The income statement reports the success or profitability of the company’s operations over a specific period of time. For example, Softbyte SA’s income statement is dated “For the Month Ended September 30, 2017.” It is prepared from the data appearing in the revenue and expense columns of Illustration 1-10 (page 21). The heading of the statement identifies the company, the type of statement, and the time period covered by the statement.

The income statement lists revenues first, followed by expenses. Then, the statement shows net income (or net loss). When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.

Although practice varies, we have chosen to list expenses in order of magnitude in our illustrations. (We will consider alternative formats for the income statement in later chapters.)

Note that the income statement does not include investment and dividend transactions between the shareholders and the business in measuring net income. For example, as explained earlier, the cash dividend from Softbyte SA was not regarded as a business expense. This type of transaction is considered a reduction of retained earnings, which causes a decrease in equity.

• HELPFUL HINT
The heading of each statement identifies the company, the type of statement, and the specific date or time period covered by the statement.

• HELPFUL HINT
The arrows in this illustration show the interrelationships of the four financial statements.

1. Net income is computed first and is needed to determine the ending balance in retained earnings.
2. The ending balance in retained earnings is needed in preparing the statement of financial position.
3. The cash shown on the statement of financial position is needed in preparing the statement of cash flows.

• HELPFUL HINT
Note that final sums are double-underlined, and negative amounts (in the statement of cash flows) are presented in parentheses.

GLOSSARY REVIEW

Accounting

The information system that identifies, records, and communicates the economic events of an organization to interested users. (p. 4).

Assets

Resources a business owns. (p. 12).

Auditing

The examination of financial statements by an independent accountant in order to express an opinion as to the fairness of presentation. (p. 27).

Basic accounting equation

Assets = Liabilities + Equity. (p. 12).

Bookkeeping

A part of accounting that involves only the recording of economic events. (p. 4).

Comprehensive income statement

A financial statement that presents items that are not included in the determination of net income, referred to as other comprehensive income. (p. 22).

Convergence

Effort to reduce differences between U.S. GAAP and IFRS to enhance comparability. (p. 8).

Corporation

A business organized as a separate legal entity under corporation law, having ownership divided into transferable shares. (p. 10).

Dividend

A distribution of cash or other assets by a corporation to its shareholders. (pp. 13-14).

Economic entity assumption

An assumption that requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. (p. 10).

Equity

The ownership claim on a company’s total assets. (p. 13).

Ethics

The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair. (p. 7).

Expanded accounting equation

Assets = Liabilities + Share Capital-Ordinary + Revenues – Expenses – Dividends. (p. 15).

Expenses

The cost of assets consumed or services used in the process of earning revenue. (p. 13).

Fair value principle

An accounting principle stating that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). (p. 9).

Faithful representation

Numbers and descriptions match what really existed or happened-they are factual. (p. 8).

Financial accounting

The field of accounting that provides economic and financial information for investors, creditors, and other external users. (p. 6).

Financial Accounting Standards Board (FASB)

An organization that establishes generally accepted accounting principles in the United States (GAAP). (p. 8).

Forensic accounting

An area of accounting that uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud. (p. 28).

Generally accepted accounting principles (GAAP)

Accounting standards issued in the United States by the Financial Accounting Standards Board. (p. 8).

Historical cost principle (cost principle)

An accounting principle that states that companies should record assets at their cost. (p. 8).

Income statement

A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. (p. 22).

International Accounting Standards Board (IASB)

An accounting standard-setting body that issues standards adopted by many countries outside of the United States. (p. 8).

International Financial Reporting Standards (IFRS)

International accounting standards set by the International Accounting Standards Board (IASB). (p. 8).

Liabilities

Creditor claims on total assets. (p. 12).

*Management consulting

An area of public accounting ranging from development of accounting and computer systems to support services for marketing projects and merger and acquisition activities. (p. 27).

Managerial accounting

The field of accounting that provides internal reports to help users make decisions about their companies. (p. 5).

Monetary unit assumption

An assumption stating that companies include in the accounting records only transaction data that can be expressed in terms of money. (p. 9).

Net income

The amount by which revenues exceed expenses. (p. 22).

Net loss

The amount by which expenses exceed revenues. (p. 22).

Partnership

A business owned by two or more persons associated as partners. (p. 10).

Private (or managerial) accounting

An area of accounting within a company that involves such activities as cost accounting, budgeting, design and support of accounting information systems, and tax planning and preparation. (p. 28).

Proprietorship

A business owned by one person. (p. 10).

Public accounting

An area of accounting in which the accountant offers expert service to the general public. (p. 27).

Relevance

Financial information that is capable of making a difference in a decision. (p. 8).

Retained earnings statement

A financial statement that summarizes the changes in retained earnings for a specific period of time. (p. 22).

Revenues

The gross increase in equity resulting from business activities entered into for the purpose of earning income. (p. 13).

Share capital-ordinary

Amounts paid in by shareholders for the ordinary shares they purchase. (p. 13).

Statement of cash flows

A financial statement that summarizes information about the cash inflows (receipts) and cash outflows (payments) for a specific period of time. (p. 22).

Statement of financial position (balance sheet)

A financial statement that reports the assets, liabilities, and equity of a company at a specific date. (p. 22).

*Taxation

An area of public accounting involving tax advice, tax planning, preparing tax returns, and representing clients before governmental agencies. (p. 27).

Transactions

The economic events of a business that are recorded by accountants. (p. 14).

Analyze the effect of transactions on assets, liabilities, and equity.

(LO 6, 7)

Hayes Computer Timeshare Company entered into the following transactions during May 2017.

1. Purchased office equipment for $10,000 from Office Outfitters on account.
2. Paid $3,000 cash for May rent on storage space.
3. Received $12,000 cash from customers for contracts billed in April.
4. Performed services for Bayliss Construction Company for $4,000 cash.
5. Paid Southern Power Co. $10,000 cash for energy usage in May.
6. Shareholders invested an additional $30,000 in the business.
7. Paid Office Outfitters for the equipment purchased in (1) above.
8. Incurred advertising expense for May of $1,500 on account.

Instructions

Indicate with the appropriate letter whether each of the transactions above results in:

1. An increase in assets and a decrease in assets.
2. An increase in assets and an increase in equity.
3. An increase in assets and an increase in liabilities.
4. A decrease in assets and a decrease in equity.
5. A decrease in assets and a decrease in liabilities.
6. An increase in liabilities and a decrease in equity.
7. An increase in equity and a decrease in liabilities.

Solution

PRACTICE PROBLEM

Prepare a tabular summary and financial statements.

(LO 7, 8)

Legal Services Company Ltd. was formed on July 1, 2017. During the first month of operations, the following transactions occurred.

1. Shareholders invested NT$10,000,000 in cash in exchange for ordinary shares of Legal Services Company Ltd.
2. Paid NT$800,000 for July rent on office space.
3. Purchased office equipment on account NT$3,000,000.
4. Performed legal services for clients for cash NT$1,500,000.
5. Borrowed NT$700,000 cash from a bank on a note payable.
6. Performed legal services for client on account NT$2,000,000.
7. Paid monthly expenses: salaries NT$500,000, utilities NT$300,000, and advertising NT$100,000.

WileyPLUS

Brief Exercises, DO IT! Review, Exercises, and Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: Asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS

EXERCISES

Classify the three activities of accounting.

(LO 1)

E1-1 Sondgeroth NV performs the following accounting tasks during the year.

1. _____ Analyzing and interpreting information.
2. _____ Classifying economic events.
3. _____ Explaining uses, meaning, and limitations of data.
4. _____ Keeping a systematic chronological diary of events.
5. _____ Measuring events in monetary units.
6. _____ Preparing accounting reports.
7. _____ Reporting information in a standard format.
8. _____ Selecting economic activities relevant to the company.
9. _____ Summarizing economic events.

Accounting is “an information system that identifies, records, and communicates the economic events of an organization to interested users.”

Instructions

Categorize the accounting tasks performed by Sondgeroth NV as relating to either the identification (I), recording (R), or communication (C) aspects of accounting.

Identify users of accounting information.

(LO 2)

E1-2 (a) The following are users of financial statements.

• _____ Customers
• _____ Labor unions
• _____ Marketing manager
• _____ Production supervisor
• _____ Securities regulator
• _____ Store manager
• _____ Suppliers
• _____ Taxing agency
• _____ Vice president of finance

Instructions

Identify the users as being either external users (E) or internal users (I).

(b) The following questions could be asked by an internal user or an external user.

• _____ Can we afford to give our employees a pay raise?
• _____ Did the company earn a satisfactory income?
• _____ Do we need to borrow in the near future?
• _____ How does the company’s profitability compare to other companies?
• _____ What does it cost us to manufacture each unit produced?
• _____ Which product should we emphasize?
• _____ Will the company be able to pay its short-term debts?

Instructions

Identify each of the questions as being more likely asked by an internal user (I) or an external user (E).

Discuss ethics and the historical cost principle.

(LO 3)

E1-3 Leon Manternach, president of Manternach SE, has instructed Carla Ruden, the head of the accounting department for Manternach SE, to report the company’s recently acquired land in the company’s accounting reports at its fair value of €170,000 instead of its cost of €100,000. Manternach says, “I think we got a real deal on the purchase. It is probably worth €170,000. Showing the land at €170,000 will make our company look like a better investment when we try to attract new investors next month.”

Instructions

Explain the ethical situation involved for Carla Ruden, identifying the stakeholders and the alternatives.

Use accounting concepts.

(LO 4, 5)

E1-4 The following situations involve accounting principles and assumptions.

1. Julia Company A/S owns buildings that are worth substantially more than they originally cost. In an effort to provide more relevant information, Julia reports the buildings at fair value in its accounting reports.
2. Dekalb Company AG includes in its accounting records only transaction data that can be expressed in terms of money.
3. Omar Shariff, president of Omar’s Oasis SJSC, records his personal living costs as expenses of the Oasis.

Instructions

For each of the three situations, state if the accounting method used is correct or incorrect. If correct, identify which standard or assumption supports the method used. If incorrect, identify which standard or assumption has been violated.

Classify accounts as assets, liabilities, and equity.

(LO 6)

E1-5 Robinson Cleaners AG has the following statement of financial position items.

Instructions

Classify each item as an asset, liability, or equity.

Analyze the effect of transactions.

(LO 7)

E1-6 Selected transactions for Spring Cruises ASA are listed below.

1. Sold ordinary shares for cash to start business.
2. Paid monthly rent.
3. Purchased equipment on account.
4. Billed customers for services performed.
5. Paid dividends.
6. Received cash from customers billed in (4).
7. Incurred advertising expense on account.
8. Purchased additional equipment for cash.
9. Received cash from customers when service was performed.

Instructions

List the numbers of the above transactions and describe the effect of each transaction on assets, liabilities, and equity. For example, the first answer is (1) Increase in assets and increase in equity.

Analyze the effect of transactions on assets, liabilities, and equity.

(LO 7)

E1-7 Collins Computer Timeshare Company SA entered into the following transactions during May 2017.

1. Purchased computer terminals for R$20,000 from Digital Equipment on account.
2. Paid R$3,000 cash for May rent on storage space.
3. Received R$14,000 cash from customers for contracts billed in April.
4. Performed computer services for Schmidt Construction Company for R$2,400 cash.
5. Paid Central States Power Co. R$11,000 cash for energy usage in May.
6. Shareholders invested an additional R$32,000 in the business.
7. Paid Digital Equipment for the terminals purchased in (1) above.
8. Incurred advertising expense for May of R$1,100 on account.

Instructions

Indicate with the appropriate letter whether each of the transactions above results in:

1. An increase in assets and a decrease in assets.
2. An increase in assets and an increase in equity.
3. An increase in assets and an increase in liabilities.
4. A decrease in assets and a decrease in equity.
5. A decrease in assets and a decrease in liabilities.
6. An increase in liabilities and a decrease in equity.
7. An increase in equity and a decrease in liabilities.

Analyze transactions and compute net income

(LO 7, 8)

E1-8 An analysis of the transactions made by J. L. Kang & Co. Ltd., a public accounting firm, for the month of August is shown on the next page. Each increase and decrease in equity is explained.

Instructions

1. Describe each transaction that occurred for the month.
2. Determine how much equity increased for the month.
3. Compute the amount of net income for the month.

Prepare financial statements.

(LO 8)

E1-9 An analysis of transactions for J. L. Kang & Co. Ltd. was presented in E1-8. Assume that August is the company’s first month of business.

Instructions

Prepare an income statement and a retained earnings statement for August and a statement of financial position at August 31, 2017.

Determine net income (or loss).

(LO 8)

E1-10 Kimmy A.Ş. had the following assets and liabilities on the dates indicated.

December 31	Total Assets	Total Liabilities
2016	400,000	260,000
2017	480,000	300,000
2018	590,000	400,000

Kimmy began business on January 1, 2016, with an investment of 100,000 from shareholders.

Instructions

From an analysis of the change in equity during the year, compute the net income (or loss) for:

1. 2016, assuming Kimmy paid 15,000 in dividends for the year.
2. 2017, assuming shareholders made an additional investment of 50,000 and Kimmy paid no dividends in 2017.
3. 2018, assuming shareholders made an additional investment of 15,000 and Kimmy paid dividends of 30,000 in 2018.

Analyze financial statements items.

(LO 8)

E1-11 Two items are omitted from each of the following summaries of statement of financial position and income statement data for two companies for the year 2017, Steven Craig Ltd. and Georgia Enterprises Ltd.

Instructions

Determine the missing amounts.

Prepare income statement, comprehensive income statement, and retained earnings statement.

(LO 8)

E1-12 The following information relates to Karen Weigel Co. Ltd. for the year 2017.

Instructions

After analyzing the data, prepare (a) an income statement, (b) a comprehensive income statement, and (c) a retained earnings statement for the year ending December 31, 2017.

Correct an incorrectly prepared statement of financial position.

(LO 8)

E1-13 Lynn Dreise is the bookkeeper for Sanculi Company SpA. Lynn has been trying to get the statement of financial position of Sanculi Company SpA to balance correctly. Sanculi’s statement of financial position is shown as follows.

Instructions

Prepare a correct statement of financial position.

Compute net income and prepare a statement of financial position.

(LO 8)

E1-14 Bear Park Ltd., a camping ground in the Lake District, has compiled the following financial information as of December 31, 2017.

Instructions

1. Determine Bear Park’s net income for 2017.
2. Prepare a statement of financial position for Bear Park Ltd. as of December 31, 2017.

Prepare an income statement and comprehensive income statement.

(LO 8)

E1-15 Presented below is financial information related to the 2017 operations of Delgado Cruise Company SA.

Instructions

Prepare the 2017 income statement and comprehensive income statement for Delgado Cruise Company SA.

Prepare a retained earnings statement.

(LO 8)

E1-16 Presented below is information related to Williams and Douglas, Attorneys at Law Ltd.

Instructions

Prepare the 2017 retained earnings statement for Williams and Douglas, Attorneys at Law Ltd.

Prepare a cash flow statement.

(LO 8)

E1-17 This information is for Java Company Ltd. for the year ended December 31, 2017 (amounts in thousands).

Instructions

Prepare the 2017 statement of cash flows for Java Company Ltd.

PROBLEMS: SET A

Analyze transactions and compute net income.

(LO 6, 7)

P1-1A Kinney’s Repair Ltd. was started on May 1. A summary of May transactions is presented below.

1. Shareholders invested £10,000 cash in the business in exchange for ordinary shares.
2. Purchased equipment for £5,000 cash.
3. Paid £400 cash for May office rent.
4. Paid £700 cash for supplies.
5. Incurred £250 of advertising costs in the Beacon News on account.
6. Received £4,700 in cash from customers for repair service.
7. Declared and paid a £1,000 cash dividend.
8. Paid part-time employee salaries £1,000.
9. Paid utility bills £160.
10. Performed repair service worth £980 on account.
11. Collected cash of £120 for services billed in transaction (10).

Check figures next to some Problems give you a key number, to let you know if you are on the right track with your solution.

(a) Total assets £13,120

(b) Net income £3,870

Instructions

1. Prepare a tabular analysis of the transactions, using the following column headings: Cash, Accounts Receivable, Supplies, Equipment, Accounts Payable, Share Capital, and Retained Earnings (with separate columns for Revenues, Expenses, and Dividends). Include margin explanations for any changes in Retained Earnings. Revenue is called Service Revenue.
2. From an analysis of the Retained Earnings columns, compute the net income or net loss for May.

Analyze transactions and prepare income statement, retained earnings statement, and statement of financial position.

(LO 6, 7, 8)

P1-2A On August 31, 2017, the statement of financial position of Donahue Veterinary Clinic Ltd. showed Cash £9,000, Accounts Receivable £1,700, Supplies £600, Equipment £6,000, Accounts Payable £3,600, Share Capital—Ordinary £13,000, and Retained Earnings £700. During September, the following transactions occurred.

1. Paid £2,900 cash for accounts payable due.
2. Collected £1,300 of accounts receivable.
3. Purchased additional equipment for £2,100, paying £800 in cash and the balance on account.
4. Recognized revenue of £7,300, of which £2,500 is collected in cash and the balance is due in October.
5. Declared and paid a £400 cash dividend.
6. Paid salaries £1,700, rent for September £900, and advertising expense £200.
7. Incurred utilities expense for month on account £170.
8. Received £10,000 from Capital Bank on a 6-month note payable.

Instructions

(a) Ending cash £15,900

(b) Net income £4,330

 Total assets £29,800

1. Prepare a tabular analysis of the September transactions beginning with August 31 balances. The column headings should be as follows: $\text{Cash}+\text{Accounts Receivable}+\text{Supplies}+\text{Equipment}=\text{Notes Payable}+\text{Accounts Payable}+\text{Share Capital}+\text{Retained Earnings}+\text{Revenues}-\text{Expenses}-\text{Dividends}$.
2. Prepare an income statement for September, a retained earnings statement for September, and a statement of financial position at September 30, 2017.

Prepare income statement, retained earnings statement, and statement of financial position.

(LO 8)

P1-3A On May 1, 2017, Park Flying School Ltd., a company that provides flying lessons, was started with an investment of 45,000 cash in the business. Following are the assets and liabilities of the company on May 31, 2017, and the revenues and expenses for the month of May (all amounts in thousands).

Cash	4,500	Notes Payable	28,000
Accounts Receivable	7,420	Rent Expense	1,000
Equipment	64,000	Maintenance and
Service Revenue	6,800	Repairs Expense	400
Advertising Expense	500	Gasoline Expense	2,500
Accounts Payable	1,400	Utilities Expense	400

No additional investments were made in May, but the company paid dividends of 480,000 during the month.

Instructions

(a) Net income 2,000

 Total assets 75,920

(b) Net income 1,400

1. Prepare an income statement and a retained earnings statement for the month of May and a statement of financial position at May 31. (Show numbers in thousands.)
2. Prepare an income statement and a retained earnings statement for May assuming the following data are not included above: (1) 900,000 worth of services were performed and billed but not collected at May 31, and (2) 1,500,000 of gasoline expense was incurred but not paid.

Analyze transactions and prepare financial statements.

(LO 6, 7, 8)

P1-4A Matt Stiner started a delivery service, Stiner Deliveries Ltd., on June 1, 2017. The following transactions occurred during the month of June.

June 1	Shareholders invested £10,000 cash in the business in exchange for ordinary shares.
2	Purchased a used van for deliveries for £14,000. Matt paid £2,000 cash and signed a note payable for the remaining balance.
3	Paid £500 for office rent for the month.
5	Performed services worth £4,800 on account.
9	Declared and paid £300 in cash dividends.
12	Purchased supplies for £150 on account.
15	Received a cash payment of £1,250 for services performed on June 5.
17	Purchased gasoline for £100 on account.
20	Received a cash payment of £1,500 for services performed.
23	Made a cash payment of £500 on the note payable.
26	Paid £250 for utilities.
29	Paid for the gasoline purchased on account on June 17.
30	Paid £1,000 for employee salaries.

Instructions

(a) Total assets $25,800

(b) Net income £4,450

(c) Cash £8,100

1. Show the effects of the previous transactions on the accounting equation using the following format.

   

   Include margin explanations for any changes in the Retained Earnings account in your analysis.
2. Prepare an income statement for the month of June.
3. Prepare a statement of financial position at June 30, 2017.

Determine financial statement amounts and prepare retained earnings statement.

(LO 7, 8)

P1-5A Financial statement information about four different companies is as follows.

	Crosby Company	Stills Company	Nash Company	Young Company
January 1, 2017
Assets	HK$ 900,000	HK$1,100,000	(g)	HK$1,500,000
Liabilities	650,000	(d)	HK$ 750,000	(j)
Equity	(a)	500,000	450,000	1,000,000
December 31, 2017
Assets	(b)	1,370,000	2,000,000	(k)
Liabilities	550,000	750,000	(h)	800,000
Equity	400,000	(e)	1,300,000	1,400,000
Equity changes in year
Additional investment	(c)	150,000	100,000	150,000
Dividends	100,000	(f)	140,000	100,000
Total revenues	3,500,000	4,200,000	(i)	5,000,000
Total expenses	3,300,000	3,850,000	3,420,000	(l)

Instructions

1. Determine the missing amounts. (Hint: For example, to solve for (a), $\text{Assets}-\text{Liabilities}=\text{Equity}=\mathrm{HK\$}\mathrm{250,000}$.)
2. Prepare the retained earnings statement for Stills Company. Assume beginning retained earnings was HK$200,000.
3. Write a memorandum explaining the sequence for preparing financial statements and the interrelationship of the retained earnings statement to the income statement and statement of financial position.

The Matcha Creations problem starts in this chapter and continues in every chapter. You also can find this problem at the book’s companion website.

MC1 Mei-ling Lee spent much of her childhood learning the art of cookie-making from her grandmother. They passed many happy hours mastering every type of cookie imaginable and later creating new recipes that were both healthy and delicious. Now at the start of her second year in college, Mei-ling is investigating various possibilities for starting her own business as part of the requirements of the entrepreneurship program in which she is enrolled.

A long-time friend insists that Mei-ling has to somehow include cookies in her business plan, especially her famous green tea creations. After a series of brainstorming sessions, Mei-ling settles on the idea of operating a cookie-making school. She will start on a part-time basis and offer her services in people’s homes. Now that she has started thinking about it, the possibilities seem endless. During the fall, she will concentrate on holiday cookies. She will offer individual lessons and group sessions (which will probably be more entertainment than education for the participants). Mei-ling also decides to include children in her target market.

The first difficult decision is coming up with the perfect name for her business. In the end, she settles on “Matcha Creations” and then moves on to more important issues.

Instructions

1. What form of business organization—proprietorship, partnership, or corporation—do you recommend that Mei-ling use for her business? Discuss the benefits and weaknesses of each form and give the reasons for your choice.
2. Will Mei-ling need accounting information? If yes, what information will she need and why? How often will she need this information?
3. Identify specific asset, liability, and equity accounts that Matcha Creations will likely use to record its business transactions.
4. Should Mei-ling open a separate bank account for the business? Why or why not?