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Gattaca answer questions #1-10 while you watch the film

Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting.

Chapter 1 Accounting in Business 5

• Preparation • Analysis • External auditing • Regulatory • Consulting • Planning • Criminal investigation

• Preparation • Planning • Regulatory • Investigations • Consulting • Enforcement • Legal services • Estate plans

• General accounting • Cost accounting • Budgeting • Internal auditing • Consulting • Controller • Treasurer • Strategy

• Lenders • Consultants • Analysts • Traders • Directors • Underwriters • Planners • Appraisers

• FBI investigators • Market researchers • Systems designers • Merger services • Business valuation • Forensic accounting • Litigation support • Entrepreneurs

Opportunities in Accounting

Financial Taxation Accounting-relatedManagerial

EXHIBIT 1.2 Accounting Opportunities

Exhibit 1.3 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting involves accounting services such as auditing and taxation. Opportunities also exist in government and not-for-profit agen- cies, including business regulation and law enforcement.

Accounting specialists are highly regarded, and their professional standing is often denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements, pass an exam, and be ethical. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), certified fraud examiner (CFE), and certified foren- sic accountant (CrFA).

Accounting specialists are in demand. Exhibit 1.4 reports average annual salaries for several accounting positions. Salaries vary based on location, company size, and other factors.

Public accounting

24%

Government and

not-for-profit 22%

Private accounting

54%

EXHIBIT 1.3 Accounting Jobs by Area

Point: The largest accounting firms are EY, KPMG, PwC, and Deloitte.

Point: Higher education yields higher pay: Master’s degree $73,738 Bachelor’s degree 56,665 Associate’s degree 39,771 High school degree 30,627 No high school degree 20,241

EXHIBIT 1.4 Accounting Salaries

Public Accounting Salary

Partner . . . . . . . . . . . . . . . . . . . . . . $245,000

Manager (6–8 years) . . . . . . . . . . 112,000

Senior (3–5 years) . . . . . . . . . . . . 90,000

Junior (0–2 years) . . . . . . . . . . . . 62,500

Private Accounting Salary

CFO . . . . . . . . . . . . . . . . . . . . . . . . $290,000

Controller/Treasurer . . . . . . . . . . . 180,000

Manager (6–8 years) . . . . . . . . . . 98,500

Senior (3–5 years) . . . . . . . . . . . . 81,500

Junior (0–2 years) . . . . . . . . . . . . . 58,000

Recordkeeping Salary

Full-charge bookkeeper . . . . . . . . $60,500

Accounts manager . . . . . . . . . . . . 58,000

Payroll manager . . . . . . . . . . . . . . 59,500

Accounting clerk (0–2 years) . . . . 39,500

Identify the following users of accounting information as either an (a) external or (b) internal user.

C1 C2 Accounting Users

NEED-TO-KNOW 1-1 1. Regulator 2. CEO 3. Shareholder

4. Marketing manager 5. Executive employee 6. External auditor

7. Production manager 8. Nonexecutive employee 9. Bank lender

Solution

1. a 2. b 3. a 4. b 5. b 6. a 7. b 8. a 9. a. Do More: QS 1-1, QS 1-2, E 1-1,

E 1-2, E 1-3

NEED-TO-KNOWs highlight key procedures and concepts in learning accounting; instructional audio/video recordings accompany each one

6 Chapter 1 Accounting in Business

Ethics—A Key Concept For information to be useful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that separate right from wrong. They are accepted standards of good and bad behavior.

Accountants face ethical choices as they prepare financial reports. These choices can affect the salaries and bonuses paid to workers. They even can affect the success of products and ser- vices. Misleading information can lead to a bad decision that harms workers and the business. There is an old saying: Good ethics are good business. Exhibit 1.5 gives a three-step process for making ethical decisions.

C3 Explain why ethics are crucial to accounting.

FUNDAMENTALS OF ACCOUNTING

Use ethics to recognize an ethical concern.

Consider all consequences.

Choose best option after weighing all consequences.

1. Identify ethical concerns 2. Analyze options 3. Make ethical decisionEXHIBIT 1.5 Ethical Decision Making

Point: A Code of Conduct is available at AICPA.org.

Fraud Triangle: Ethics under Attack The fraud triangle shows that three factors push a person to commit fraud. Opportunity. A person must be able to commit fraud with a low risk of getting caught. Pressure, or incentive. A person must feel pressure or have incentive to commit fraud. Rationalization, or attitude. A person justifies fraud or does not see its criminal nature.

The key to stopping fraud is to focus on prevention. It is less expensive and more effective to prevent fraud from happening than it is to detect it.

To help prevent fraud, companies set up internal controls. Internal controls are procedures to protect assets, ensure reliable accounting, promote efficiency, and uphold company policies. Examples are good records, physical controls (locks), and independent reviews.

Enforcing Ethics In response to major accounting scandals, like those at Enron and WorldCom, Congress passed the Sarbanes-Oxley Act, also called SOX, to help stop financial abuses. SOX requires documentation and verification of internal controls and emphasizes effec- tive internal controls. Management must issue a report stating that internal controls are effective. Auditors verify the effectiveness of internal controls. Ignoring SOX can lead to penalties and criminal prosecution of executives. CEOs and CFOs who knowingly sign off on bogus account- ing reports risk millions of dollars in fines and years in prison.

Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank, has two important provisions. Clawback Mandates recovery (clawback) of excessive pay. Whistleblower SEC pays whistleblowers 10% to 30% of sanctions exceeding $1 million.

O pp

or tu

nit y

Rationalization

Pressure

Point: An audit examines whether financial statements are prepared using GAAP.

Point: SOX requires a business that sells stock to disclose a code of ethics for its executives.

Ethics Pay The $100 million mark in total payments made by the SEC to whistleblowers was recently surpassed. Since the SEC began awarding whistleblowers a percentage of money from sanctions, over 14,000 tips have been reported. Many of the tips come from accountants. ■

Ethical Risk

Ethical Risk boxes highlight ethical issues from practice

Chapter 1 Accounting in Business 7

Generally Accepted Accounting Principles Financial accounting is governed by concepts and rules known as generally accepted account- ing principles (GAAP). GAAP wants information to have relevance and faithful representa- tion. Relevant information affects decisions of users. Faithful representation means information accurately reflects the business results.

The Financial Accounting Standards Board (FASB) is given the task of setting GAAP from the Securities and Exchange Commission (SEC). The SEC is a U.S. government agency that oversees proper use of GAAP by companies that sell stock and debt to the public.

International Standards Our global economy demands comparability in accounting re- ports. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. These standards are similar to, but sometimes different from, U.S. GAAP. The FASB and IASB are working to reduce differences between U.S. GAAP and IFRS.

Conceptual Framework The FASB conceptual framework in Exhibit 1.6 consists of the following. Objectives—to provide information useful to investors, creditors,

and others. Qualitative characteristics—to require information that has rele-

vance and faithful representation. Elements—to define items in financial statements. Recognition and measurement—to set criteria for an item to be

recognized as an element; and how to measure it.

Principles, Assumptions, and Constraint There are two types of accounting principles (and assumptions). General principles are the assumptions, concepts, and guidelines for preparing financial statements; these are shown in purple font in Exhibit 1.7, along with key as- sumptions in red font. Specific principles are de- tailed rules used in reporting business transactions and events; they are described as we encounter them.

Accounting Principles There are four general principles. Measurement principle (cost principle)

Accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. Information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence. Later chapters cover adjust- ments to market and introduce fair value.

Revenue recognition principle Revenue is recognized (1) when goods or services are pro- vided to customers and (2) at the amount expected to be received from the customer. Revenue (sales) is the amount received from selling products and services. The amount received is usually in cash, but it also can be a customer’s promise to pay at a future date, called credit sales. (To recognize means to record it.)

C4 Explain generally accepted accounting principles and define and apply several accounting principles.

Point: CPAs who audit financial statements must disclose if they do not comply with GAAP.

Objectives of financial accounting

Recognition and measurement

Qualitative characteristics Elements

EXHIBIT 1.6 Conceptual Framework

GAAPGAAP

Measurement

Full disclosure

P

Revenue recognition

Expense recognition

sepExpExpen tiogrecogrec tionionoongnitr

Business entity

Time period

F lFul sclosuuurescdiscd ssd clos

Monetary unit

Going concern

Cost-benefit

Principles

Assumptions

Constraint

EXHIBIT 1.7 Building Blocks for GAAP

Point: A company pays $500 for equipment. The cost principle requires it be recorded at $500. It makes no difference if the owner thinks this equipment is worth $700.

Example: A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded? Answer: It is recorded over time as it is earned; record $400 revenue for June and $400 for July.

8 Chapter 1 Accounting in Business

Expense recognition principle (matching principle) A company records the expenses it incurred to generate the revenue reported. An example is rent costs of office space.

Full disclosure principle A company reports the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Example: Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded? Answer: If revenue is earned over time, record $100 expense in June and $100 in July.

Measurement and Recognition Revenues for the Seattle Seahawks, Atlanta Falcons, Green Bay Packers, and other professional football teams include ticket sales, television broadcasts, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they are a liability until the NFL team plays the game for which the ticket was sold. At that point, the liability is removed and revenues are reported. ■

Decision Insight

©Shane Roper/CSM/REX/Shutterstock

Accounting Assumptions There are four accounting assumptions. Going-concern assumption Accounting information presumes that the business will con-

tinue operating instead of being closed or sold. This means, for example, that property is re- ported at cost instead of liquidation value.

Monetary unit assumption Transactions and events are expressed in monetary, or money, units. Examples of monetary units are the U.S. dollar and the Mexican peso.

Time period assumption The life of a company can be divided into time periods, such as months and years, and useful reports can be prepared for those periods.

Business entity assumption A business is accounted for separately from other business entities and its owner. Exhibit 1.8 describes four common business entities.

EXHIBIT 1.8 Attributes of Businesses

Sole Proprietorship Partnership Corporation Limited Liability Company (LLC)

Number of owners 1 owner; easy to set up . 2 or more, called partners; easy to set up .

1 or more, called stockholders; can get many investors by selling stock or shares of corporate ownership .*

1 or more, called members .

Business taxation No additional business income tax .

No additional business income tax .

Additional corporate income tax . No additional business income tax .

Owner liability Unlimited liability . Owner is per- sonally liable for proprietorship debts .

Unlimited liability . Partners are jointly liable for partnership debts .

Limited liability . Owners, called stock- holders (or shareholders), are not liable for corporate acts and debts .

Limited liability . Owners, called mem- bers, are not personally liable for LLC debts .

Legal entity Not a separate legal entity . Not a separate legal entity . A separate entity with the same rights and responsibilities as a person .

A separate entity with the same rights and responsibilities as a person .

Business life Business ends with owner death or choice .

Business ends with a partner death or choice .

Indefinite . Indefinite .

*When a corporation issues only one class of stock, it is called common stock (or capital stock).

Tax Services

Accounting Constraint The cost-benefit constraint, or cost constraint, says that infor- mation disclosed by an entity must have benefits to the user that are greater than the costs of providing it. Materiality, or the ability of information to influence decisions, is also sometimes mentioned as a constraint. Conservatism and industry practices are sometimes listed as well.

Point: Proprietorships, partner- ships, and LLCs are managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who hire managers to run the business.

Chapter 1 Accounting in Business 9

Entrepreneur You and a friend develop a new design for ice skates that improves speed. You plan to form a busi- ness to manufacture and sell the skates. You and your friend want to minimize taxes, but your big concern is potential lawsuits from customers who might be injured on these skates. What form of organization do you set up? ■ Answer: You should probably form an LLC. An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject to an additional business income tax. You also must examine the ethical and social aspects of starting a business where injuries are expected.

Decision Ethics Decision Ethics boxes are role-playing exercises that stress ethics in accounting

Solution

a. no b. no c. no d. no e. yes f. yes g. yes h. yes i. no j. yes k. yes l. yes

Part 1: Identify each of the following terms/phrases as either an accounting (a) principle, (b) assumption, or (c) constraint.

C3 C4 Accounting Guidance

NEED-TO-KNOW 1-2 1. Cost-benefit 2. Measurement 3. Business entity

4. Going-concern 5. Full disclosure 6. Time period

7. Expense recognition 8. Revenue recognition

Solution

1. c 2. a 3. b 4. b 5. a 6. b 7. a 8. a

Part 2: Complete the following table with either a yes or a no regarding the attributes of a partnership, corporation, and LLC.

Attribute Present Partnership Corporation LLC

Business taxed . . . . . . . . . . . a . e . i .

Limited liability . . . . . . . . . . . b . f . j .

Legal entity . . . . . . . . . . . . . . c . g . k .

Unlimited life . . . . . . . . . . . . d . h . l .

Do More: QS 1-3, QS 1-4, QS 1-5, QS 1-6, E 1-4, E 1-5,

E 1-6, E 1-7

Accounting shows two basic aspects of a company: what it owns and what it owes. Assets are resources a company owns or controls. The claims on a company’s assets—what it owes—are separated into owner (equity) and nonowner (liability) claims. Together, liabilities and equity are the source of funds to acquire assets.

Assets Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are web servers for an online services company, musical instru- ments for a rock band, and land for a vegetable grower. Assets include cash, supplies, equip- ment, land, and accounts receivable. A receivable is an asset that promises a future inflow of resources. A company that provides a service or product on credit has an account receivable from that customer.

Liabilities Liabilities are creditors’ claims on assets. These claims are obligations to pro- vide assets, products, or services to others. A payable is a liability that promises a future out- flow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes (loans) payable to banks, and taxes payable.

Equity Equity is the owner’s claim on assets and is equal to assets minus liabilities. Equity is also called net assets or residual equity.

Point: “On credit” and “on account” mean cash is paid at a future date.

BUSINESS TRANSACTIONS AND ACCOUNTING A1 Define and interpret the accounting equation and each of its components.

Point: Double taxation means that (1) the corporation income is taxed and (2) any dividends to owners are taxed as part of the owners’ personal income.

10 Chapter 1 Accounting in Business

Accounting Equation The relation of assets, liabilities, and equity is shown in the following accounting equation. The accounting equation applies to all transactions and events, to all companies and orga- nizations, and to all points in time.

Assets = Liabilities + Equity

We can break down equity to get the expanded accounting equation. Point: This equation can be rearranged. Example: Assets − Liabilities = Equity

Big Data The SEC keeps an online database called EDGAR (sec.gov/edgar) that has accounting information for thousands of companies, such as Columbia Sportswear, that issue stock to the public. The annual report filing for most publicly traded U.S. companies is known as Form 10-K, and the quarterly filing is Form 10-Q. Information ser- vices such as Finance.Yahoo.com offer online data and analysis. ■

Decision Insight

©Greg Epperson/Shutterstock

Part 1: Use the accounting equation to compute the missing financial statement amounts.

Accounting Equation

NEED-TO-KNOW 1-3

A1

Company Assets Liabilities Equity

Bose $150 $ 30 $ (a)

Vogue $ (b) $100 $300

Solution

a. $120 b. $400

Part 2: Use the expanded accounting equation to compute the missing financial statement amounts.

Company Assets Liabilities Common Stock Dividends Revenues Expenses

Tesla $200 $ 80 $100 $5 $ (a) $40

YouTube $400 $160 $220 $ (b) $ 120 $90

Solution

a. $65 b. $10 Do More: QS 1-7, QS 1-8,

E 1-8, E 1-9

We see that equity increases from owner investments, called stock issuances, and from reve- nues. It decreases from dividends and from expenses. Equity consists of four parts.

Equity

Assets = Liabilities + Contributed Capital + Retained Earnings

= Liabilities + Common Stock − Dividends + Revenues − Expenses

Common Stock

Common stock reflects inflows of cash and other net assets from stockholders in exchange for stock (stock is part of contributed capital and covered in later chapters).

Dividends Dividends are outflows of cash and other assets to stockholders that reduce equity.

Revenues

Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consulting services provided, facilities rented to others, and commissions from services.

Expenses

Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees.

+ − + −

Contributed capital

Retained earnings

Chapter 1 Accounting in Business 11

Transaction Analysis Business activities are described in terms of transactions and events. External transactions are exchanges of value between two entities, which cause changes in the accounting equation. An example is the sale of the AppleCare Protection Plan by Apple. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An example is Target’s use of its supplies, which are reported as expenses when used. Events are happen- ings that affect the accounting equation and are reliably measured. They include business events such as changes in the market value of certain assets and liabilities and natural events such as fires that destroy assets and create losses.

This section uses the accounting equation to analyze 11 transactions and events of FastFor- ward, a start-up consulting (service) business, in its first month of operations. Remember that after each transaction and event, assets always equal liabilities plus equity.

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consult- ing business named FastForward and set up as a corporation. FastForward evaluates the performance of footwear and accessories. Taylor owns and manages the business, which will publish online re- views and consult with clubs, athletes, and others who purchase Nike and Adidas products.

Taylor invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, cash (an asset) and stockholders’ equity each equals $30,000. Equity is increased by the owner’s investment (stock issuance), which is included in the column titled Common Stock. The effect of this transaction on FastForward is shown in the accounting equation as follows (we label the equity entries).

P1 Analyze business transac- tions using the accounting equation.

FASTForward

Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of Nike and Adidas footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It simply changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of footwear are assets because of the expected future benefits from the test results of their performance.

Assets = Liabilities + Equity

Cash = Common Stock (1) +$30,000 = +$30,000 Owner investment

Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to acquire equipment for testing footwear. Like Transaction 2, Transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected fu- ture benefits from testing footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.

Assets = Liabilities + Equity

Cash + Supplies = Common Stock Old Bal . $30,000 = $30,000 (2) − 2,500 + $2,500 ________ ________ ________ New Bal . $27,500 + $ 2,500 = $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Common Stock Old Bal . $27,500 + $2,500 = $30,000 (3) −26,000 + $26,000 _________ _______ ___________ ________ New Bal . $ 1,500 + $2,500 + $ 26,000 = $30,000

$30,000 $30,000

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

In vo

ic e

B ill

In vo

ic e

B ill Lones

Bes t Bu

y St ock

BANK

Assets Liabilities + Equity=

Real company names are in bold magenta

12 Chapter 1 Accounting in Business

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of footwear and accessories are needed. These additional supplies cost $7,100, but FastForward has only $1,500 in cash. Taylor arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount.

Example: If FastForward pays $500 cash in Transaction 4, how does this partial payment affect the liability to CalTech? Answer: The liability to CalTech is reduced to $6,600 and the cash balance is reduced to $1,000.

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common + Revenues Payable Stock Old Bal . $1,500 + $9,600 + $26,000 = $7,100 + $30,000 (5) +4,200 + $4,200 Consulting _________ ________ __________ ________ __________ _________ New Bal . $5,700 + $9,600 + $26,000 = $7,100 + $30,000 + $ 4,200

$41,300 $41,300

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Transaction 5: Provide Services for Cash FastForward plans to earn revenues by selling online ad space and consulting with clients about footwear and accessories. It earns net income only if its revenues are greater than its expenses. In its first job, FastForward pro- vides consulting services and immediately collects $4,200 cash. The accounting equation re- flects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is shown in the far right column under Revenues because the cash received is earned by providing consult- ing services.

Point: Revenue recognition prin- ciple requires that revenue is rec- ognized when work is performed.

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 to rent its facilities. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is shown in the following accounting equation as Transaction 6. FastForward also pays the biweekly $700 salary of the company’s only em- ployee. This is shown in the accounting equation as Transaction 7. Both Transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, not assets, because their benefits are used in December (they have no future benefits after December). The accounting equation shows that both transactions reduce cash and equity. The far right column shows these decreases as Expenses.

Point: Expense recognition prin- ciple requires that expenses are recognized when the revenue they help generate is recorded.

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common Stock Payable Old Bal . $1,500 + $2,500 + $26,000 = $30,000 (4) + 7,100 +$7,100 _______ _______ ________ __________ ________ New Bal . $1,500 + $9,600 + $26,000 = $ 7,100 + $30,000

$37,100 $37,100

⎧ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Supplies + Equipment = Accounts + Common + Revenues − Expenses Payable Stock Old Bal . $5,700 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 (6) −1,000 − $1,000 Rent _________ ________ __________ _________ __________ _________ _________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 Salaries _________ ________ __________ _________ __________ _________ _________ New Bal . $4,000 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 − $ 1,700

$39,600 $39,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Increases in expenses yield decreases in equity.

Chapter 1 Accounting in Business 13

Transaction 8: Provide Services and Facilities for Credit FastForward pro- vides consulting services of $1,600 and rents its test facilities for an additional $300 to Adidas on credit. Adidas is billed for the $1,900 total. This transaction creates a new asset, called ac- counts receivable, from Adidas. Accounts receivable is increased instead of cash because the payment has not yet been received. Equity is increased from the two revenue components shown in the Revenues column of the accounting equation.

Point: Transaction 8, like 5, records revenue when work is performed, not necessarily when cash is received.

Transaction 9: Receipt of Cash from Accounts Receivable The client in Transaction 8 (Adidas) pays $1,900 to FastForward 10 days after it is billed for consulting ser- vices. This Transaction 9 does not change the total amount of assets and does not affect liabili- ties or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward performed the services in Transaction 8, not when the cash is collected.

Point: Transaction 9 involved no added client work, so no added revenue is recorded.

Point: Receipt of cash is not always a revenue.

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (Transaction 4), leaving $6,200 unpaid. This transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an ex- pense even though cash flows out of FastForward (instead the expense is recorded when FastForward uses these supplies).

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $4,000 + $9,600 + $26,000 = $7,100 + $30,000 + $4,200 − $1,700 (8) + $1,900 + 1,600 Consulting + 300 Rental ________ _________ _______ _________ _______ _________ _______ __________ New Bal . $4,000 + $ 1,900 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $4,000 + $1,900 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700 (9) +1,900 − 1,900 _________ _________ _______ _________ _______ _________ _______ ________ New Bal . $5,900 + $ 0 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700

$41,500 $41,500

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common + Revenues − Expenses Receivable Payable Stock Old Bal . $5,900 + $ 0 + $9,600 + $26,000 = $7,100 + $30,000 + $6,100 − $1,700 (10) −900 −900 _______ __________ _______ _________ _______ _________ ________ ________ New Bal . $5,000 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 + $6,100 − $1,700

$40,600 $40,600

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

14 Chapter 1 Accounting in Business

Summary of Transactions Exhibit 1.9 shows the effects of these 11 transactions of FastForward using the accounting equa- tion. Assets equal liabilities plus equity after each transaction.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock Old Bal . $5,000 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 + $6,100 − $1,700 (11) − 200 − $200 Dividends _______ _______ _______ ________ _______ _________ ______ _______ _______ New Bal . $4,800 + $ 0 + $9,600 + $26,000 = $6,200 + $30,000 − $200 + $6,100 − $1,700

$40,400 $40,400

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

Increases in dividends yield decreases in equity.

Transaction 11: Payment of Cash Dividend FastForward declares and pays a $200 cash dividend to its owner (the sole shareholder). Dividends (decreases in equity) are not reported as expenses because they do not help earn revenue. Because dividends are not expenses, they are not used in computing net income.

Assets = Liabilities + Equity

Cash + Accounts + Supplies + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock (1) $30,000 = $30,000 (2) − 2,500 + $2,500 __________ ________ __________ Bal . 27,500 + 2,500 = 30,000 (3) −26,000 + $26,000 __________ ________ ____________ __________ Bal . 1,500 + 2,500 + 26,000 = 30,000 (4) + 7,100 = +$7,100 __________ ________ ____________ _________ __________ Bal . 1,500 + 9,600 + 26,000 = 7,100 + 30,000 (5) + 4,200 + $4,200 __________ ________ ____________ _________ __________ ________ Bal . 5,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 (6) − 1,000 − $1,000 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,700 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,000 (7) − 700 − 700 __________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 9,600 + 26,000 = 7,100 + 30,000 + 4,200 − 1,700 (8) + $1,900 + 1,600 + 300 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 4,000 + 1,900 + 9,600 + 26,000 = 7,100 + 30,000 6,100 − 1,700 (9) + 1,900 − 1,900 __________ ________ ____________ _________ __________ ________ ________ Bal . 5,900 + 0 + 9,600 + 26,000 = 7,100 + 30,000 + 6,100 − 1,700 (10) − 900 − 900 __________ ________ ________ ____________ _________ __________ ________ ________ Bal . 5,000 + 0 + 9,600 + 26,000 = 6,200 + 30,000 + 6,100 − 1,700 (11) − 200 − $200 __________ ________ ________ ____________ _________ __________ ______ ________ ________ Bal . $ 4,800 + $ 0 + $ 9,600 + $ 26,000 = $ 6,200 + $ 30,000 − $ 200 + $6,100 − $ 1,700

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses.

Jan. 1 Jamsetji Tata invested $4,000 cash in Tata Company in exchange for its common stock. 5 The company purchased $2,000 of equipment on credit. 14 The company provided $540 of services for a client on credit. 21 The company paid $250 cash for an employee’s salary.

Transaction Analysis

NEED-TO-KNOW 1-4

P1

Do More: QS 1-10, QS 1-11, E 1-10, E 1-11, E 1-13

Chapter 1 Accounting in Business 15

Solution

Assets = Liabilities + Equity

Cash + Accounts + Equipment = Accounts + Common − Dividends + Revenues − Expenses Receivable Payable Stock Jan. 1 $4,000 = $4,000 Jan. 5 + $2,000 +$2,000 Bal . 4,000 + 2,000 = 2,000 + 4,000 Jan. 14 + $540 + $540 Bal . 4,000 + 540 + 2,000 = 2,000 + 4,000 + 540 Jan. 21 −250 − $250 Bal . 3,750 + 540 + 2,000 = 2,000 + 4,000 + 540 − 250

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩ ⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

$6,290 $6,290

Financial statements are prepared in the order below using the 11 transactions of FastForward. (These statements are unadjusted—we explain this in Chapters 2 and 3.) The four financial statements and their purposes follow.

COMMUNICATING WITH USERS P2 Identify and prepare basic financial statements and explain how they interrelate.

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from Trans- actions 5 and 8 and rental revenue of $300 from Transaction 8. Expenses are reported after revenues. Rent and salary expenses are from Transactions 6 and 7. Expenses are the costs to generate the revenues reported. Net income occurs when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Net income (or loss) is shown at the bottom of the state- ment and is the amount reported in December. Stockholders’ investments and dividends are not part of income.

Financial Statement Purpose

Income statement Describes a company’s revenues and expenses and computes net income or loss over a period of time.

Statement of retained earnings Explains changes in retained earnings from net income (or loss) and any dividends over a period of time.

Balance sheet Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.

Statement of cash flows Identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

Layout

Revenue – Expenses

Net income

Beg. retained earnings + Net income – Dividends

End. retained earnings

Assets = Liabilities + Equity

+/– Operating C.F. +/– Investing C.F. +/– Financing C.F.

Change in cash

Point: Net income is sometimes called earnings or profit.

Key terms are in bold and defined again in the glossary

16 Chapter 1 Accounting in Business

FASTFORWARD Balance Sheet

December 31, 2019

Assets Liabilities Cash . . . . . . . . . . . . . $ 4,800 Accounts payable . . . . . . . . . . . . . . . . $ 6,200 _____________ Supplies . . . . . . . . . . 9,600 Total liabilities . . . . . . . . . . . . . . . . . . 6,200

Equipment . . . . . . . . . 26,000 Equity Common stock . . . . . . . . . . . . . . . . . . 30,000

Retained earnings . . . . . . . . . . . . . . . 4,200 _____________ Total equity . . . . . . . . . . . . . . . . . . . . . 34,200 _________ _____________ Total assets . . . . . . . . . $ 40,400 Total liabilities and equity . . . . . . . . . $ 40,400 _________ _____________ _________ _____________

Point: The income statement, the statement of retained earnings, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

FASTFORWARD Income Statement

For Month Ended December 31, 2019

Revenues

Consulting revenue ($4,200 + $1,600) . . . . . . . . . . . . . . . . . . . . . $ 5,800 Rental revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 ____________ Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,100

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 ____________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 _____________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,400 _____________ _____________

FASTFORWARD Statement of Cash Flows

For Month Ended December 31, 2019

Cash flows from operating activities

Cash received from clients ($4,200 + $1,900) . . . . . . . . . . . . . . $ 6,100 Cash paid for expenses ($2,500 + $900 + $1,000 + $700) . . . . (5,100) __________ Net cash provided by operating activities . . . . . . . . . . . . . . . . . . $ 1,000

Cash flows from investing activities

Cash paid for equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26,000) __________ Net cash used by investing activities . . . . . . . . . . . . . . . . . . . . . . (26,000)

Cash flows from financing activities

Cash investments from shareholders . . . . . . . . . . . . . . . . . . . . . . 30,000 Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . (200) __________ Net cash provided by financing activities . . . . . . . . . . . . . . . . . . 29,800 ___________ Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800

Cash balance, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . 0 ___________ Cash balance, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800 ___________ ___________

Point: A single ruled line means an addition or subtraction. Final totals are double underlined. Negative amounts may or may not be in parentheses.

EXHIBIT 1.10 Financial Statements and Their Links

Point: A statement’s heading iden- tifies the company, the statement title, and the date or time period.

FASTFORWARD Statement of Retained Earnings

For Month Ended December 31, 2019

Retained earnings, December 1, 2019 . . . . . . . . . . . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,400 _____________ 4,400

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 _____________ Retained earnings, December 31, 2019 . . . . . . . . . . . . . . . . . . . . . $     4,200 _____________ _____________

Point: Arrow lines show how the statements are linked. 1 Net income is used to compute retained earnings. 2 Retained earnings is used to

prepare the balance sheet. 3 Cash from the balance sheet is

used to reconcile the statement of cash flows.

3

2

1

Chapter 1 Accounting in Business 17

Statement of Retained Earnings The statement of retained earnings reports how retained earnings changes over the reporting period. This statement shows beginning retained earnings, events that increase it (net income), and events that decrease it (dividends and net loss). Ending retained earnings is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of retained earnings is the second report in Exhibit 1.10. The beginning balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports a beginning balance equal to the prior period’s ending balance (such as from November 30). FastForward’s statement shows the $4,400 of net income for the period, which links the income statement to the statement of retained earnings (see line 1 ). The state- ment also reports the $200 cash dividend and FastForward’s end-of-period retained earnings balance.

Balance Sheet FastForward’s balance sheet is the third report in Exhibit 1.10. This statement shows FastForward’s financial position at the end of business day on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity balance is $34,200. Line 2 shows the link between the ending balance of the statement of retained earnings and the retained earnings balance on the balance sheet. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Both are acceptable.) As always, the accounting equation balances: Assets of $40,400 = Liabilities of $6,200 + Equity of $34,200.

Statement of Cash Flows FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the $5,100 cash paid for supplies, rent, and employee salaries. Outflows are in paren- theses to denote subtraction. Net cash provided by operating activities for December is $1,000. The second section reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include long-term borrowing and repay- ing of cash from lenders and the cash investments from, and dividends to, stockholders. FastForward reports $30,000 from the owner’s initial investment and a $200 cash dividend. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows an increased cash balance of $4,800. The ending balance is also $4,800 as it started with no cash—see line 3 .

Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

Prepare the (a) income statement, (b) statement of retained earnings, and (c) balance sheet for Apple using the following condensed data from its fiscal year ended September 30, 2017 ($ in millions).

P2 Financial Statements

NEED-TO-KNOW 1-5

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234

Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 192,223 Investments and other assets . . . . . . . . . . . 303,373

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 Land and equipment (net) . . . . . . . . . . . . . . 33,783

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,289 Selling, general, and other expenses . . . . . 39,835

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 Accounts receivable . . . . . . . . . . . . . . . . . . . 17,874

Retained earnings, Sep . 24, 2016 . . . . . . . . . . . 96,998 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169 Retained earnings, Sep . 30, 2017 . . . . . . . 98,180

APPLE

©Pavel1964/Shutterstock

18 Chapter 1 Accounting in Business

Solution ($ in millions)

APPLE Income Statement

For Fiscal Year Ended September 30, 2017

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 Expenses Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $141,048 Selling, general, and other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,835 ______________ Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,883 ______________ Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 ______________ ______________

APPLE Statement of Retained Earnings

For Fiscal Year Ended September 30, 2017

Retained earnings, Sep . 24, 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,998 Plus: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,351 ______________ 145,349 Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,169 ______________ Retained earnings, Sep . 30, 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 98,180 ______________ ______________

APPLE Balance Sheet

September 30, 2017

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 Accounts payable . . . . . . . . . . . . . . . . . . . $ 49,049 Accounts receivable . . . . . . . . . . . . . . . . . . . . . 17,874 Other liabilities . . . . . . . . . . . . . . . . . . . . . 192,223 ___________ Land and equipment (net) . . . . . . . . . . . . . . . . 33,783 Total liabilities . . . . . . . . . . . . . . . . . . . . . . 241,272 Investments and other assets . . . . . . . . . . . . . 303,373 Equity Common stock . . . . . . . . . . . . . . . . . . . . . 35,867 Retained earnings . . . . . . . . . . . . . . . . . . 98,180 ___________ Total equity . . . . . . . . . . . . . . . . . . . . . . . . 134,047 ___________ ___________ Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 Total liabilities and equity . . . . . . . . . . . . $375,319 ___________ ___________ ___________ ___________

Do More: QS 1-12, QS 1-13, QS 1-14, E 1-15, E 1-16,

E 1-17

Return on AssetsDecision Analysis

We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we use a company’s prior-year ratios and competitor ratios to identify good, bad, or average performance. This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Return on assets (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

Decision Analysis (a section at the end of each chapter) covers ratios for decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 13

A2 Compute and interpret return on assets.

EXHIBIT 1.11 Return on Assets Return on assets =

Net income Average total assets

Net income is from the annual income statement, and average total assets is computed by adding the begin- ning and ending amounts for that same period and dividing by 2. Nike reports total net income of $4,240 million for the current year. At the beginning of the current year its total assets are $21,396 million, and at the end of the current year they total $23,259 million. Nike’s return on assets for the current year is:

Return on assets = $4,240 million

($21,396 million + $23,259 million)/2 = 19.0%

Chapter 1 Accounting in Business 19

Is a 19.0% return on assets good or bad for Nike? To help answer this question, we compare (benchmark) Nike’s return with its prior performance and the return of its competitor, Under Armour (see Exhibit 1.12). Nike shows a stable pattern of good returns that reflects effective use of assets. Nike has outperformed Under Armour in each of the last three years. Its management performed well based on Nike’s return on assets.

EXHIBIT 1.12 Nike and Under Armour Returns

Return on Assets Current Year 1 Year Ago 2 Years Ago

Nike . . . . . . . . . . . . . . . . . . . 19 .0% 17 .5% 16 .3% Under Armour . . . . . . . . . . 7 .9 9 .4 11 .4

Business Owner You own a winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 14% return on its assets. The industry return for competitors of this manufacturer is 9%. Do you purchase this manufacturer? ■ Answer: The 14% return on assets for the manufacturer exceeds the 9% industry return. This is positive for a potential purchase. Also, this purchase is an opportunity to spread your risk over two businesses. Still, you should hesitate to purchase a business whose 14% return is lower than your current 21% return. You might better direct efforts to increase investment in your resort if it can earn more than the 14% alternative.

Decision Maker

Decision Analysis ends with a role-playing scenario to show the usefulness of ratios

After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month of business.

a. Aug. 1 Worthy invested $3,000 cash and $15,000 of equipment in Expressions in exchange for its common stock.

b. 2 Expressions paid $600 cash for furniture for the shop. c. 3 Expressions paid $500 cash to rent space in a strip mall for August. d. 4 Purchased $1,200 of equipment on credit for the shop (recorded as accounts payable). e. 15 Expressions opened for business on August 5. Cash received from haircutting services in the

first week and a half of business (ended August 15) was $825. f. 16 Expressions provided $100 of haircutting services on credit. g. 17 Expressions received a $100 check for services previously rendered on credit. h. 18 Expressions paid $125 cash to an assistant for hours worked for the grand opening. i. 31 Cash received from services provided during the second half of August was $930. j. 31 Expressions paid $400 cash toward the accounts payable entered into on August 4. k. 31 Expressions paid a $900 cash dividend to Worthy (sole shareholder).

Required

1. Arrange the following asset, liability, and equity titles in a table similar to the one in Exhibit 1.9: Cash; Accounts Receivable; Furniture; Store Equipment; Accounts Payable; Common Stock; Dividends; Revenues; and Expenses. Show the effects of each transaction using the accounting equation.

2. Prepare an income statement for August. 3. Prepare a statement of retained earnings for August. 4. Prepare a balance sheet as of August 31. 5. Prepare a statement of cash flows for August. 6. Determine the return on assets ratio for August.

PLANNING THE SOLUTION Set up a table like Exhibit 1.9 with the appropriate columns for accounts. Analyze each transaction and show its effects as increases or decreases in the appropriate columns. Be

sure the accounting equation remains in balance after each transaction. Prepare the income statement, and identify revenues and expenses. List those items on the statement,

compute the difference, and label the result as net income or net loss. Use information in the Equity columns to prepare the statement of retained earnings. Use information in the last row of the transactions table to prepare the balance sheet. Prepare the statement of cash flows; include all events listed in the Cash column of the transactions

table. Classify each cash flow as operating, investing, or financing. Calculate return on assets by dividing net income by average assets.

COMPREHENSIVE

Transaction Analysis, Statement Preparation, and Return on Assets

NEED-TO-KNOW 1-6

Comprehensive Need-to-Know is a review of key chapter content; the Planning the Solution section offers strategies in solving it

20 Chapter 1 Accounting in Business

SOLUTION 1.

Assets = Liabilities + Equity

Cash + Accounts + Furniture + Store = Accounts + Common − Dividends + Revenues − Expenses Receivable Equipment Payable Stock a. $3,000 $15,000 $18,000 b. − 600 + $600 _______ ______ _________ _________ Bal . 2,400 + 600 + 15,000 = 18,000 c. − 500 − $500 _______ ______ _________ _________ ______ Bal . 1,900 + 600 + 15,000 = 18,000 − 500 d. + 1,200 +$1,200 _______ ______ _________ _________ _________ ______ Bal . 1,900 + 600 + 16,200 = 1,200 + 18,000 − 500 e. + 825 + $ 825 _______ ______ _________ _________ _________ _______ ______ Bal . 2,725 + 600 + 16,200 = 1,200 + 18,000 + 825 − 500 f. + $100 + 100 _______ ______ ______ _________ _________ _________ _______ ______ Bal . 2,725 + 100 + 600 + 16,200 = 1,200 + 18,000 + 925 − 500 g. + 100 − 100 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 2,825 + 0 + 600 + 16,200 = 1,200 + 18,000 + 925 − 500 h. − 125 − 125 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 2,700 + 0 + 600 + 16,200 = 1,200 + 18,000 + 925 − 625 i. + 930 + 930 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 3,630 + 0 + 600 + 16,200 = 1,200 + 18,000 + 1,855 − 625 j. − 400 − 400 _______ ______ ______ _________ _________ _________ _______ _______ Bal . 3,230 + 0 + 600 + 16,200 = 800 + 18,000 + 1,855 − 625 k. − 900 − $ 900 _______ ______ ______ _________ _________ _________ ________ _______ _______ Bal . $ 2,330 + 0 + $ 600 + $ 16,200 = $ 800 + $ 18,000 − $ 900 + $1,855 − $625 _______ ______ ______ _________ _________ _________ ________ _______ _______ _______ ______ ______ _________ _________ _________ ________ _______ _______

[continued on next page]

2.

EXPRESSIONS Income Statement

For Month Ended August 31

Revenues

Haircutting services revenue . . . . . . . . . . . . . $ 1,855

Expenses

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . $ 500

Wages expense . . . . . . . . . . . . . . . . . . . . . . . 125

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . 625

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,230

3.

EXPRESSIONS Statement of Retained Earnings

For Month Ended August 31

Retained earnings, August 1* . . . . . . . . . . . . . $ 0

Plus: Net income . . . . . . . . . . . . . . . . . . . . . 1,230 1,230

Less: Dividends . . . . . . . . . . . . . . . . . . . . . . . 900

Retained earnings, August 31 . . . . . . . . . . . . . $ 330

* If Expressions had existed before August 1, the beginning retained earnings balance would equal the prior period’s ending balance.

Chapter 1 Accounting in Business 21

6. Return on assets = Net income

Average assets =

$1,230 ($18,000* + $19,130)∕2

= $1,230 $18,565

= 6.63%

*Uses the initial $18,000 investment as the beginning balance for the start-up period only.

4.

EXPRESSIONS Balance Sheet

August 31

Assets Liabilities Cash . . . . . . . . . . . . . . . . . . . . . $ 2,330 Accounts payable . . . . . . . . . . . . . . . . . . $ 800 Furniture . . . . . . . . . . . . . . . . . 600 Equity Store equipment . . . . . . . . . . . 16,200 Common stock . . . . . . . . . . . . . . . . . . . . . 18,000 Retained earnings . . . . . . . . . . . . . . . . . . 330 Total equity . . . . . . . . . . . . . . . . . . . . . . . . 18,330 Total assets . . . . . . . . . . . . . . . $19,130 Total liabilities and equity . . . . . . . . . . . . $19,130

5.

EXPRESSIONS Statement of Cash Flows

For Month Ended August 31

Cash flows from operating activities Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,855 Cash paid for expenditures ($500 + $125 + $400) . . . . . . . . . . (1,025) Net cash provided by operating activities . . . . . . . . . . . . . . . . . . $ 830 Cash flows from investing activities Cash paid for furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600) Cash flows from financing activities Cash investments from shareholders . . . . . . . . . . . . . . . . . . . . . . 3,000 Cash dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . (900) Net cash provided by financing activities . . . . . . . . . . . . . . . . . . 2,100 Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330 Cash balance, August 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Cash balance, August 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,330

APPENDIX

Return and Risk 1A This appendix covers return and risk analysis. Net income is often linked to return. Return on assets (ROA) is stated in ratio form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest re- turn such as 2%. We also could invest in a company’s stock, or even start our own business. How do we decide among these options? The answer depends on our trade-off between return and risk. Risk is the uncertainty about the return we will earn. All business investments involve risk, but some in- vestments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts). If we buy a share of eBay or any other company, we might get a large return. However, we have no guarantee of any return; there is even the risk of loss. Exhibit 1A.1 shows recent returns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds have a low expected return, but they also have low risk because they are backed by the U.S. govern- ment. High-risk corporate bonds have a much larger potential return but have much higher risk. The trade-off between return and risk is a normal part of business. Higher risk implies higher, but riskier, expected returns. To help us make better decisions, we use accounting information to assess both return and risk.

A3 Explain the relation between return and risk.

EXHIBIT 1A.1 Average Returns for Bonds with Different Risks

Annual Return

U.S. Treasury

Low-risk corporate

Medium-risk corporate

High-risk corporate

0% 4% 8% 12%

10.9%

8.3%

5.8%

2.5%

22 Chapter 1 Accounting in Business

APPENDIX

Business Activities1B This appendix explains how the accounting equation is linked to business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning is defining an organization’s ideas, goals, and actions.

Financing Financing activities provide the resources organizations use to pay for assets such as land, buildings, and equipment. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources loaned by creditors (lenders).

Investing Investing activities are the acquiring and disposing of assets that an organization uses to buy and sell its products or services. Some organizations require land and factories to operate. Others need only an office. Invested amounts are referred to as assets. Creditor and owner financing hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This yields the accounting equation: Assets = Liabilities + Equity.

Operating Operating activities involve using resources to research, develop, purchase, produce, distribute, and market products and services. Sales and revenues are the inflow of assets from selling products and services. Costs and expenses are the outflow of assets to support operating activities. Exhibit 1B.1 summarizes business activities. Planning is part of each ac- tivity and gives them meaning and focus. Investing (assets) and financing (li- abilities and equity) are opposite each other because they always are equal. Operating activities are below to show that they are the result of investing and financing.

C5 Identify and describe the three major activities of organizations.

Point: Investing (assets) and financing (liabilities plus equity) totals are always equal.

EXHIBIT 1B.1 Activities of Organizations

Operating

Planning

P

la nn

in g

Planning

In vo

ic e

B ill

In vo

ic e

B ill Lones

Bes t Bu

y St ock

BANK

Investing BANKBANKBANKBANKBANK

Financing

ACCOUNTING USES External users: Do not directly run the organization and have limited access to its accounting information. Examples are lenders, shareholders, boards of directors, external auditors, nonexecutive employees, labor unions, regulators, voters, donors, suppliers, and customers. Internal users: Directly manage organization operations. Examples are the CEO and other executives, research and development managers, purchasing managers, production managers, and other managerial-level employees. Private accounting: Accounting employees working for businesses. Public accounting: Offering audit, tax, and accounting services to others.

ETHICS AND ACCOUNTING Fraud triangle: Factors that push a person to commit fraud. ∙ Opportunity: Must be able to commit fraud with a low risk of getting

caught. ∙ Pressure, or incentive: Must feel pressure or have incentive to commit

fraud. ∙ Rationalization, or attitude: Justifies fraud or does not see its criminal

nature.

Summary: Cheat Sheet

SYSTEM OF ACCOUNTS Assets: Resources a company owns or controls that are expected to yield future benefits. Liabilities: Creditors’ claims on assets. These are obligations to provide assets, products, or services to others. Equity: Shareholders’ claim on assets. It consists of:

Common stock reflects inflows of cash and other net assets from stockholders in exchange for stock.

Dividends are outflows of cash and other assets to stockholders that reduce equity.

Revenues increase equity (via net income) from sales of products and services to customers; examples are sales of products, consult- ing services provided, facilities rented to others, and commissions from services.

Expenses decrease equity (via net income) from costs of providing products and services to customers; examples are costs of employee time, use of supplies, advertising, utilities, and insurance fees.

Common Stock+ Dividends−

Revenues+

Expenses−

Common business entities: Sole Proprietorship Partnership

Number of owners 1 owner; easy to set up . 2 or more, called partners; easy to set up .

Business taxation No additional business income tax . No additional business income tax .

Owner liability Unlimited liability . Owner is personally liable for proprietorship debts .

Unlimited liability . Partners are jointly liable for partnership debts .

Legal entity Not a separate legal entity . Not a separate legal entity .

Business life Business ends with own

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