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Accounting Principles:
A Business Perspective,
Financial Accounting (Chapters 1 – 8)
A Textbook Equity Open College Textbook
originally by
Hermanson, Edwards, and Maher

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Consistent with it’s strategic mission to provide free and low-cost textbooks, this is Textbook
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Textbook Provenance (1998 - 2011)

1998 Edition
Accounting: A Business Perspective (Irwin/Mcgraw-Hill Series in Principles of Accounting)
[Hardcover] Roger H
...

Maher (Author) Eighth Edition
Hardcover: 944 pages
Publisher: Richard D Irwin; 7 Sub edition (April 1998)
Language: English
ISBN-10: 0075615851
ISBN-13: 978-0075615859
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Accounting”, Revision Editor: Donald J
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Managerial Accounting”, Revision Editor: Donald J
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Preface from the eight edition:
Philosophy and purpose
Imagine that you have graduated from college without taking an accounting course
...

While attending a sales managers' meeting, financial results are reviewed by the Vice President of Sales
and terms such as gross margin percentage, cash flows from operating activities, and LIFO inventory
methods are being discussed
...
You try to do so, but it is obvious to everyone in the meeting that you do not
know what you are talking about
...
If you understand how accounting information is prepared, you
will be in an even stronger position when faced with a management decision based on accounting
information
...
If the
financial statements of an enterprise are to properly represent the results of operations and the
financial condition of the company, the transactions must be analyzed and recorded in the accounts
following generally accepted accounting principles
...
If
expenses are reported as assets, liabilities and their related expenses are omitted from the financial
statements, or reported revenues are recorded prematurely or do not really exist, the financial
statements are misleading
...

We wrote this text to give you an understanding of how to use accounting information to analyze
business performance and make business decisions
...
We use the
annual reports of real companies to illustrate many of the accounting concepts
...

Gaining an understanding of accounting terminology and concepts, however, is not enough to
ensure your success
...
4 of 433

business situations, work effectively as a member of a team, and communicate your ideas clearly
...


Curriculum concerns
Significant changes have been recommended for accounting education
...
The typical accounting graduate seems unable to successfully deal
with complex and unstructured "real world" accounting problems and generally lacks communication
and interpersonal skills
...
The traditional lecture and structured problem solving method
approach would be supplemented or replaced with a more informal classroom setting dealing with
cases, simulations, and group projects
...
Study groups would be
formed so that students could tutor other students
...

One of the most important benefits you can obtain from a college education is that you "learn how
to learn"
...
Change is occurring at an increasingly rapid pace
...
Much of the information you learn in college will be obsolete in just a few years
...
Memorizing is much less important than learning
how to think critically
...
The section at the end of each
chapter titled, "Beyond the numbers—Critical thinking", provides the opportunity for you to address
unstructured case situations, the analysis of real companies' financial situations, ethics cases, and team
projects
...
For many of these items, you will use written and oral
communication skills in presenting your results
...
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Objectives and overall approach of the eighth
edition
The Accounting Education Change Commission (AECC) made specific recommendations regarding
teaching materials and methods used in the first-year accounting course
...
The AECC states:
The first course in accounting can significantly benefit those who enter business,
government, and other organizations, where decision-makers use accounting
information
...
All organizations have accountability
responsibilities to their constituents, and accounting, properly used, is a powerful tool in
creating information to improve the decisions that affect those constituents
...
To help accomplish
this, the text has a section preceding each chapter entitled, "Careers in accounting"
...
Those who choose not to major in accounting, which is a majority of those taking
this course, will become better users of accounting information because they will know something
about the preparation of that information
...
We seek to involve the business
student more in real world business applications as we introduce and explain the subject matter
...


1 Accounting Education Change Commission, Position Statement No
...
1-2
...
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 "Accounting perspective: Uses of technology" boxes throughout the text demonstrate

how technology has affected the way accounting information is prepared, manipulated, and
accessed
...
These situations, taken from annual reports

of real companies and from articles in current business periodicals such as Accounting Today, and
Management Accounting, relate to subject matter discussed in that chapter or present other
useful information
...

 Real world questions and real world business decision cases are included in almost every

chapter
...
Many of the real world questions and business decision cases are based
on this annual report
...
Placed throughout the text, these illustrations
give students real world data to consider while learning about different accounting techniques
...

 Chapters 1-16 contain a section entitled, "Analyzing and using the financial results"
...
For instance, this section in Chapter 4 discusses the current ratio as it relates to a
classified balance sheet
...
As stated
earlier, this appendix is included with the text and contains the significant portions of the annual
report of The Limited, Inc
...
This section

contains business decision cases, annual report analysis problems, writing assignments based on
the Ethical perspective and Broader perspective boxes, group projects, and Internet projects
...
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Pedagogy
Students often come into accounting principles courses feeling anxious about learning the subject
matter
...

 Improvements in the text's content reflect feedback from adopters, suggestions by reviewers,

and a serious study of the learning process itself by the authors and editors
...

These paragraphs provide students with the reasons for proceeding to the new material and
explain the progression of topics within the chapter
...

 Each chapter has an "Understanding the learning objectives" section
...
We were the first
authors (1974) to ever include Learning objectives in an accounting text
...
The objectives are also indicated for each exercise and problem
...
These demonstration problems help students to
assess their own progress by showing them how problems that focus on the topic(s) covered in the
chapter are worked before students do assigned homework problems
...
End-of-chapter glossaries contain the definition
...
The

answers and explanations appear at the end of the chapter
...

 In the margin beside each exercise and problem, we have included a description of the

requirements and the related Learning objective(s)
...

 Throughout the text we use examples taken from everyday life to relate an accounting concept

being introduced or discussed to students' experiences
...
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Ethics
There is no better time to emphasize high ethical standards to students
...
These items present situations in which
students are likely to find themselves throughout their careers
...


End-of-chapter materials
Describing teaching methods, the AECC stated, "Teachers
...
Students' involvement should be
promoted by methods such as cases, simulations, and group projects
...
Business decision cases require critical thinking in complex situations often based
on real companies
...
The Ethics cases require students to respond in writing to situations
they are likely to encounter in their careers
...
The
Group projects for each chapter teach students how to work effectively in teams, a skill that was
stressed by the AECC and is becoming increasingly necessary for success in business
...

A team approach can also be introduced in the classroom using the regular exercises and problems
in the text
...
Using this team approach in class can help re-energize the classroom by creating an
active, informal environment in which students learn from each other
...
These projects are designed to be used throughout the
semester or quarter
...

Other key features regarding end-of-chapter material follow
...
2
...
9 of 433

 A uniform chart of accounts appears in a separate file you can download
...
We believe students will benefit
from using the same chart of accounts for all homework problems in those chapters
...
Another comprehensive problem at the end of Chapter 19 reviews
the material covered in Chapters 18 and 19
...

 Some of the end-of-chapter problem materials (questions, exercises, problems, business decision

cases, other "Beyond the numbers" items, and comprehensive review problems) have been
updated
...

 All end-of-chapter exercises and problems have been traced back to the chapters to ensure that

nothing is asked of a student that does not appear in the book
...
Also, we took notes while teaching from the text and clarified problem and
exercise instructions that seemed confusing to our students
...
10 of 433

Table of Contents
1 The Accounting Environment
...
1 Learning objectives
...
2 Accounting Defined
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3 Employment opportunities in accounting
...
4 Financial accounting versus managerial accounting
...
5 Development of financial accounting standards
...
6 Ethical behavior of accountants
...
7 Critical thinking and communication skills
...
8 Internet skills
...
9 How to study the chapters in this text
...
30
2
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30
2
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30
2
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31
2
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33
2
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34
2
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39
2
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40
2
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41
2
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45
2
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48
2
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49
2
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52
2
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53
2
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54
2
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55
2
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57
2
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58
2
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60
3 Recording business transactions
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1 Learning objectives
...
2 Salary potential of accountants
...
3 The account and rules of debit and credit
...
4 Recording changes in assets, liabilities, and stockholders' equity
...
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3
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86
3
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87
3
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90
3
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91
3
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105
3
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115
3
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123
3
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124
4 Adjustments for financial reporting
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1 Learning objectives
...
2 A career as a tax specialist
...
3 Cash versus accrual basis accounting
...
4 The need for adjusting entries
...
5 Classes and types of adjusting entries
...
6 Adjustments for deferred items
...
7 Adjustments for accrued items
...
8 Effects of failing to prepare adjusting entries
...
9 Analyzing and using the financial results—trend percentages
...
10 Understanding the learning objectives
...
190
5
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190
5
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190
5
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191
5
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191
5
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199
5
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200
5
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201
5
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210
5
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216
5
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223
5
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224
6 Accounting theory
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1 Learning objectives
...
2 A career as an accounting professor
...
3 Traditional accounting theory
...
4 Underlying assumptions or concepts
...
5 Other basic concepts
...
6 The measurement process in accounting
...
7 The major principles
...
8 Modifying conventions (or constraints)
...
9 The financial accounting standards board's conceptual framework project
...
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6
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271
6
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273
6
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6
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279
6
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279
6
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280
6
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283
7 Introduction to inventories and the classified income statement
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1 Learning objective
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2 A career as a CEO
...
3 Two income statements compared— Service company and merchandising company

...
4 Sales revenues
...
5 Cost of goods sold
...
6 Classified income statement
...
7 Analyzing and using the financial results—Gross margin percentage
...
8 Understanding the learning objectives
...
9 Appendix: The work sheet for a merchandising company
...
10 Key terms
...
11 Self-test
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359
8
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359
8
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359
8
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360
8
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361
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363
8
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387
8
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395
8
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395
Alphabetical Index
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13 of 433

1 The Accounting Environment
1
...




Describe the functions performed by accountants
...




Differentiate between financial and managerial accounting
...

You have embarked on the challenging and rewarding study of accounting—an old and timehonored discipline
...

Record-keeping in an accounting sense is thought to have begun about 4000 BCE
The record-keeping, control, and verification problems of the ancient world had many
characteristics similar to those we encounter today
...

A study of the evolution of accounting suggests that accounting processes have developed primarily
in response to business needs
...
History shows that the higher the level of civilization, the more elaborate the accounting
methods
...
In 1494, a
Franciscan monk, Luca Pacioli, described the double-entry Method of Venice system in his text called
Summa de Arithmetica, Geometric, Proportion et Proportionate (Everything about arithmetic,
geometry, and proportion)
...

Since Pacioli's days, the roles of accountants and professional accounting organizations have
expanded in business and society
...
Complementing their obligation to society,
accountants have analytical and evaluative skills needed in the solution of ever-growing world

p
...
The special abilities of accountants, their independence, and their high ethical standards
permit them to make significant and unique contributions to business and areas of public interest
...
Your financial and economic decisions as a student and
consumer involve accounting information
...
Understanding the discipline of accounting also can influence
many of your future professional decisions
...

Every profit-seeking business organization that has economic resources, such as money, machinery,
and buildings, uses accounting information
...
Accounting also serves as the language providing financial information about not-for-profit
organizations such as governments, churches, charities, fraternities, and hospitals
...

The accounting system of a profit-seeking business is an information system designed to provide
relevant financial information on the resources of a business and the effects of their use
...
Companies present this relevant
information in their financial statements
...

As a background for studying accounting, this Introduction defines accounting and lists the
functions accountants perform
...
Because accounting information must
conform to certain standards, we discuss several prominent organizations contributing to these
standards
...
You will realize that you are constantly exposed to accounting
information in your everyday life
...
2 Accounting Defined
The American Accounting Association—one of the accounting organizations discussed later in this
Introduction—defines accounting as "the process of identifying, measuring, and communicating

p
...
1
This information is primarily financial—stated in money terms
...
As a measurement and communication process for business,
accounting supplies information that permits informed judgments and decisions by users of the data
...
Bank officials, for example, may study a company's financial statements
to evaluate the company's ability to repay a loan
...
Accounting also
supplies management with significant financial data useful for decision making
...
Accounting information is valuable because decision makers can use it
to evaluate the financial consequences of various alternatives
...
They can reduce uncertainty by using professional judgment to
quantify the future financial impact of taking action or delaying action
...
This information tells
how management has discharged its responsibility for protecting and managing the company's
resources
...
In
fulfilling this obligation, accountants prepare financial statements such as an income statement, a
statement of retained earnings, a balance sheet, and a statement of cash flows
...

Accounting is often confused with bookkeeping
...
Accounting includes bookkeeping but goes well beyond it
in scope
...

Specifically the accounting process consists of the following groups of functions (see Exhibit 1
below):
1 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, III
...
1
...
16 of 433

 Accountants observe many events (or activities) and identify and measure in financial terms

(dollars) those events considered evidence of economic activity
...
) The purchase and sale of goods and services are economic
events
...

 Accountants report on economic events (or business activity) by preparing financial statements

and special reports
...
Interpretation may involve determining how the
business is performing compared to prior years and other similar businesses
...
3 Employment opportunities in accounting
During the last half-century, accounting has gained the same professional status as the medical and
legal professions
...
In addition,
several million people hold accounting-related positions
...
These include public accounting, management (industrial) accounting,
governmental or other not-for-profit accounting, and higher education
...
This increase is greater than for any other profession
...

Public accounting firms offer professional accounting and related services for a fee to
companies, other organizations, and individuals
...
The exam is administered by computer
...

These requirements vary by state
...
As of the year 2000, five years of
course work were required to become a member of the AICPA
...

Other states (called two-tier states) issue the CPA certificate immediately after the candidate passes the
exam
...
CPAs who want to renew their licenses to practice must stay current through continuing
p
...
No one can claim to be a CPA
and offer the services normally provided by a CPA unless that person holds an active license to
practice
...
18 of 433

The public accounting profession in the United States consists of the Big-Four international CPA
firms, several national firms, many regional firms, and numerous local firms
...
At all levels, these
public accounting firms provide auditing, tax, and, for nonaudit clients, management advisory (or
consulting) services
...
Users of a company's financial
statements are more confident that the company is presenting its statements fairly when a CPA has
audited the statements
...
Independent auditors of the CPA
firm check some of the company's records by contacting external sources
...
After completing a company audit,
independent auditors give an independent auditor's opinion or report
...
annual report in the Annual report appendix at the end of the
text
...
As you will learn in the next section,
auditors within a business also conduct audits, which are not independent audits
...

In 2002 The Sarbanes-Oxley Act was passed
...
The Act created the Public Company Accounting Oversight Board
...
The Board
oversees and investigates the audits and auditors of public companies and can sanction both firms and
individuals for violations of laws, regulations, and rules
...
Corporate
audit committees, rather than the corporate management, are now responsible for hiring,
compensating, and overseeing the external auditors
...
The objective in preparing tax returns is to use legal means to minimize the taxes
paid
...
Tax planning helps clients know the tax
effects of each financial decision
...
Management
p
...
However, the
Sarbanes-Oxley Act specifically prohibits providing certain types of consulting services to a publiclyheld company by its external auditor
...
Accounting firms can perform many of these services for publicly held
companies they do not audit
...

In contrast to public accountants, who provide accounting services for many clients, management
accountants provide accounting services for a single business
...

Management accountants may or may not be CPAs
...
The
ICMA is an affiliate of the Institute of Management Accountants, an organization primarily consisting
of management accountants employed in private industry
...
Many management
accountants specialize in one particular area of accounting
...
Many management accountants become
specialists in the design and installation of computerized accounting systems
...
They ensure that the company's
divisions and departments follow the policies and procedures of management
...
The
Institute of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully
completed the IIA examination and met certain other requirements
...
They have essentially the same educational background and training as accountants in
public accounting and management accounting
...

Often the duties of these accountants relate to tax revenues and expenditures
...
20 of 433

investigating tax fraud
...
g
...
These agencies often employ governmental accountants who can
review and evaluate the utilities' financial statements and rate increase requests
...

Not-for-profit organizations, such as churches, charities, fraternities, and universities, need
accountants to record and account for funds received and disbursed
...

Approximately 10,000 accountants are employed in higher education
...

Faculty positions exist in two-year colleges, four-year colleges, and universities with graduate
programs
...
Starting salaries will continue to rise significantly because
of the shortage
...

A section preceding each chapter, entitled "Careers in accounting", describes various accounting
careers
...


1
...
Decision makers outside the business are affected in some way by the performance of the
business
...
For
this reason, accounting is divided into two categories: financial accounting for those outside and
managerial accounting for those inside
...
Stockholders and
creditors are two of the outside parties who need financial accounting information
...
Consequently, financial accounting
information relates to the company as a whole, while managerial accounting focuses on the parts or
segments of the company
...
21 of 433

Management accountants in a company prepare the financial statements
...
The financial
statements are the representations of management, not the CPA firm that performs the audit
...
The groups and some of their possible questions are:
 Owners and prospective owners
...
Should a loan be granted to the company? Will the company be able

to pay its debts as they become due?
 Employees and their unions
...
Does the company offer useful products at fair prices? Will the company survive

long enough to honor its product warranties?
 Governmental units
...
Is the company providing useful products and gainful employment for citizens

without causing serious environmental problems?
General-purpose financial statements provide much of the information needed by external users of
financial accounting
...
Many
companies publish these statements in annual reports
...
, annual report in the
Annual report appendix
...

Financial accounting information is historical in nature, reporting on what has happened in the
past
...

These generally accepted accounting principles for businesses or governmental organizations have
developed through accounting practice or been established by an authoritative organization
...


p
...
The information managers use may range from broad, long-range planning
data to detailed explanations of why actual costs varied from cost estimates
...
For example, a

production manager wants information on costs of production but not of advertising
...
For instance, a budget would show financial plans for the

coming year
...

Managerial accounting generates information that managers can use to make sound decisions
...
In this sense, capital
means money used by the company to purchase resources such as machinery and buildings and to
pay expenses of conducting the business
...

 Production decisions—deciding what products are to be produced, by what means, and

when
...


1
...
These are the American Institute of
Certified Public Accountants, the Financial Accounting Standards Board, the Governmental
Accounting Standards Board, the Securities and Exchange Commission, the American Accounting
Association, the Financial Executives Institute, and the Institute of Management Accountants
...

The American Institute of Certified Public Accountants (AICPA) is a professional organization of
CPAs
...
Until recent years, the AICPA was the
dominant organization in the development of accounting standards
...
23 of 433

1959, the AICPA Committee on Accounting Procedure issued 51 Accounting Research Bulletins
recommending certain principles or practices
...
Through its monthly magazine, the Journal of Accountancy, its research division,
and its other divisions and committees, the AICPA continues to influence the development of
accounting standards and practices
...

In 1973, an independent, seven-member, full-time Financial Accounting Standards Board
(FASB) replaced the Accounting Principles Board
...
The old Accounting Research Bulletins and Accounting Principles
Board Opinions are still effective unless specifically superseded by a Financial Accounting Standards
Board Statement
...

The Emerging Issues Task Force of the FASB interprets official pronouncements for general
application by accounting practitioners
...

In 1984, the Governmental Accounting Standards Board (GASB) was established with a
full-time chairperson and four part-time members
...
This organization is the private sector organization now
responsible for the development of new governmental accounting concepts and standards
...

Created under the Securities and Exchange Act of 1934, the Securities and Exchange
Commission (SEC) is a government agency that administers important acts dealing with the
interstate sale of securities (stocks and bonds)
...
This includes virtually every major US
business corporation
...
The
SEC indicates to the FASB the accounting topics it believes the FASB should address
...
One of its quarterly magazines, The Accounting Review, carries many articles
p
...
Another quarterly journal, Accounting Horizons, reports
on more practical matters directly related to accounting practice
...
Students may join the AAA as
associate members by contacting the American Accounting Association, 5717 Bessie Drive, Sarasota,
Florida 34233
...
Many of its members are chief financial officers (CFOs)
of very large corporations
...
These CFOs played a major role in restructuring American businesses in the early
1990s
...
Through its Committee on Corporate
Reporting (CCR) and other means, the FEI is very effective in representing the views of the private
financial sector to the FASB and to the Securities and Exchange Commission and other regulatory
agencies
...
The primary focus of the organization is on the use of
management accounting information for internal decision making
...
Thus, through its Management Accounting
Practices (MAP) Committee and other means, the IMA provides input on financial accounting
standards to the Financial Accounting Standards Board and to the Securities and Exchange
Commission and other regulatory agencies
...

Their reactions are in the form of written statements sent to the FASB and testimony given at FASB
hearings
...


1
...
For
instance, both the American Institute of Certified Public Accountants and the Institute of Management
Accountants have formulated such codes
...

p
...
Most
of us sense what is right and wrong
...
Almost any
day, newspaper headlines reveal public officials and business leaders who did not do the right thing
...
These individuals followed slogans such as: "Get
yours while the getting is good"; "Do unto others before they do unto you"; and "You have done wrong
only if you get caught"
...

An accountant's most valuable asset is an honest reputation
...
They also like
themselves and what they represent
...
They sometimes find their names mentioned in The Wall Street Journal and news
programs in an unfavorable light, and former friends and colleagues look down on them
...
Fortunately, the accounting profession has many leaders
who have taken the high road, gained the respect of friends and colleagues, and become role models for
all of us to follow
...
We know you will
benefit from thinking about the situational ethics in these cases
...
Instead of making the cases "close calls", we have
attempted to include situations business students might actually encounter in their careers
...
7 Critical thinking and communication skills
Accountants in practice and business executives have generally been dissatisfied with accounting
graduates' ability to think critically and to communicate their ideas effectively
...

To address these concerns, we have included a section at the end of each chapter entitled, "Beyond
the numbers—Critical thinking"
...
Most of the other end-of-chapter materials also involve analysis and
written communication of ideas
...
In writing such a memorandum, identify your role (auditor,
p
...
Present your ideas clearly and concisely
...

These skills are important in succeeding in the business world
...


1
...
It is important for accountants and students to be able to use the
Internet to find relevant information
...
Your instructor might assign some of these, or you could pursue them on your
own
...
9 How to study the chapters in this text
In studying each chapter:
 Begin by reading the learning objectives at the beginning of each chapter
...

 Read the chapter content
...
If you learn best by reading about a concept and then working a
short exercise that illustrates that concept, work the exercises as you read the chapter
...

 Study the Key terms to see if you understand each term
...

 Take the Self-test and then check your answers with those at the end of the chapter
...
Then, compare your solution to the correct solution that follows immediately
...
If you

cannot answer a particular question, refer back into the chapter for the needed information
...

 Work the Problems assigned by your instructor, using the forms available
...
freeloadpress
...


p
...

 Work the Study guide for the chapter
...
The Study guide can be downloaded from the
publisher's website (www
...
com)
...
Remember
that a knowledge of accounting will serve you well regardless of the career you pursue
...
Proponents of this movement say that it will boost
cross-border investment, deepen international capital markets and save multinational
companies, who must currently report under multiple systems, a lot of time and
money
...
It seeks to develop a globally accepted set of financial reporting
standards (IFRSs) under the direction of its standards-setting body, the International
Accounting Standards Board (IASB)
...
S
...
S
...
Today approximately 113 countries require or allow the use of
IFRS for the preparation of financial statements by publicly held companies
...
S
...
In fact, on November 14, 2008, the SEC released for public comment a
proposed roadmap with a timeline and key milestones for adopting IFRS beginning in
2014”
...


The AICPA has a link on its website to a page with current

p
...
You might like to check it out from
time to time at http://www
...
com/Backgrounder_Get_Ready
...
There is also a
wealth of information on the IFRS website at http://ifrs
...


Students from countries other than the US should check the website of the professional
accounting organization in your country for an update on the current status
...
org and
search on IFRS you will find a number of links to documents covering the planned migration
to IFRS in India
...
29 of 433

2 Accounting and its use in business decisions
2
...




Distinguish among the three types of activities performed by business organizations
...



State the basic accounting equation and describe its relationship to the balance sheet
...



Prepare an income statement, a statement of retained earnings, and a balance sheet
...


2
...
In fact, the aspiration
to start a business, to be an entrepreneur, is nearly universal
...
In fact, if you ask owners of small
businesses which skill they wish they had more expertise in, they will very frequently reply
“accounting”
...

Most successful entrepreneurs have learned that it takes a lot more than a great marketing idea or
product innovation to make a successful business
...
Entrepreneurs must be able to raise capital, either from
banks or investors
...
Business owners quickly learn that in order to survive they
need to be well-rounded, savvy individuals who can successfully manage these diverse relationships
...

In addition to providing a good foundation for entrepreneurship in any business, an accounting
degree offers other ways of building your own business
...
This can
p
...
One advantage of
this career is that you can establish your practice in virtually any location ranging from large cities to
rural settings
...
Expertise such as this, which may be in a field
outside of traditional accounting practice, can generate billing rates well in the excess of USD 100 an
hour
...
Now you are
ready to learn about the forms of business organizations and the types of business activities they
perform
...
These financial statements
show the results of decisions made by management
...

In this chapter, you also study the accounting process (or accounting cycle) that accountants use to
prepare those financial statements
...
In a systematic manner, accountants
analyze, record, classify, summarize, and finally report these data in the financial statements of
businesses
...


2
...
A business entity is any business organization, such as a hardware store or grocery store, that
exists as an economic unit
...
This
1

separate existence of the business organization is known as the business entity concept
...

Assume, for example, that you own two businesses, a physical fitness center and a horse stable
...
Thus, you would normally keep separate accounting records for each business
...
Usually these terms are set in
bold
...

p
...
You can determine this fact because you are treating your physical fitness
center and horse stable as two separate business entities
...
Therefore, you cannot include the car you drive only for
personal use as a business activity of your physical fitness center or your horse stable
...

As you will see shortly, the business entity concept applies to the three forms of businesses—single
proprietorships, partnerships, and corporations
...
Since most large businesses
are corporations, we use the corporate approach in this text and include only a brief discussion of
single proprietorships and partnerships
...
Single proprietors include physicians, lawyers, electricians, and other
people in business for themselves
...
No legal formalities are necessary to organize such businesses, and usually
business operations can begin with only a limited investment
...
For
accounting purposes, however, the business is a separate entity from the owner
...
For example, owners of single
proprietorships should not enter the cost of personal houses or car payments in the financial records of
their businesses
...
Often the same persons who own the business also manage the business
...

A partnership begins with a verbal or written agreement
...
These terms include the initial
investment of each partner, the duties of each partner, the means of dividing profits or losses between
the partners each year, and the settlement after the death or withdrawal of a partner
...
However, as with the single proprietorship, for accounting purposes, the partnership is a
separate business entity
...
32 of 433

A corporation is a business incorporated under the laws of a state and owned by a few
stockholders or thousands of stockholders
...

The corporation is unique in that it is a separate legal business entity
...
They buy shares of stock, which are units of ownership, in the
corporation
...
The corporate form of business protects the personal assets of the owners from the creditors of
the corporation
...
They elect a board of directors to represent
their interests
...

Accounting is necessary for all three forms of business organizations, and each company must
follow generally accepted accounting principles (GAAP)
...


An accounting perspective: Business insight
Although corporations constitute about 17 per cent of all business organizations, they
account for almost 90 per cent of all sales volume
...


2
...
Business entities can also be grouped by the type of business
activities they perform—service companies, merchandising companies, and manufacturing companies
...


2 When individuals seek a bank loan to finance the formation of a small corporation, the bank often
requires those individuals to sign documents making them personally responsible for repaying the
loan if the corporation cannot pay
...

p
...
This group includes accounting firms, law

firms, and dry cleaning establishments
...

 Merchandising companies purchase goods that are ready for sale and then sell them to

customers
...
We begin the description of accounting for merchandising companies in
Chapter 6
...
Manufacturing companies include steel
mills, auto manufacturers, and clothing manufacturers
...
These financial statements provide relevant financial information both to those inside the
company—management—and to those outside the company—creditors, stockholders, and other
interested parties
...


2
...
For example, one of your objectives in
owning a physical fitness center may be to improve your physical fitness
...
Profitability is the ability to generate
income
...
Unless a business can produce
satisfactory income and pay its debts as they become due, the business cannot survive to realize its
other objectives
...
Together they present the profitability and strength of a
company
...

The statement of retained earnings shows the change in retained earnings between the beginning
and end of a period (e
...
a month or a year)
...
The statement of cash flows shows the cash inflows and outflows for a company
over a period of time
...
You can see this similarity in the financial statements of actual companies in the appendix of
this textbook
...
In accounting, we measure profitability for a period,
p
...
Revenues are the inflows of assets (such as cash) resulting from the sale of products
or the rendering of services to customers
...
Expenses are the costs incurred to
produce revenues
...
If the revenues of a period exceed the expenses of the same period, net income results
...
When expenses exceed revenues, the
business has a net loss, and it has operated unprofitably
...
, for July 2010
...

Metro’s income statement for the month ended 2010 July 31, shows that the revenues (or delivery
fees) generated by serving customers for July totaled USD 5,700
...
As a result of these business activities, Metro’s net income for July was USD 2,100
...
Even though corporations are taxable entities, we ignore corporate income taxes at this point
...
The statement of retained earnings explains the changes in retained earnings
between two balance sheet dates
...

Dividends are the means by which a corporation rewards its stockholders (owners) for providing it
with investment funds
...
Corporations are not
required to pay dividends and, because dividends are not an expense, they do not appear on the income
statement
...
Then, the
company no longer retains a portion of the income earned but passes it on to the stockholders
...

The statement of retained earnings for Metro Courier, Inc
...
Organized on June 1, Metro did not earn any revenues or incur any expenses
during June
...
Metro then adds its USD
p
...
Since Metro paid no dividends in July, the USD 2,100 would be the ending
balance of retained earnings
...

A
...
Statement of Retained Earnings
METRO COURIER , INC
...
Balance Sheet
METRO COURIER, INC
...
If there had been a net loss, it would have deducted the loss from the beginning balance on the
statement of retained earnings
...
36 of 433

USD 500, the loss would be deducted from the beginning balance in retained earnings of USD 2,100
...

Dividends could also have affected the Retained Earnings balance
...
’s net income for August was actually USD 1,500
(revenues of USD 5,600 less expenses of USD 4,100) and (2) the company declared and paid dividends
of USD 1,000
...

Statement of Retained Earnings
For the Month Ended 2010 August 31
Retained earnings, August 1
...

Total
...

Retained earnings, August 31
...

That specific moment is the close of business on the date of the balance sheet
...
A balance sheet is like a photograph; it captures the financial position of a company at a
particular point in time
...
As you study about the
assets, liabilities, and stockholders’ equity contained in a balance sheet, you will understand why this
financial statement provides information about the solvency of the business
...
They are also called the resources of the
business
...
Assets have value because a business can
use or exchange them to produce the services or products of the business
...
, amount to USD 38,700
...

Liabilities are the debts owed by a business
...
A business incurs many of its liabilities by purchasing items on credit
...


3

3 Most notes bear interest, but in this chapter we assume that all notes bear no interest
...

p
...
, is a corporation
...
Metro’s stockholders’ equity consists of (1) USD 30,000 paid for shares of
capital stock and (2) retained earnings of USD 2,100
...
Retained earnings generally consists of the accumulated net income
of the corporation minus dividends distributed to stockholders
...
At this point, simply note that the balance sheet heading includes the name of the organization
and the title and date of the statement
...
The balance sheet shows these claims under the heading
“Liabilities and Stockholders’ Equity”
...
The
statement of cash flows shows the cash inflows and cash outflows from operating, investing, and
financing activities
...
Investing activities generally include business
transactions involving the acquisition or disposal of long-term assets such as land, buildings, and
equipment
...

Chapter 16 describes the statement of cash flows in detail
...
Normally, a firm prepares a statement of cash flows for the same
time period as the income statement
...
, since it was formed on 2010 June 1
...

METRO COURIER, INC
...


$2
...

(700)
Increase in accounts payable
...


600
$2,000

Cash flows from investing activities:
Purchase of trucks
...


(2,500)

Net cash used by investing activities
...


$6,000

Proceeds from sale of capital stock
...
38 of 433

Net cash provided by financing activities
...


36,000
$15,500

At this point in the course, you need to understand what a statement of cash flows is rather than
how to prepare it
...

The income statement, the statement of retained earnings, the balance sheet, and the statement of
cash flows of Metro Courier, Inc
...
They are the end
products of the accounting process, which we explain in the next section
...
The accounting process details how this
picture was made
...
Management is the first to know the financial results; then, it publishes the financial
statements to inform other users
...


2
...
Then, we show you how to recognize a business transaction and describe underlying
assumptions that accountants use to record business transactions
...

In the balance sheet presented in Exhibit 2 (Part C), the total assets of Metro Courier, Inc
...
This equality shows that the assets of a business
are equal to its equities; that is,
Assets = Equities
Assets were defined earlier as the things of value owned by the business, or the economic resources
of the business
...
For example, assume that you
purchased a new company automobile for USD 15,000 by investing USD 10,000 in your own
corporation and borrowing USD 5,000 in the name of the corporation from a bank
...
You can further describe the USD
5,000 as a liability because you owe the bank USD 5,000
...
Since the owners in a
corporation are stockholders, the basic accounting equation becomes:
Assets A = Liabilities L + Stockholders’ Equity SE
From Metro’s balance sheet in Exhibit 2 (Part C), we can enter in the amount of its assets, liabilities,
and stockholders’ equity:

p
...

Therefore, this equation must always be in balance
...
The liabilities and
stockholders’ equity show the sources of an existing group of assets
...

Together, creditors and owners provide all the assets in a corporation
...
However, companies can sometimes
improve their profitability by borrowing from creditors and using the funds effectively
...
However, the equality of the basic accounting equation always holds
...
An exchange of cash for merchandise
is a transaction
...
For example, the objective measure of the exchange may be USD 5,000
...
Merely placing an
order for goods is not a recordable transaction because no exchange has taken place
...
A source document is any
written or printed evidence of a business transaction that describes the essential facts of that
transaction
...
We handle source documents
constantly in our everyday life
...


2
...
Both preparers and users of financial statements must understand these assumptions:
 Business entity concept (or accounting entity concept)
...
The business entity concept
assumes that each business has an existence separate from its owners, creditors, employees,
customers, other interested parties, and other businesses
...
40 of 433

 Money measurement concept
...
This form of measurement
is known as money measurement
...
Most of the amounts in an accounting

system are the objective money prices determined in the exchange process
...
Cost is the sacrifice made or the resources given
up, measured in money terms, to acquire some desired thing, such as a new truck (asset)
...
Unless strong evidence exists to the contrary,

accountants assume that the business entity will continue operations into the indefinite future
...
Assuming that the
entity will continue indefinitely allows accountants to value long-term assets, such as land, at
cost on the balance sheet since they are to be used rather than sold
...
For instance, accountants would still record
land purchased in 1988 at its cost of USD 100,000 on the 2010 December 31, balance sheet
even though its market value has risen to USD 300,000
...
According to the periodicity (time periods) concept

or assumption, an entity’s life can be meaningfully subdivided into time periods (such as
months or years) to report the results of its economic activities
...
To begin, we divide Metro’s transactions into
two groups: (1) transactions affecting only the balance sheet in June, and (2) transactions affecting the
income statement and/or the balance sheet in July
...


2
...
An
error in transaction analysis results in incorrect financial statements
...
, that led to the statements in Exhibit 2 follow
...
The second set of transactions (for July) (1b–6b) are repeated in Exhibit 4 (Part A)
...
41 of 433

2
...
1 1a
...
, was organized as a corporation on 2010 June 1, the company issued
shares of capital stock for USD 30,000 cash to Ron Chaney, his wife, and their son
...
Consequently, the transaction yields the following basic
accounting equation:
Assets
Transaction

Explanation
Beginning
balances
Stockholder
s invested
cash
Balance
after
transaction

1a

Accounts
Receivable

Cash

$ -030,000

$ -0-

=Liabilities +
Trucks

$ -0-

Office
Equipment

Accounts
Payable

$ -0-

Stockholders' Equity

Notes
Payable
+

= $ -0-

Capital
Stock
$ -030,000

$ -0-

$ 30,000

$ 30,000

Increased
by
$30,000

Increased by
$30,000

2
...
2 2a
...
Chaney signed the note for the company
...
After including the effects of this transaction, the basic accounting equation
is:
Transaction

2a

Explanation
Balances
before
transaction
Borrowed
money
Balance
after
transaction

Cash
$ 30,000

Assets
Accounts
Trucks
Receivable
$ -0-

$ -0-

Office
Equipment
$ -0-

= Liabilities +
Accounts
Notes
Payable
Payable
= $ -0-

$ -0-

6,000
$ 36,000
Increased by
$6,000

Stockholder's Equity
Capital
+ Stock
$ 30,000

6,000
=

$ 6,000

+ $ 30,000

Increased by
$6,000

2
...
3 3a
...

Trucks and office equipment are assets because the company uses them to earn revenues in the future
...
This transaction decreased cash and increased trucks and office

p
...
Metro received two assets and gave up
one asset of equal value
...
The accounting equation now is:
Assets
Cash

=

Accounts
Receivable

$ 36,000

$ -0-

$ -0-

(21,500)
$

Trucks

Office
Equipment

Accounts
Payable

$ -0- =

$ -0-

20,000

Notes
Payable

Capital
+ Stock

$ 6,000

$ 6,000

$ 1,500 =

+ $ 30,000

+ $ 30,000

1,500

$ 20,000

14,500

Decreased
by
$21,500

Stockholders'
Equity

Liabilities +

Increased
Increased by
by
$1,500
$20,000

2
...
4 4a
...
(To purchase an item on account means to buy it on credit
...
As
stated earlier, accounts payable are amounts owed to suppliers for items purchased on credit
...
8
...
Paid an account payable
Eight days after receiving the bill, Metro paid USD 1,000 for the office equipment purchased on
account (transaction 4a)
...
Thus, the assets and liabilities both are reduced by USD 1,000, and the equation again
balances as follows:

p
...
Summary of Transactions

$ -0-

Decreased
by
$1,000

METRO COURIER, INC
...
Balance Sheet
METRO COURIER, INC
...
A
summary of transactions is a teaching tool used to show the effects of transactions on the
accounting equation
...
This amount

p
...
You can see how the totals at the
bottom of Part A of Exhibit 3 tie into the balance sheet shown in Part B
...
These totals become the beginning balances for July 2010
...
We used this procedure to help you focus on the accounting equation as it
relates to the balance sheet
...
They
form businesses so their assets can generate greater amounts of assets
...
The results of these activities appear in the income
statement
...


2
...
This means that the revenues earned by providing goods
and services to customers must exceed the expenses incurred
...
, began selling services and incurring expenses
...


2
...
1 1b
...
This transaction increased an asset (cash) by USD 4,800
...

The USD 4,800 is a revenue earned by the business and, as such, increases stockholders’ equity (in
the form of retained earnings) because stockholders prosper when the business earns profits
...

Revenues increase the amount of retained earnings while expenses and dividends decrease them
...
In later
chapters, the revenues, expenses, and dividends are accounted for separately from retained earnings
during the accounting period and are transferred to retained earnings only at the end of the accounting
period as part of the closing process described in Chapter 4
...
45 of 433

Metro would record the increase in stockholders’ equity brought about by the revenue transaction
as a separate account, retained earnings
...
The expectation is that revenue
transactions will exceed expenses and yield net income
...
Later chapters show that because of complexities in handling large
numbers of transactions, revenues and expenses affect retained earnings only at the end of an
accounting period
...

Transac
tion

Explanation

Cash

Beginning balances
(Exhibit 3)
Earned service revenue
and received cash
Balances after transaction

1b

$

13,500

Assets
Accounts
Trucks
Receivable
$ -0-

$ 20,000

Office
Equipment
$ 2,500 =

=Liabilities +
Accounts
Notes
Payable
Payable
$ -0-

$

6,000

Stockholders' Equity
Capital + Retained
Stock
Earnings
$ 30,000

$ -0-

4,800
$

4,800

18,300

$ 20,000

$ 2,500 =

$

6,000

Increased by
$4,800

+ $ 30,000 $ 4,800
Increased
by
$4,800

2
...
2 2b
...
The company granted credit rather than requiring the customer to pay cash immediately
...
The transaction consists of exchanging services for the customer’s
promise to pay later
...
However, the
transaction differs because the company has not received cash
...
As noted earlier, an account receivable is the amount due from a
customer for goods or services already provided
...
Accounting recognizes such claims as assets
...
46 of 433

2
...
3 3b
...
The customer will pay
the remaining USD 700 later
...
The transaction increases cash by USD 200 and decreases
accounts receivable by USD 200
...
When the company performed the services, it recorded the revenue
...

Assets
Transact Explanation
ion

Cash

Balances before
transaction
3b

$

Accounts
Receivable
18,300

$

=Liabilities +
Trucks

900 $

Collected cash
on account

$

200

$

18,500

Accounts
Payable

Notes Payable

+ Capital
Stock

20,000

$ 6,000

$ 30,000

20,000

$700

$ 2,500
=

$ 2,500
=

$ 6,000

+ $ 30,000

(200)

Balances after
transaction

Office
Equipment

Stockholders' +Equity

Increased by
$200

Decreased by
$200

2
...
4 4b
...
This transaction is an exchange of cash for employee
services
...
Salaries
(or wages) are costs companies incur to produce revenues, and companies consider them an expense
...
Expense
transactions reduce net income
...

Assets
Cash
$

18,500
(2,600)
$ 15,900

Accounts
Receivable

Trucks

Office
Equipment

= Liabilities +
Accounts
Notes
Payable
Payable +

Stockholders' Equity
Capital Stock

$

700

$ 20,000

$ 2,500 =

$6,000

$ 30,000

$

700

$ 20,000

$ 2,500 =

$6,000 +

$ 30,000

Decreased by
$2,600

Retained Earnings
$

5,700
(2,600)
$ 3,100

Decreased by
$2,600

2
...
5 5b
...
This transaction causes a decrease in cash
of USD 400 and a decrease in retained earnings of USD 400 because of the incurrence of rent expense
...
47 of 433

Assets
Cash

Accounts Receivable

$ 15,900
(400)
$ 15,500
Decreased by
$400

$

700

$

700

= Liabilities +
Stockholders' Equity
Office
Accounts Notes
Retained
+ Capital Stock
Equipment Payable Payable
Earnings
$ 3,100
$ 20,000
$ 2,500 =
$ 6,000
$ 30,000
(400)
$ 20,000
$ 2,500 =
$ 6,000
+ $ 30,000
$ 2,700
Decreased by
$400
Trucks

2
...
6 6b
...

This transaction involves an increase in accounts payable (a liability) because Metro has not yet paid
the bill and a decrease in retained earnings because Metro has incurred an expense
...
10 Summary of balance sheet and income statement
transactions
Part A of Exhibit 4 summarizes the effects of all the preceding transactions on the assets, liabilities,
and stockholders’ equity of Metro Courier, Inc
...
The beginning balances are the ending
balances in Part A of Exhibit 3
...
Note how the accounting equation remains in balance after each
transaction and at the end of the month
...
The itemized data in the Retained
Earnings column are the revenue and expense items in Part C of Exhibit 4 and those reported earlier in
the income statement in Part A of Exhibit 2
...
Remember that the financial statements are not an
end in themselves, but are prepared to assist users of those statements to make informed decisions
...


p
...
11 Dividends paid to owners (stockholders)
Stockholders’ equity is (1) increased by capital contributed by stockholders and by revenues earned
through operations and (2) decreased by expenses incurred in producing revenues
...
Thus, if
the owners receive a cash dividend, the effect would be to reduce the retained earnings part of
stockholders’ equity; the amount of dividends is not an expense but a distribution of income
...
Also, he was
helping companies find accounting systems that would fit their information needs
...
The licensing agreement
with the software company specified that the basic charge for one site was USD 4,000
and that USD 1,000 must be paid for each additional site where the software was used
...

However, he was upset that management wanted him to install the software at eight
other sites in the company and did not intend to pay the extra USD 8,000 due the
software company
...
If
they do find out, we will pay the extra fee at that time
...
” James believed he might lose this client if he
did not do as management instructed
...
49 of 433

An accounting perspective: Uses of technology
Accountants and others can access the home pages of companies to find their annual
reports and other information, home pages of CPA firms to find employment
opportunities and services offered, and home pages of government agencies,
universities, and any other agency that has established a home page
...
You can access libraries, even in foreign countries, newspapers, such as The
Wall Street Journal, and find addresses and phone numbers of anyone in the nation
...


p
...
Summary of Transactions
METRO COURIER, INC
...
2)
Earned service revenue and
received cash

$
13,500

-Liabilities
Accounts
Receiv- Trucks
able
$ -0-

4b

Paid salaries

5b

6b

Paid rent

$ -0-

$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ -0-

$ 30,000

$ 4,800

$ 900

900(B)
$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ 20,000 $ 2,500 =

$ 6,000 +

$ 5,700

$ 30,000

(200)
$ 700

$ 5,700
(2,600)(C)

$ 700

$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ 700

$ 20,000 $ 2,500 =

$ 6,000 +

$ 30,000

$ 3,100
(400)(D)

Received bill for gas and oil used

$ 2,700

600
$15,500(
$
$ 700(G)
F)
20,000(H)

End-of-month balances

$ 6,000 +

Retained
Earnings

900
$
18,300
200
$
18,500
(2,600)
$
15,900
(400)
$
15,500

Collected cash on account

Notes Payable Capital
+
Stock

4,800(A)

Earned service revenue on account

3b

$ 20,000 $ 2,500 =

Stockholders' Equity

4,800
$
18,300

2b

Office
Accounts
Equipment Payable

+

$38,700

$ 2,500

=(I)

$

600(J)

$6,600

(600)(E)

+
(K)

$ 6,000

$ 30,000(L)

$ 2,100(M)

$32,100

B
...

Balance Sheet
2010 July 31
Liabilities and Stockholders'
(F)$15,500 Liabilities:

Accounts receivable (G)700

Accounts payable

(J)$600

Trucks

(H)20,000

Notes payable

(K)6,000

Office equipment

(I)2,500

Total liabilities Stockholders' equity $6,600
Capital stock

Total assets

$38,700

(L)$30,000

Retained earnings
Total stockholders'
equity
Total liabilities and
stockholders' equity

(M)2,100
$32,100
$38,700

C
...

Income Statement
For the Month Ended 2010 July 31
Revenues:
Service revenue

(A+B)$ 5,700

Expenses:

p
...
12 Analyzing and using the financial results—the equity ratio
The two basic sources of equity in a company are stockholders and creditors; their combined
interests are called total equities
...
In formula format:
Equity ratio=

Stockholders ' equity
Total equities

The higher the proportion of equities (or assets) supplied by the owners, the more solvent the
company
...

An example illustrates this concept: Suppose that a company with USD 100,000 in assets could
have raised the funds to acquire those assets in these two ways:
Case 1
Assets
...
$20,000
Stockholders' equity
...
$100,000 Liabilities
...
$20,000

When a company suffers operating losses, its assets decrease
...
In Case 2, the assets would have to
shrink only 20 per cent before the liabilities would equal the assets
...
Therefore, creditors are safer in Case 1 and will more
readily lend money to the company
...
Therefore, owners are better off in Case 2 if the borrowed funds
can earn more than they cost
...
1%
40
...
6

p
...

Companies such as Johnson & Johnson and 3M Corporation employ a higher proportion of
stockholders’ equity (a lower proportion of debt) than GE in an effort to have stronger balance sheets
(more solvency)
...
Every company must strike a balance between solvency and profitability to ensure longrun survival
...

Chapter 1 has introduced two important components of the accounting process—the accounting
equation and the business transaction
...
Understanding how data are accumulated, classified,
and reported in financial statements helps you understand how to use financial statement data in
making decisions
...
Therefore, before you graduate
you should be able to use word processing, spreadsheet, and database software
...
In many universities, you
can learn these skills in courses taken for credit
...


2
...

 A partnership is an unincorporated business owned by two or more persons associated as

partners and is often managed by them
...

 Service companies perform services for a fee
...


p
...

 The income statement reports the revenues and expenses of a company and shows the

profitability of that business organization for a stated period of time
...
g
...

 The balance sheet lists the assets, liabilities, and stockholders’ equity (including dollar

amounts) of a business organization at a specific moment in time
...

 The accounting equation is Assets = Liabilities + Stockholders’ equity
...

 The right side of the equation represents the right side of the balance sheet and shows who

provided the funds to acquire the things of value (assets)
...
Other transactions affect both balance sheet items and
income statement items (revenues, expenses, and eventually retained earnings)
...

 The income statement appears in Exhibit 2 (Part A) and Exhibit 4 (Part C)
...

 The balance sheet appears in Exhibit 2 (Part C) and Exhibit 4 (Part B)
...

 The equity ratio shows the percentage that assets would have to shrink before a company would

become insolvent (liabilities exceed assets)
...
14 Appendix: A comparison of corporate accounting with
accounting for a sole proprietorship and a partnership
Some textbook authors use a sole proprietorship and a partnership form of business ownership to
illustrate accounting concepts and practices
...
54 of 433

invest in corporations
...

This appendix briefly describes the differences in accounting for these three forms of business
ownership
...

As you learned in this chapter, the stockholders’ equity section of the balance sheet for a
corporation consists of capital stock and retained earnings
...
The owner’s equity section
of a partnership is similar to that of a single proprietorship except that it shows a capital account and
its balance for each partner
...
$100,000
Retained

Sole Proprietorship
Owner's equity:
John Smith,
Capital
...
$75,000
Sam Jones,

earnings
...
75,000

Total
...
However, the items in the owner’s equity section of the balance sheets of a sole
proprietorship and a partnership always remain as just shown
...
Thus, all of the amounts in
the various stockholders’ equity accounts for a corporation are in the owner’s capital account in a single
proprietorship
...

The Dividends account in a corporation is similar to an owner’s drawing account in a single
proprietorship
...
In a
partnership, each partner has a drawing account
...


2
...
The following transactions
occurred during June:
June 1 Shares of capital stock were issued for USD 10,000 cash
...
55 of 433

4 A horse stable and riding equipment were rented (and paid for) for the month at a cost of USD
1,200
...

15 Boarding fees of USD 3,000 for June were charged to those owning horses boarded at the stable
...
)
20 Miscellaneous expenses of USD 600 were paid
...
The loan is due to be repaid in five years
...

30 Salaries of USD 700 for the month were paid
...
(Fees are due on
July 10
...
Use columns headed Cash, Accounts Receivable,
Land, Accounts Payable, Notes Payable, Capital Stock, and Retained Earnings
...

Prepare an income statement for June 2010
...

Prepare a balance sheet as of 2010 June 30
...
56 of 433

2
...

Assets
Date
June
1
4

Explanation

Cash

Capital stock issued

$ 10,000

Rent expense

GREEN HILLS RIDING STABLE, INCORPORATED
Summary of Transactions
Month of June 2010
=
Liabilities +
Accounts
Accounts
Land
Receivable
Payable

Stockholders Equity
Capital +
Retained
Stock
Earnings

(1,200)

=

8

Boarding fees

+ $ 10,000

$ (1,200)

Feed expense

15

$ 10,000

=

$ 8,800

$

Salaries paid

30

+ $ 10,000

800

+ $ 10,000

3,000

$

3,000

=

$

$

3,000

=

800

3,000

Riding and lesson
fees billed

$

3,000

400

+ $ 10,000

$

400

$ 40,000

$ 40,000 =

$

800

$ 40,000

(700)
$

3,000

$ 40,000 =

$

800

$ 40,000

+ $ 10,000

$ 40,000

$

800

$ 40,000

+ $ 10,000

2,800
$ 7,500

1,000

$

(700)
$ 7,500

$

+ $ 10,000

$ 40,000
$ 8,200

$ (2,000)

(600)

Purchased land by
borrowing

30

800

$ (1,200)
(800)

(600)
$ 8,200

29

$

$
$ 8,800

Miscellaneous
expenses

800

=

$ 8,800

20

Notes
Payable

$

5,800

$

(300)

2,800
$

2,500

b)
GREEN HILLS RIDING STABLE, INCORPORATE
Income Statement
For the Month Ended 2010 June 30
Revenues:
Horse boarding fees revenue

$

Riding and lesson fee revenue

2,800

3,000

Total revenues

$

5,800

Expenses:
Rent expense

$

Feed expense

800

Salaries expense

700

Miscellaneous expense

600

Total expenses
Net income

1,200

3,300
$

2,500

c)
GREEN HILLS RIDING STABLE, INCORPORATED
Statement of Retained Earnings
For the Month Ended 2010 June 30
Retained earnings, June 1
$ -0Add: Net income for June
2,500
Total
$ 2,500
Less: Dividends
-0Retained earnings, June 30
$ 2,500

p
...
00

2
...

Accounts payable Amounts owed to suppliers for goods or services purchased on credit
...

Assets Things of value owned by the business
...

To their owners, assets possess service potential or utility that can be measured and expressed in
money terms
...
Also called a statement of
financial position
...

Capital stock The title given to an equity account showing the investment in a business
corporation by its stockholders
...

Corporation Business incorporated under the laws of one of the states and owned by a few
stockholders or by thousands of stockholders
...

Dividend Payment (usually of cash) to the owners of a corporation; it is a distribution of
income to owners rather than an expense of doing business
...

p
...

Equity ratio A ratio found by dividing stockholders’ equity by total equities (or total assets)
...

Expenses Costs incurred to produce revenues, measured by the assets surrendered or
consumed in serving customers
...

Income statement Financial statement that shows the revenues and expenses and reports the
profitability of a business organization for a stated period of time
...

Liabilities Debts owed by a business—or creditors’ equity
...

Manufacturing companies Companies that buy materials, convert them into products, and
then sell the products to other companies or to final customers
...

Money measurement concept Recording and reporting economic activity in a common
monetary unit of measure such as the dollar
...

Net loss Amount by which the expenses of a period exceed the revenues of the same period
...

Partnership An unincorporated business owned by two or more persons associated as
partners
...

Profitability Ability to generate income
...

Retained earnings Accumulated net income less dividend distributions to stockholders
...

Service companies Companies (such as accounting firms, law firms, or dry cleaning
establishments) that perform services for a fee
...

Solvency Ability to pay debts as they become due
...

Source document Any written or printed evidence of a business transaction that describes the
essential facts of that transaction, such as receipts for cash paid or received
...
59 of 433

Statement of cash flows Financial statement showing cash inflows and outflows for a
company over a period of time
...

Stockholders’ equity The owners’ interest in a corporation
...

Summary of transactions Teaching tool used in Chapter 1 to show the effects of transactions
on the accounting equation
...


2
...
18
...

The three forms of business organizations are single proprietorship, partnership, and trust
...

The income statement shows the profitability of the company and is dated as of a particular date,
such as 2010 December 31
...

The balance sheet contains the same major headings as appear in the accounting equation
...
18
...

The ending balance in retained earnings is shown in the:
a
...

b
...

c
...

d
...

Which of the following is not a correct form of the accounting equation?
a
...

b
...

c
...

d
...


p
...
Exchange-price concept
...
Inflation accounting concept
...
Business entity concept
...
Going-concern concept
...
Liabilities increase and stockholders’ equity increases
...
Both assets and liabilities increase
...
Both assets and stockholders’ equity increase
...
None of the above
...
Both cash and retained earnings decrease
...
Both cash and retained earnings increase
...
Both accounts receivable and retained earnings increase
...
Accounts payable increases and retained earnings decreases
...


2
...
3


Questions
Accounting has often been called the language of business
...




How do liabilities and stockholders’ equity differ? How are they similar?



How do accounts payable and notes payable differ? How are they similar?



Define revenues
...
How are expenses measured?



What is a balance sheet? On what aspect of a business does the balance sheet provide
information?



What is an income statement? On what aspect of a business does this statement provide
information?



What information does the statement of retained earnings provide?



Identify the three types of activities shown in a statement of cash flows
...
61 of 433



What is the accounting equation? Why must it always balance?



Give an example from your personal life that illustrates your use of accounting
information in reaching a decision
...
At the first meeting you
attend, mention is made of building a new church
...
The vendor stated that the
equipment was worth USD 2,400
...




Increase both an asset and a liability
...




Decrease both a liability and an asset
...




Decrease both an asset and retained earnings
...




Decrease both an asset and retained earnings
...
What were the net income or loss
amounts in the latest three years? Discuss the meaning of the changes after reading
management’s discussion and analysis of financial condition and results of operations
...
Has the solvency of the company improved from one year to the next?
Discuss
...
62 of 433

2
...
4

Exercises

Exercise A Match the descriptions in Column B with the appropriate terms in Column A
...

2
...

4
...

6
...

Merchandising company
...

Manufacturing company
...

Single proprietorship
...

b
...

d
...

f
...

The form of organization used by most large businesses
...

Buys goods in their finished form and sells them to
customers in that same form
...

Performs services for a fee
...
A cash dividend of USD 300 was declared and paid during the year
...
Compute the net income for the year
...
Assume expenses for the year were USD 9,000
...

Exercise C On 2010 December 31, Perez Company had assets of USD 150,000, liabilities of USD
97,500, and capital stock of USD 30,000
...
Dividends declared and paid amounted to USD 3,000
...
Compute the company’s retained earnings on 2010 December 31
...
Compute the company’s retained earnings on 2011 December 31
...
At the end of the year, retained earnings amounted to USD 135,000
...
Compute retained
earnings and total assets at the beginning of the year
...
For the events that do have an effect, present an analysis of the
transaction showing its two sides or dual nature
...
Purchased equipment for cash, USD 12,000
...
Purchased a truck for USD 40,000, signed a note (with no interest) promising payment in 10
days
...
Paid USD 1,600 for the current month’s utilities
...
Paid for the truck purchased in (b)
...
Employed Mary Childers as a salesperson at USD 1,200 per month
...


p
...
Signed an agreement with a bank in which the bank agreed to lend the company up to USD
200,000 any time within the next two years
...
Purchased office equipment on account
...
Paid an account payable
...
Earned service revenue on account
...
Borrowed money by signing a note at the bank
...
Paid salaries for month to employees
...
Received cash on account from a charge customer
...
Received gas and oil bill for month
...
Purchased delivery truck for cash
...
Declared and paid a cash dividend
...
No dollar amounts are needed, and
you need not fill in the Explanation column
...
The stockholders invested USD 100,000 cash in the business by purchasing capital stock
...
Land costing USD 40,000 was purchased by paying cash
...
The company performed services for a customer who agreed to pay USD 18,000 in one month
...
Paid salaries for the month, USD 12,000
...
Paid USD 14,000 on an account payable
...
Increase cash; decrease some other asset
...
Decrease cash; increase some other asset
...
Increase an asset; increase a liability
...
Decrease retained earnings; decrease an asset
...
Increase an asset other than cash; increase retained earnings
...
Decrease an asset; decrease a liability
...
Employees were paid USD 20,000 for services received during the month
...
64 of 433

b
...

c
...
No interest was involved
...
Paid a USD 200 account payable
...

Exercise K Given the following facts, prepare a statement of retained earnings for Brindle
Company, a tanning salon, for August 2010:
Balance in retained earnings at end of July, USD 188,000
...

Net income for August, USD 72,000
...
, as of 2010
December 31, were as follows:
Accounts payable
Accounts receivable
Capital stock
Cash
Land
Building
Equipment
Notes payable
Retained earnings

$60,000
90,000
100,000
40,000
80,000
50,000
30,000
20,000
?

Prepare a balance sheet
...

Exercise M Merck & Co
...
is a world leader in the discovery, development, manufacture and
marketing of a broad range of human and animal health products
...
As of
the end of 2, its 2
...
Given
the following data for Merck, calculate the equity ratios for 2003 and 2002
...

2003

2002

Stockholders' equity

USD 14,832,400,000

USD 13,241,600,000

Total equities

USD 39,910,400,000

USD 35,634,900,000

p
...
18
...

2 The company borrowed USD 40,000 from the bank on a note
...

11 Cash received for services performed to date was USD 15,200
...

15 Employee wages were paid, USD 13,200
...

31 Interest paid to the bank for May was USD 140
...
)
31 The customer of May 14 paid USD 3,200 of the amount owed to the company
...

Prepare a summary of transactions (see Part A of Exhibit 4)
...
Determine
balances after each transaction to show that the accounting equation balances
...
, a company that takes care of lawns and shrubbery of
personal residences, engaged in the following transactions in April 2010:
Apr
...

4 The company bought equipment for cash, USD 101,760
...

15 Cash received for services performed to date was USD 3,840
...

30 Of the receivable (see April 16), USD 3,072 was collected in cash
...

30 An order was placed for miscellaneous equipment costing USD 28,800
...
Prepare a summary of transactions (see Part A of Exhibit 4)
...
Determine
balances after each transaction to show that the basic accounting equation balances
...
66 of 433

b
...

Problem C Analysis of the transactions of the Moonlight Drive-In Theater for June 2010 disclosed
the following:
Ticket revenue

USD 180000

Equipment rent expense

50000

Film rent expense

53400

Concession revenue

29600

Advertising expense

18600

Salaries expense

60000

Utilities expense

14100

Cash dividends declared and paid

12000

Balance sheet amounts at June 30 include the following:
Cash

USD 140,000

Land

148000

Accounts payable

87600

Capital stock

114000

Retained earnings as of 2010 June 1

84900

a
...

b
...

c
...

d
...
67 of 433

Problem D Little Folks Baseball, Inc
...
At the beginning of its second year of operations, its balance sheet appeared as
follows:
LITTLE FOLKS BASEBALL
Balance Sheet 2010 April 30
Assets
Cash

$

Accounts Receivable

80,000

56,000

Land

600,000

Total assets

$

736,000

$

64,000

Liabilities and Stockholders' Equity
Liabilities:
Accounts payable
Stockholders' Equity:
Capital stock
Retained earnings
Total liabilities and stockholders' equity

$ 400,000
272,000
672,000
$ 736,000

The summarized transactions for May 2010 are as follows:
a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

a
...
Determine balances after each transaction
...
Prepare an income statement for May 2010
...
Prepare a statement of retained earnings for May 2010
...
Prepare a balance sheet as of 2010 May 31
...
(Common practice is to show the most recent period first
...
68 of 433

TARGET-LINE GOLF DRIVING RANGE
Comparative Balance Sheet
May 31, April 30,
2010

2010

Assets
Cash
Land
Total assets
Liabilities and Stockholders' Equity
Accounts payable
Capital stock
Retained earnings
Total liabilities and stockholders' equity
TARGET-LINE GOLF DRIVING RANGE
Income Statement
For the Month Ended 2010 May 31
Revenues:

$56,400 $46,800
163,200 144,000
$219,600 $190,800
$18,000 $27,600
144,000 144,000
57,600
19,200
$219,600 $190,800

Service revenue

$64,000

Expenses:
Salaries expense
Equipment rental expense
Net income

$16,000
9,600

25,600
$38,400

All revenues earned are on account
...


2
...
6

Alternate problems

Alternate problem A Preston Auto Paint Company had the temporary free use of an old building
and completed the following transactions in September 2010:
Sept
...

5 The company bought painting and sanding equipment for cash at a cost of USD 25,000
...

The customer furnished the special paint
...

20 Additional sanding equipment that cost USD 2,800 was acquired today; payment was postponed
until September 28
...

30 Employee salaries for the month, USD 2,200, were paid
...

Prepare a summary of transactions (see Part A of Exhibit 4) for the company for these transactions
...
69 of 433

and Retained Earnings
...

Alternate problem B Quick-Start Home Repair Company completed the following transactions
in June 2010:
June 1 The company was organized and received USD 200,000 cash from the issuance of capital
stock
...

7 The company borrowed USD 10,000 from its bank on a note
...

12 Expenses of operating the business so far this month were paid in cash, USD 3,400
...

25 The company paid USD 4,065 on its loan from the bank, including USD 4,050 of principal and
USD 15 of interest
...
Interest is an expense, which reduces
retained earnings
...

30 An order (contract) was received from a customer for repair services to be performed tomorrow,
which will be billed at USD 3,000
...
Prepare a summary of transactions (see Part A of Exhibit 4)
...
Determine
balances after each transaction to show that the basic accounting equation balances
...
Prepare a balance sheet as of 2010 June 30
...
,
for the year ending 2010 June 30
...


p
...

Prepare an income statement for the year ended 2010 June 30
...
71 of 433

Oct
...

1 The company paid rent for the premises for October, USD 19,200
...

10 The company collected USD 14,400 of the accounts receivable in the balance sheet at September
30
...

15 Parking revenue earned but not yet collected from fleet customers was USD 6,000
...

19 The company paid advertising expenses of USD 1,200 for October
...

24 The company incurred miscellaneous expenses of USD 840
...

31 Cash receipts for the last 10 days of the month from daily customers were USD 8,400
...

31 Billings to monthly customers totaled USD 21,600 for October
...

a
...
Determine balances after each transaction
...
Prepare an income statement for October 2010
...
Prepare a statement of retained earnings for October 2010
...
Prepare a balance sheet as of 2010 October 31
...
(Common practice is to show
the most recent period first
...
,
Income Statement For the Month Ended 2010 June 3
Revenues:

$
$
$
$

60,000
-036,000
96,000
24,000
60,000
12,000
96,000

p
...

State the probable causes of the changes in each of the balance sheet accounts from May 31 to 2010
June 30
...
18
...
During the next six years, Crane earned a reputation
as an excellent employee—hardworking, dedicated, and dependable—in the light construction industry
...

Crane then decided to go into business for himself under the name Jim’s Fix-It Shop, Inc
...
He completed many repair and
remodeling jobs for homeowners and apartment owners
...
He operated out of his garage, which he had converted into a
shop, adding several new pieces of power woodworking equipment
...
He has been offered
an annual salary of USD 50,000 and a package of fringe benefits (medical and hospitalization
insurance, pension contribution, vacation and sick pay, and life insurance) worth approximately USD
8,000 per year
...
But he dislikes giving up his business since he has
thoroughly enjoyed being his own boss, even though it has led to an average workweek well in excess of
the standard 40 hours
Suppose Crane comes to you for assistance in gathering the information needed to help him make a
decision
...
Using logic and your own life experiences, indicate the nature of the
information Jim needs if he is to make an informed decision
...
Does the accounting information
available enter directly into the decision? Write a memorandum to Jim describing the information he
will need to make an informed decision
...
(See the format in Group Project E below
...
73 of 433

Annual report analysis B Recall that in this chapter we showed that the equity ratio is calculated
by dividing stockholders’ equity by total equities (or total assets)
...
This latter calculation tells the proportion of assets
financed by debt rather than the proportion of assets financed by stockholders’ equity
...
Thus, if 25 per cent of assets were financed by debt, 75
per cent were financed by stockholders’ equity
...

2003
Total
liabilities

2002

2001

2000

1999

1998

1997

USD

USD

USD

USD

USD

USD

USD

857,870

568,492

394,545

1,772,205

1,937,570

1,546,005

1,109,337

(000's)
Total

2380339

2017118

1344375

930044

815541

555519

376035

stockholder
s equity
Study these amounts and comment on the solvency of the company
...
Could Gateway have grown this
much without increasing liabilities?
Annual report analysis C Look at The Limited, Inc
...
In that report you will find a letter outlining Management’s responsibilities concerning the
financial statements, as well as the report of the independent auditors
...
74 of 433

To what extent does the independent auditor examine evidence?
Ethics case- writing experience D Refer to “An ethical perspective: State university”
...
Which of the alternatives you have discussed would you recommend?
Group project E In teams of two or three students, interview a businessperson in your
community
...
Each team should write a memorandum to the instructor summarizing the results of
the interview
...

Group project F With a team composed of one or two other students, conceive of a business that
you would like to form after graduation
...
Prepare a summary of transactions showing
how each transaction affects the accounting equation
...
For instance, instead of grouping all assets in one
number, show cash, accounts receivable, and so on in your accounting equation
...
Be careful to cite sources for your information
...
To quote without giving the source is plagiarism and should be avoided at all costs
...
18
...
nokia
...

Visit the following website for Ford Motor Company:
p
...
ford
...
Based on your investigation, write a short paper describing the general
content of the annual report
...
18
...
18
...
1

Answers to self-test
True-False

False
...

True
...

False
...

True
...

True
...


2
...
9
...
The ending balance in retained earnings is shown in both the statement of retained earnings
and in the balance sheet
...
This form of the equation would not balance
...
The inflation accounting concept was not one of the ones discussed
...

c
...

c
...


p
...
1 Learning objectives
After studying this chapter, you should be able to:


Use the account as the basic classifying and storage unit for accounting information
...



List the steps in the accounting cycle
...




Post journal entries to the accounts in the ledger
...



Analyze and use the financial results—horizontal and vertical analyses
...
2 Salary potential of accountants
Selecting a major represents much more than the choice of courses a student takes in college
...
Few professionals would recommend a specific career choice based
solely on salaries
...
Outlined below is information on selected salaries for many accounting-related
careers
...
Salaries at all levels
can vary significantly between locations
...


p
...
roberthalf
...
Also, accounting
professors are generally familiar with starting salaries and job opportunities for accounting graduates,
so you may want to address more specific questions about potential careers and salaries with them
...
These statements are the end products of the financial accounting process,
which is based on the accounting equation
...
The results of these decisions are communicated to users—management,
creditors, and investors—and serve as a basis for making future decisions
...
We recorded the transactions in Chapter 1
as increases or decreases in the assets, liabilities, and stockholders' equity items of the accounting
equation
...

When working through these sample transactions, you probably suspected that listing all transactions
as increases or decreases in the transactions summary columns would be too cumbersome in practice
...
Chapter 2 teaches you how
to actually record business transactions in the accounting process
...
Using these tools, you can
follow a company through its various business transactions
...
This is the double-entry accounting
p
...
Understanding this system
enables you to better understand the content of financial statements so you can use the information
provided to make informed business decisions
...
3 The account and rules of debit and credit
A business may engage in thousands of transactions during a year
...

Steps in recording business transactions
Look at Exhibit 5 to see the steps in recording and posting the effects of a business transaction
...
These source
documents include such items as bills received from suppliers for goods or services received, bills sent
to customers for goods sold or services performed, and cash register tapes
...
Then a firm posts (transfers) that
information to accounts in the ledger
...
However, before you can record the journal entry, you must understand the rules of debit
and credit
...

Fortunately, most business transactions are repetitive
...

For example, a company may have thousands of receipts or payments of cash during a year
...

An account is a part of the accounting system used to classify and summarize the increases,
decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and
expense
...
Every business has a Cash account in its accounting system because knowledge
of the amount of cash on hand is useful information
...
For example, one
accountant might name an account Notes Payable and another might call it Loans Payable
...
The account title should be logical to
help the accountant group similar transactions into the same account
...

The number of accounts in a company's accounting system depends on the information needs of
those interested in the business
...
79 of 433

useful in making decisions
...
The amount of
cash is useful information; the form of cash often is not
...
The name of the account, such as Cash, appears across the top of the T
...
A T-account
appears as follows:

An accounting perspective: Business insight
Have you ever considered starting your own business? If so, you will need to
understand accounting to successfully run your business
...
Accounting
information also tells you why you are performing as reported
...


Exhibit 5: The steps in recording and posting the effects of a business transaction
In Chapter 1, you saw that each business transaction affects at least two items
...
This result was illustrated in the summary of transactions in Exhibit 1
...
In the following

p
...

Accountants use the term debit instead of saying, "Place an entry on the left side of the T-account"
...
Debit (abbreviated
Dr
...
) means right side
...

Any Account
Left, or
debit, side

Right, or
credit, side

After recognizing a business event as a business transaction, we analyze it to determine its increase
or decrease effects on the assets, liabilities, stockholders' equity items, dividends, revenues, or
expenses of the business
...

In each business transaction we record, the total dollar amount of debits must equal the total dollar
amount of credits
...
The accounting requirement that each transaction be
recorded by an entry that has equal debits and credits is called double-entry procedure, or duality
...

The dual recording process produces two sets of accounts—those with debit balances and those with
credit balances
...
Then, some assurance exists
that the arithmetic part of the transaction recording process has been properly carried out
...


3
...
Assets, which are on the left of the equal sign, increase on the left side of the Taccounts
...
You already know that the left side of the T-account is the debit side and the right side

1The abbreviations “Dr
...
” are based on the Latin words “debere” and “credere”
...

p
...
So you should be able to fill in the rest of the rules of increases and decreases by
deduction, such as:
Assets
Debit for
increases

=
Credit for
decreases

Liabilities
Debit for
decreases

Credit for
increases

+ Stockholders' Equity
Debit for
Credit for
decreases
increases

To summarize:
 Assets increase by debits (left side) to the T-account and decrease by credits (right side) to the T-

account
...

Applying these two rules keeps the accounting equation in balance
...

Assume a corporation issues shares of its capital stock for USD 10,000 in transaction 1
...
) The company records the receipt of USD 10,000 as follows:
(Dr
...
)

Capital Stock
(1)

(Cr
10,000

This transaction increases the asset, cash, which is recorded on the left side of the Cash account
...

Assume the company borrowed USD 5,000 from a bank on a note (transaction 2)
...
The firm records this
transaction as follows:
(Dr
...
)

(Cr)

Notes Payable
(2)

(1)

5,000
(2)

10,000
5,000

Observe that liabilities, Notes Payable, increase with an entry on the right (credit) side of the
account
...
However, this is not done in practice because of
the volume of revenue and expense transactions
...
Since firms need the amounts of revenues

p
...
The recording rules for revenues and expenses are:
 Record increases in revenues on the right (credit) side of the T-account and decreases on the

left (debit) side
...

 Record increases in expenses on the left (debit) side of the T-account and decreases on the

right (credit) side
...

To illustrate these rules, assume the same company received USD 1,000 cash from a customer for
services rendered (transaction 3)
...


(Dr
...
)

1,000

Service Revenue
(3)

(Cr)
1,000

Now assume this company paid USD 600 in salaries to employees (transaction 4)
...
2
(Dr)

Cash

(1)

10,000

(2)

5,000

(3)

1,000

(4)

(Cr)
600

(Dr
...
Thus, the firm records payment of a USD 2,000 cash dividend (transaction
5) as follows:
(Dr)

(Cr)

Cash

(1)

10,000

(4)

600

(2)

5,000

(5)

Dividends3
2,000

(Cr)

2,000

(3)

(Dr
...
Those deductions are ignored here
...
83 of 433

3

At the end of the accounting period, the accountant transfers any balances in the expense, revenue,
and Dividends accounts to the Retained Earnings account
...
We
discuss and illustrate this step in Chapter 4
...
If the sum of the debits exceeds the sum of the
credits, the account has a debit balance
...
The account has a debit balance of USD 13,400, computed as total
debits of USD 16,000 less total credits of USD 2,600
...
)
(1)
(2)
(3)

Cash
10,000
5,000
1,000

(Cr)
600
2,000

(4)
(5)

16,000

Dr
...
For instance, assume that a company has an Accounts Payable account with a total of USD
10,000 in debits and USD 13,000 in credits
...
)
10,000

Accounts Payable
7,000
6,000

10,000

(Cr)

13,000
Cr
...
Conversely, because credits increase liability, capital stock, retained
earnings, and revenue accounts, they normally have credit (or right-side) balances
...

p
...
Later, as you proceed in your
study of accounting, the rules will become automatic
...
When the account balances are totaled, they conform to the following independent
equations:
Assets = Liabilities + Stockholders' Equity
Debits = Credits
The arrangement of these two formulas gives the first three rules of debit and credit:
 Increases in asset accounts are debits; decreases are credits
...

 Decreases in stockholders' equity accounts are debits; increases are credits
...
Increase assets
...


Decreases assets
...
Decrease liabilities
...


3
...


Increase

+

-

-

+

stockholders' equity
...

4
...


4
...


for

for

for

for

5
...


5
...


increase

decrease

decrease

increase

6
...


6
...


Exhibit 6: Rules of debit and credit
The debit and credit rules for expense and Dividends accounts and for revenue accounts follow
logically if you remember that expenses and dividends are decreases in stockholders' equity and
revenues are increases in stockholders' equity
...
85 of 433

debit side, expense and Dividend accounts increase on the debit side
...
The last three debit
and credit rules are:
 Decreases in revenue accounts are debits; increases are credits
...

 Increases in Dividends accounts are debits; decreases are credits
...
Note first the treatment of expense and
Dividends accounts as if they were subclassifications of the debit side of the Retained Earnings
account
...
Next, we discuss the accounting cycle and indicate where
steps in the accounting cycle are discussed in Chapters 2 through 4
...
5 The accounting cycle
The accounting cycle is a series of steps performed during the accounting period (some
throughout the period and some at the end) to analyze, record, classify, summarize, and report useful
financial information for the purpose of preparing financial statements
...
Business
transactions are measurable events that affect the financial condition of a business
...

These two events may briefly interrupt the operation of the business
...

Business transactions can be the exchange of goods for cash between the business and an external
party, such as the sale of a book, or they can involve paying salaries to employees
...
The evidence that a business event
has occurred is a source document such as a sales ticket, check, and so on
...
4
After you have determined that an event is a measurable business transaction and have adequate
proof of this transaction, mentally analyze the transaction's effects on the accounting equation
...
In such
an electronic computer environment, source documents might exist only in the computer databases
of the two parties involved in the transaction
...
86 of 433

learned how to do this in Chapter 1
...
The eight steps in the accounting cycle and the chapters that discuss them are:
 Analyze transactions by examining source documents (Chapters 1 and 2)
...

 Post journal entries to the accounts in the ledger (Chapter 2)
...


(This step includes adjusting entries from Chapter 3
...

 Journalize and post adjusting entries (Chapters 3 and 4)
...

 Prepare a post-closing trial balance (Chapter 4)
...
Notice that firms perform the
last five steps at the end of the accounting period
...
After the statements have been delivered to
management, the adjusting and closing entries can be journalized and posted
...

You can perform many of these steps on a computer with an accounting software package
...
This understanding removes the mystery of what the
computer is doing when it takes in raw data and produces financial statements
...
6 The journal
In explaining the rules of debit and credit, we recorded transactions directly in the accounts
...
Thus, all the
effects of a single business transaction would not appear in any one account
...
To have a permanent record of an entire transaction, the accountant uses a book or record
known as a journal
...
A journal
entry is the recording of a business transaction in the journal
...
A transaction is entered in a journal before it is entered in ledger accounts
...
87 of 433

transaction is initially recorded in a journal rather than directly in the ledger, a journal is called a book
of original entry
...
Chapter 4 briefly describes several special journals
...
As shown in Exhibit 8, a general
journal contains the following columns:

Exhibit 7: Steps in the accounting cycle

p
...
28

Cash (+A)

Post
...

100

Capital Stock (+SE)

300

Debit

Credit

5 0 0 0 0
5 0 0 0 0

Stockholders invested $50,000 cash in business
...
The first column on each journal page is for the date
...
For all other journal
entries on a page, this column contains only the day of the month, until the month changes
...
The first line of an entry shows the account

debited
...
Notice that we indent the credit account
title to the right
...
Any necessary explanation of a transaction appears on the
line(s) below the credit entry and is indented halfway between the accounts debited and
credited
...
When a journal entry is self-explanatory,
we omit the explanation
...
This column shows the account number of the debited or

credited account
...
No number appears in this column until the information has
been posted to the appropriate ledger account
...

 Debit column
...

 Credit column
...


An account perspective: Uses of technology
Preparing journal entries in a computerized system is different than in a manual
system
...
After
you type the account number, the computer shows the account title in its proper
position
...
89 of 433

amount of the debit
...
If not, the computer
prompts you for the account number of the credit
...
When there is more than one credit, you can override the
amount and enter the correct amount
...
If your debits and credits are not equal, the computer warns you and makes
you correct the error
...
As you enter the journal entries, the computer automatically posts them
to the ledger accounts
...

A summary of the functions and advantages of using a journal follows:
The journal—
 Records transactions in chronological order
...

 Supplies an explanation of each transaction when necessary
...

 Eliminates the need for lengthy explanations from the accounts
...

 Assists in maintaining the ledger in balance because the debit(s) must always equal the credit(s)

in each journal entry
...


3
...
The ledger
may be in loose-leaf form, in a bound volume, or in computer memory
...
The terms real
accounts and permanent accounts also refer to balance sheet accounts
...
They are
permanent accounts because their balances are not transferred (or closed) to any other account at
the end of the accounting period
...
Nominal
literally means "in name only"
...
90 of 433

temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the
Retained Earnings account at the end of the accounting period
...
The chart of accounts can be compared to a table of contents
...

Individual accounts are in sequence in the ledger
...
For example, a company might
number asset accounts, 100-199; liability accounts, 200-299; stockholders' equity accounts and
Dividends account, 300-399; revenue accounts, 400-499; and expense accounts, 500-599
...
The uniform chart of accounts used in the first 11 chapters appears in a
separate file at the end of the text
...
Companies may use other numbering systems
...
The important idea is that
companies use some numbering system
...


3
...
The company offers beginning through advanced training with
convenient scheduling
...
The company rents a building and is responsible for paying the utilities
...
The accounting process used by this company is similar to
that of any small company
...
91 of 433

Acct
...


Description

100

Cash

Bank deposits and cash on hand
...


107

Supplies on Hand

Items such as paper, envelopes, writing materials, and other
materials used in performing training services for customers or
in doing administrative
and clerical office work
...

Rent paid in advance of the periods for which the rent
payment applies
...

Amounts owed to creditors for items purchased

Assets

200

Accounts Payable

Liabilities

216

Unearned Service Fees

Stockholders'
equity
Dividends
Revenues

300
310
320
400
505

Capital Stock Retained
Earnings
Dividends
Service Revenue
Advertising Expense

from them
...

The stockholders' investment in the business
...

The amount of dividends declared to stockholders
...

The cost of advertising incurred in the current period
...


511

Utilities Expense

The cost of utilities incurred in the current period
...


Notice the gaps left between account numbers (100, 103, 107, etc
...

To begin, a transaction must be journalized
...
Then, the information is transferred, or posted, to the proper accounts in the
ledger
...
We explain posting in more detail later in the chapter
...
Also note that the transaction date in both the general journal and the general ledger accounts
is the same
...
Our example shows the journal
entries posted to T-accounts
...

Accountants use the accrual basis of accounting
...
They recognize expenses as incurred, whether or not the company has paid
out cash
...


p
...
First, MicroTrain records the transaction in the general
journal; second, it posts the entry to the accounts in the general ledger
...
28 Stockholders invested $50,000 and formed MicroTrain Company
...
Debit
Ref
...
28 Cash (+A)
100
5 0 0 0 0
Capital Stock (+SE)

300

Credit

5 0 0 0 0

Stockholders invested $50,000 cash in business
...
)

Capital Stock

Acct
...
100

(Cr
...
No
...
)

2010
Nov
...
)
2010

50,000

Nov
...
The company prepares financial statements at the
end of each month
...

The balance sheet reflects ledger account balances as of the close of business on 2010 November 30
...
The ledger accounts show
these closing balances as beginning balances (Beg
...

Now assume that in December 2010, MicroTrain Company engaged in the following transactions
...

MICROTRAIN COMPANY Balance Sheet 2010 November 30
Assets
Cash

Liabilities and Stockholders' Equity
$50,000

Stockholders' equity:
Capital stock

Total Assets

$50,000

$50,000

Total liabilities and stockholders'
equity
$50,000

Exhibit 9: Balance sheet

p
...
1 Paid cash for four small trucks, $40,000
...

Ref
...


Account Titles and Explanation

Debit

Credit

100

4 0 0 0 0 (A)
4 0 0 0 0 (B)

To record the purchase of four trucks
...
)

Acct
...
150

2010 Dec
...
)

Cash

(Dr
...
No
...
1 Beg
...


50,000

(Cr
...

1

(B)40,0

00
Transaction 3: Dec
...

General Journal
Date
1

Prepaid Insurance (+A)

Post
...

108

Cash (-A)

2010 Dec
...

General Ledger
Prepaid Insurance

(Dr)

Acct
...
108

2010
Dec
...
No
...
)

2010
Dec
...
Bal

50,000

40,000
2,40

2010
Dec
...
1

Effects of transaction
An asset, prepaid insurance, increases (debited); and an asset, cash, decreases (credited) by USD
2,400
...
As you will see in Chapter 3, prepaid items are expensed as they are used
...
94 of 433

policy was only written for December, the entire USD 2,400 debit would have been to Insurance
Expense
...
1 Rented a building and paid $1,200 to cover a three-month period from this date
...

Ref
...


Account Titles and Explanation

100

Debit

Credit
1 2 0 0
1 2 0 0

Paid three months' rent on a building
...
)
2010

Acct
...
112

Dec
...
)
2010

Acct
...
100
2010

(Cr
...
1 Beg
...


50,000

Dec
...
1

40,000
2,400

Dec
...
The debit is to Prepaid Rent rather than Rent Expense because the payment covers more than
the current month
...


p
...
4 Purchased $1,400 of training supplies on account to be used over the next several months
...
Debit
Credit
Ref
...
4
Accounts Payable (+L)

200

1 4 0 0

To record the purchases of training supplies for future use
...
)

(Cr)

Acct
...
107

2010
Dec
...
)

(Cr
...
No
...
4

1,400

Effects of transaction
An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases
(credited) by USD 1,400
...

In each of the three preceding entries, we debited an asset rather than an expense
...
Whenever a
company will not fully use up an item such as insurance, rent, or supplies in the period when
purchased, it usually debits an asset
...

Companies sometimes buy items that they fully use up within the current accounting period
...
If the company fully consumes the supplies during the period of purchase, the
best practice is to debit Supplies Expense at the time of purchase rather than Supplies on Hand
...
If a company purchases insurance that it fully consumes
during the current period, the company should debit Insurance Expense at the time of purchase rather
than Prepaid Insurance
...
As illustrated in Chapter
3, following this advice simplifies the procedures at the end of the accounting period
...
96 of 433

Transaction 6: Dec
...

General Journal
Date
Account Titles and Explanation
Post
...

Cash (+A)
100
4 5 0 0
2010 Dec
...


(Dr
...
No
...
1

Beg Bal 50,000

Dec
...
7

4,500

Dec
...
1

1,200

Unearned Service Fees

(Dr
...
)

Acct
...
216
2010
Dec
...
The credit is to Unearned Service Fees rather than Service Revenue because the USD
4,500 applies to more than just the current accounting period
...
If the payment
had been for services to be provided in December, the credit would have been to Service Revenue
...
97 of 433

Transaction 7: Dec
...

General Journal
Date

Cash (+A)

15

Post
...

100

Service Revenue (+SE)

2010 Dec
...


General Ledger
Cash

(Dr
...
No
...
1 Beg Bal
...
1

40,000

Dec
...
1

2,400

Dec
...
15

4,500
5,000

Service Revenue

(Dr
...
)

Acct
...
400
2010
Dec
...

Transaction 8: Dec
...

General Journal
Date
Account Titles and Explanation
Post
...

200
1 4 0 0
2010 Dec
...

General Ledger
Accounts Payable

(Dr
...
No
...
98 of 433

2010
Dec
...
4

1,400

Cash

(Dr
...
)

Acct
...
100

2010

2010

Dec
...
50,000

Dec
...


7

Dec
...


15

Dec
...

Transaction 9: Dec
...

General Journal
Date

Account Titles and Explanation

2010 Dec
...

Ref
...


General Ledger
Accounts Receivable

(Dr
...
No
...
20

5,700
Service Revenue

(Dr
...
)

Acct
...
400
2010
Dec
...
20

5,700

Effects of transaction

p
...

Transaction 10: Dec
...

General Journal
Date

Account Titles and Explanation
24

Advertising Expense (-SE)
Accounts Payable (+L)

2010 Dec
...

Ref
...

General Ledger
Advertising Expense

(Dr
...
No
...


24

(Dr
...
)

Accounts Payable
Acct
...
200
2010

2010
Dec
...


4

Dec
...
The reason for debiting an expense rather than an asset is because all the cost
pertains to the current accounting period, the month of December
...


p
...
26 Received $500 on accounts receivable from a customer
...

Ref
...


Account Titles and Explanation

Debit

Credit

103

5 0 0
5 0 0

Received $500 from a customer on accounts receivable

General Ledger Cash
(Dr
...
No
...
1 Beg Bal
...
1

40,000

Dec
...
1

2,400

Dec
...
15
Dec
...
)

5,000
500
Acct
...
20

Dec
...
103

1,400

(Cr
...
26

500

Effects of transaction
One asset, cash, increases (debited); and another asset, accounts receivable, decreases (credited) by
USD 500
...
28 Paid salaries of $3,600 to training personnel for the first four weeks of December
...
)
General Journal
Date

Account Titles and Explanation

2010 Dec
...

Ref
...

General Ledger
Salaries Expense

(Dr
...
No
...

28

3,600
Cash

(Dr
...
No
...
)

p
...

1
Dec
...

15
Dec
...
1

40,000

4,500

Dec
...
1

1,200

500

Dec
...
28

3,600

Effects of transaction
An expense, salaries expense, increases (debited); and an asset, cash, decreases (credited) by USD
3,600
...
29 Received and paid the utilities bill for December, $150
...

Ref
...


Account Titles and Explanation

100

Debit

Credit
1 5 0
1 5 0

Paid the utilities bill for December
...
)

(Cr)

Acct
...
511

2010
Dec
...
)
Dec
...

7
Dec
...

26

(Cr
...
No
...

1
Dec
...

1
Dec
...

28
Dec
...


p
...
30 Received a bill for gas and oil used in the trucks for December, $680
...

Ref
...


Account Titles and Explanation

200

Debit

Credit
6 8 0
6 8 0

Received a bill for gas and oil used in the trucks for
December
...
)

(Cr)

Acct
...
506

2010
Dec
...
)

Dec
...
)

Acct
...
200

2010

2010
1,400

Dec
...
24

50

p
...
30

680

Effects of transaction
An expense, gas and oil expense, increases (debited); and a liability, accounts payable, increases
(credited) by USD 680
...
31 A dividend of $3,000 was paid to stockholders
...

Ref
...


Account Titles and Explanation

100

Debit

Credit
3 0 0 0
3 0 0 0

Dividends were paid to stockholders
...
)

Acct
...
320

(Cr)

2010
Dec
...
)

Acct
...
100

2010

(Cr
...
1 Beg Bal
...
1

40,000

Dec
...
1

2,400

Dec
...
1

1,200

Dec
...
17

1,400

Dec
...
29

150

Dec
...

Transaction 15 concludes the analysis of the MicroTrain Company transactions
...


An accounting perspective: Uses of technology

p
...

Then universities and scientific institutions connected to the network to meet their
research and communication needs
...
Today many companies seek customers and employees over the
Internet
...
Accountants in practice
are heavy users of the Internet to locate company data, tax regulations, and almost any
other information they need
...


3
...
The carrying out of these instructions is known as
posting
...
A journal entry directs the entry of a certain dollar amount as a debit in a specific ledger
account and directs the entry of a certain dollar amount as a credit in a specific ledger account
...
In practice, however, companies
post these journal entries to ledger accounts
...
Later, we show you
how to post the MicroTrain Company journal entries to ledger accounts
...
We post the debit
in the general ledger Cash account by using the following procedure: Enter in the Cash account the
date, a short explanation, the journal designation ("G" for general journal) and the journal page
number from which the debit is posted, and the USD 10,000 in the Debit column
...
Post the credit in a similar manner but as a credit to Account No
...
The arrows in Exhibit
10 show how these amounts were posted to the correct accounts
...
In contrast to the two-sided T-account format shown so far,
the three-column format has columns for debit, credit, and balance
...
105 of 433

advantage of showing the balance of the account after each item has been posted
...
In later chapters and in practice, the
nature of the balance is usually not indicated since it is understood
...
Often accountants omit these explanations because
each item can be traced back to the general journal for the explanation
...
Postings can be made (1) at the time the
transaction is journalized; (2) at the end of the day, week, or month; or (3) as each journal page is
filled
...
When posting the general journal, the date used in the
ledger accounts is the date the transaction was recorded in the journal, not the date the journal entry
was posted to the ledger accounts
...
Cross-indexing is the placing of (1) the account number of the ledger account in the
general journal and (2) the general journal page number in the ledger account
...
Note the arrow from Account No
...
Accountants place the number
of the general journal page from which the entry was posted in the Posting Reference column of the
ledger account
...
The notation "G1" means general journal,
page 1
...
Note the arrows from the date in
the general journal to the dates in the general ledger
...


Account Titles and Explanation

Post
...

(C)100
1 0 0 0 0 (A)

1(B) Cash (+A)
Capital Stock (+SE)

300

Credit

1 0 0 0 0 (D)

Stockholders invested $10,000 cash in the business
...

:-

Account No 100(C)

General Ledger Cash
Explanation

2010 -Jan
...

G1
G1

Debt

Credit

Balance

(A) 1 0 0 0 0

1 0 0 0 0 Dr

5 0 0 0

1 5 0 0 0 Dr

p
...
201

Notes Payable
Date

Explanation

2010 Jan
...

G1

Debt

Post
Ref
...


(B)1 Cash from stockholders

Credit
( 1 0 0 0 0
D
)

Balance
5 0 0 0 Cr

Account No
...
Normally, they place cross-reference numbers in the
Posting Reference column of the general journal when the entry is posted
...


p
...
Debit
Ref
...
28

Cash (+A)

100*

Capital Stock (+SE)

Credit

300

5 0 0 0 0
5 0 0 0 0

Stockholders invested $50,000 cash in the business
...

1

Prepaid Insurance (+A)

108

Cash (-A)

100

2 4 0 0
2 4 0 0

Purchased truck insurance to cover a one-year period
...

4

Supplies on Hand (+A)

107

Accounts Payable (+L)

200

1 4 0 0
1 4 0 0

To record the purchase of training supplies for future use
...

15

Cash (+A)

100

Service Revenue (+SE)

400

5 0 0 0
5 0 0 0

To record the receipt of cash for performing training
services for a customer
...

General Journal

Date

Account Titles and Explanation

2010 Dec
...
Debit
Ref
...
108 of 433

Service Revenue (+SE)

400

5 7 0 0

To record the performance of training services on account
for which a customer was billed
...

26

Cash (+A)

100

Accounts Receivable (-A)

5 0 0

103

5 0 0

Received $500 from a customer on accounts receivable
...

29

Utilities Expense (-SE)

511

Cash (-A)

100

1 5 0
1 5 0

Paid the utilities bill for December
...

31

Dividends (-SE)

320

Cash (-A)

100

3 0 0 0
3 0 0 0

Dividends were paid to stockholders
...
The ledger accounts need not contain explanations of all the entries, since any
needed explanations can be obtained from the general journal
...
As shown in Exhibit 11, you skip a line between journal entries to show where
one journal entry ends and another begins
...

Note that no dollar signs appear in journals or ledgers
...
When they use lined accounting work

p
...
When they use unlined paper,
they add both commas and decimal points
...
Each ledger account would appear on a separate page in the
ledger
...

All the journal entries illustrated so far have involved one debit and one credit; these journal entries
are called simple journal entries
...
The journal entry for these transactions involves more than one debit and/or credit
...

As an illustration of a compound journal entry, assume that on 2011 January 2, MicroTrain
Company purchased USD 8,000 of training equipment from Wilson Company
...

MICROTRAIN COMPANY
General Ledger
Cash

Date

Explanation

2010 Dec
...


Account No
...
20
26

1 5 9 0 0 Dr
1 4 0 0

5 0 0

Service revenue

Post
Ref
...
4

Purchased on account

Credit

Balance

5 7 0 0

5 7 0 0 Dr
5 0 0

5 2 0 0 Dr

Account No
...
103

Accounts Receivable
Date

6 4 0 0 Dr
1 0 9 0 0 Dr

Post
Ref
...
110 of 433

Account No
...
1

Post
Ref
...
1

Post
Ref
...
1

Paid cash

Debit
1

Post
Ref
...
150
Debit

Credit

4 0

Balance

0 0 0

4 0 0 0 0 Dr

Account No
...
112
Credit

Trucks
Date

Balance

Supplies

Post
Ref
...
4

Debit

Credit
1 4
1

Explanation

2010 Dec
...
1

- 0 5 0 Cr

8 )

7 3 0 Cr

Account No
...

G1

Explanation

Debit

Credit

Balance
4 5

0 0

Post
Ref
...

G2

Explanation

2010 Dec
...
320
Credit

Debt
3

Balance

0 0 0

3 0 0 0 Dr

Account No
...
31

4 5 0 0 Cr

Account No
...

G1

Debt

Credit

Balance
5 0

0 0

5 0 0 0 Cr

p
...
24

On account

Post
Ref
...
30

On account

Post
Ref
...
28

Cash paid

Debt

Credit

2010 Dec
...
507
Post
Ref
...
511

Utilities Expense
Date

5 0 Dr

Account No
...
505

Advertising Expense
Date

0 0

Post
Ref
...

No
...
112 of 433

MicroTrain paid USD 2,000 cash with the balance due on 2011 March 3
...


2

Equipment (+A)

8,000

Cash (-A)

2,000

Accounts Payable (+L)

6,000

Training equipment purchased from Wilson Company
...
However, the
dollar totals of the debits and credits are equal
...
A trial
balance is a listing of the ledger accounts and their debit or credit balances to determine that debits
equal credits in the recording process
...
Within the assets category, the most liquid
(closest to becoming cash) asset appears first and the least liquid appears last
...
Study Exhibit 13, the trial balance for
MicroTrain Company
...

When the trial balance does not balance, try re-totaling the two columns
...
If the difference is divisible by 2, you
may have transferred a debit-balanced account to the trial balance as a credit, or a credit-balanced
account as a debit
...
Thus, if the difference is USD 800, look for an account with a
balance of USD 400 and see if it is in the wrong column
...
A transposition error occurs when two digits are reversed in an
amount (e
...
writing 753 as 573 or 110 as 101)
...
g
...
00)
...


p
...

Larry Fisher was captain of the football team at Prestige University
...

Upon graduation, Larry accepted a position with Financial Deals, Inc
...
At first, things were going smoothly
...
The president of the company took a liking to
him
...
When he protested mildly, the president
said: "Come on, son, this is the way the business world works
...
"
As time went on, Larry was asked to do things that were more unethical, and finally he
was performing illegal acts
...
The president also promised Larry great wealth
sometime in the future
...
If I go down, you are going with me
...
Most of
this would be lost if the various company schemes were revealed
...
He was under great strain and believed that he could lose his
mind
...
If Larry blows the whistle, he believes he will go to
prison for his part in the schemes
...
)

If you still cannot find the error, it may be due to one of the following causes:
 Failing to post part of a journal entry
...

 Incorrectly determining the balance of an account
...

 Omitting an account from the trial balance
...
114 of 433

 Making a transposition or slide error in the accounts or the journal
...
Assuming
you have already re-totaled the columns and traced the amounts appearing in the trial balance back to
the general ledger account balances, use the following steps: Verify the balance of each general ledger
account, verify postings to the general ledger, verify general journal entries, and then review the
transactions and possibly the source documents
...
Serious errors may have been made, such as failure to record a
transaction, or posting a debit or credit to the wrong account
...
Both cash and accounts payable would be overstated by USD 100
...
Typically, you would prepare a trial balance before preparing the financial statements
...
These persons can then access simultaneously the
programs and databases stored in the LAN and can communicate with all other
persons in the LAN through email
...
Under this structure, any computer in the network
can be used to update the information stored elsewhere in the network
...
The use of networks is
designed to improve efficiency and to reduce software and hardware costs
...
10 Analyzing and using the financial results— Horizontal and
vertical analyses
The calculation of dollar and/or percentage changes from one year to the next in an item on
financial statements is horizontal analysis
...
This amount represented a 17 per cent increase
...
115 of 433

amount of the increase or decrease, subtract the 1999 amount from the 2000 amount
...

Knowing the dollar amount and percentage of change in an amount is much more meaningful than
merely knowing the amount at one point in time
...
Their decline at least partially explains the increases in some of the other
current assets
...
Any terms
in Hewlett-Packard's list of assets that you do not understand are explained in later chapters
...

Vertical analysis shows the percentage that each item in a financial statement is of some
significant total such as total assets or sales
...
3 per cent of total assets as of 1999 October 31, and had declined to
10
...
Total current assets (cash plus other amounts that will
become cash or be used up within one year) increased from 61
...
3 per cent
during 2000
...
4 per cent of total
assets as of 2000 October 31
...
0%
1
...
8%
6
...
8%
14
...
3%

15
...
5%
16
...
4%
13
...
5%
61
...
2%

12
...
4%
100
...
4%
100
...
Other data would have to be
examined before decisions could be made regarding the assets shown
...
116 of 433

substantially during 2000
...


An accounting perspective: Business insight
Many companies have been restructuring their organizations and reducing the
number of employees to cut expenses
...
One could question whether companies place
as much value on their employees as in the past
...
Companies are not permitted to show employees as assets on
their balance sheets
...
The entire process of
accounting is based on the double-entry concept
...


3
...
1

Understanding the learning objectives

 An account is a storage unit used to classify and summarize money measurements of business

activities of a similar nature
...

 A T-account resembles the letter T
...

 Credits are entries on the right side of a T-account
...

 Credits increase liability, stockholders' equity, and revenue accounts
...

 Journalize transactions in the journal
...

 Prepare a trial balance of the accounts and complete the work sheet
...


p
...

 Journalize and post closing entries
...

 A journal contains a chronological record of the transactions of a business
...
Journalizing is the process of entering a transaction in a
journal
...

 Cross-indexing is the placing of (1) the account number of the ledger account in the general

journal and (2) the general journal page number in the ledger account
...

 A trial balance is a listing of the ledger accounts and their debit or credit balances
...

 A trial balance is shown in Exhibit 13
...

 Vertical analysis shows the percentage that each item in a financial statement is of some

significant total
...
10
...
118 of 433

a
...

b
...
Insert cross-indexing references in the journal and ledger
...
Prepare a trial balance
...
10
...

GREEN HILLS RIDING STABLE, INCORPORATED
General Journal

Date
2010 July

Page1

Account Titles and Explanation
Cash (+A)

100

Capital Stock (+SE)

1

Post
...


Credit

300

2 5 0 0 0
2 5 0 0 0

Additional capital stock issued
...

8

Account Payable (-L)

200

Cash (-A)

100

8 0 0
8 0 0

Paid accounts payable
...

12

Feed Expense (-SE)

513

Accounts Payable (+L)

200

1 1 0 0
1 1 0 0

Purchased feed on account
15

Accounts Receivable (+A)

103

Horse Boarding Fee Revenue (+SE)

402

4 5 0 0
4 5 0 0

Billed boarding fees for July
...
119 of 433

24

Miscellaneous Expense (-SE)

568

Cash (-A)

8 0 0

100

8 0 0

Paid miscellaneous expenses for July
...

31

Accounts Receivable (+A)

103

Riding and Lesson Fee Revenue (+SE)

404

3 6 0 0
3 6 0 0

Billed riding and lesson fees for July
...


b
...
100

Explanation

Post
Ref
...
103

Accounts Receivable
Date

3 2 5 0 0 Dr

Explanation

Post
Ref
...
120 of 433

Account No
...


Debt

Balance

2010 July

Account No
...

G1

Cash

Debt

Credit

Explanation

Balance

2 4 0 0 0

2 4 0 0 0 Dr

Account No
...


2010 June 30
8

Cash

G1

12

Feed expense

Credit

G1

Balance

Balance

July

Debt

8 0 0 Cr

Notes Payable
Date

Post
Ref
...
201
Credit

Balance

Explanation

2010 June 30

Account No
...


Cash

Debt

Credit

Balance

Balance

July

Balance
4 0 0 0 0 Cr

Capital Stock
Date

1

1 0 0 0 0 Cr
G1

2 5 0 0 0

Explanation

2010 June 30

Balance

Post
Ref
...

G1

Cash

Explanation
15

Balance

Account No
...
402

Horse Boarding Fee Revenue
Date

Credit

2 1 0 0 Cr
Dividends

Date

3 5 0 0 0 Cr

Account No
...

G1

Debt

Credit

Balance
4 5 0 0

4 5 0 0 Cr

Account No
...
121 of 433

Date

Explanation

2010 July

31

Post
Ref
...

G1

Cash

Debt

Explanation

2010 July

12

Debt

Explanation

2010 July

31

Debt

Explanation

2010 July

24

1 1 0 0 Dr

Credit

Balance
2 0 0 Dr

Account No
...

G1

Cash

Balance

2 0 0

Miscellaneous Expense
Date

Credit

Account No
...

G1

Cash

Balance
1 4 0 0 Dr

1 1 0 0

Interest Expense
Date

3 6 0 0 Cr

Account No
...

G1

Accounts payable

Account No
...


Trial Balance
2010 July 31
Acct
...


Account Title

Debits

100

Cash

$ 9,700

Credits

103

Accounts Receivable

8,100

130

Land

40,000

140

Buildings

24,000

200

Accounts Payable

$ 1,100

201

Notes Payable

40,000

300

Capital Stock

35,000

310

Retained Earnings

320

Dividends

402

Horse Boarding Fee Revenue

404

Riding and Lesson Fee Revenue

507

Salaries Expense

1,400

513

Feed Expense

1,100

540

Interest Expense

200

568

Miscellaneous Expense

800

2,100
1,000
4,500
3,600

$86,300

$86,300

p
...
11 Key terms
Account A part of the accounting system used to classify and summarize the increases,
decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and
expense
...
It contains columns for debit, credit, and
balance
...

Accrual basis of accounting Recognizes revenues when sales are made or services are
performed, regardless of when cash is received
...

Business transactions Measurable events that affect the financial condition of a business
...

Compound journal entry A journal entry with more than one debit and/or credit
...

Credit balance The balance in an account when the sum of the credits to the account exceeds
the sum of the debits to that account
...

Debit The left side of any account; when used as a verb, to enter a dollar amount on the left side
of an account; debits increase asset, expense, and Dividends accounts and decrease liability,
stockholders' equity, and revenue accounts
...

Double-entry procedure The accounting requirement that each transaction must be
recorded by an entry that has equal debits and credits
...

Journal A chronological (arranged in order of time) record of business transactions; the
simplest form of journal is the two-column general journal
...

Journalizing A step in the accounting recording process that consists of entering the effects of
a transaction in a journal
...

Nominal accounts See temporary accounts
...


p
...

Posting Recording in the ledger accounts the information contained in the journal
...

Simple journal entry An entry with one debit and one credit
...

Debits are entered on the left side of the account, and credits are entered on the right side of the
account
...

Trial balance A listing of the ledger accounts and their debit or credit balances to determine
that debits equal credits in the recording process
...


3
...
12
...

All of the steps in the accounting cycle are performed only at the end of the accounting period
...

The left side of any account is the credit side
...

The dividends account is increased by debits
...


3
...
2

Multiple-choice

Select the best answer for each of the following questions
...
Capital Stock is debited and Cash is credited
...
Cash is debited and Dividends is credited
...
Cash is debited and Capital Stock is credited
...
None of the above
...
The recommended debit and
credit are:
a
...


p
...
Debit Prepaid Insurance, credit Cash
...
Debit Cash, credit Insurance Expense
...
Debit Cash, credit Prepaid Insurance
...
The correct debit
and credit are:
a
...

b
...

c
...

d
...

A company performed delivery services for a customer for cash
...
Debit Cash, credit Unearned Delivery Fees
...
Debit Cash, credit Delivery Fee Revenue
...
Debit Accounts Receivable, credit Delivery Fee Revenue
...
None of the above
...
The correct journal entry is:
a
...
Cash
Dividends
c
...
Cash
Capital stock

500
500
500
500

500
500
500
500

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
12
...




Give some examples of source documents
...
What are the two basic forms (styles) of accounts illustrated in the
chapter?



What is meant by the term double-entry procedure, or duality?



Describe how you would determine the balance of a T-account
...
Name the types of accounts that are:


Increased by a debit
...


p
...

Decreased by a credit
...




Increase a revenue and decrease an expense
...




Decrease an asset and increase a liability
...





Increase a liability and increase an expense
...


Describe the nature and purposes of the general journal
...




Describe a ledger and a chart of accounts
...
What difficulties could arise if no cross-indexing existed
between the general journal and the ledger accounts?



Which of the following cash payments would involve the immediate recording of an
expense? Why?


Paid vendors for office supplies previously purchased on account
...




Paid the current month's rent
...


p
...
What
are some possible causes of this difference? If the difference between the columns is
divisible by 9, what types of errors are possible?



Store equipment was purchased for USD 2,000
...
Of what help will the
trial balance be in locating this error? Why?



A student remembered that the side toward the window in the classroom was the debit
side of an account
...
Would the student's trial balance have equal debit and credit totals? If there
were no existing balances in any of the accounts to begin with, would the error prevent
the student from preparing correct financial statements? Why?

3
...
4

Exercises

Exercise A A diagram of the various types of accounts follows
...

Asset
Debit

Accounts = Liability Accounts +
Stockholders' Equity Accounts
Credit
Debit
Credit
Debit
Credit
Expense and Dividends
Revenue
Accounts Account
Debit*
Credit
Debit

Accounts
Credit*

Exercise B Prepare the journal entry required for each of the following transactions:
a
...

b
...

Exercise C Prepare the journal entry required for each of the following transactions:
a
...

b
...


p
...
Capital stock was issued for USD 200,000 cash
...
A USD 30,000 loan was arranged with a bank
...

c
...

d
...

Exercise E For each of the following unrelated transactions, give the journal entry to record the
transaction
...
You need not include
explanations or account numbers
...
Capital stock was issued for USD 100,000 cash
...
Salaries for a period were paid to employees, USD 24,000
...
Services were performed for customers on account, USD 40,000
...
, a
company that rents wedding clothing and accessories
...
Each
set is designated by the small letters to the left of the amount
...


p
...


'

(e)

1,000

18,200

Accounts Receivable

(c)

1,800

(J)

Service Revenue

12,000

Bal
...

on Hand

1,800

(J)

13,80C

Rent Expense

30,000

Bal
...
,
as they appear at 2010 December 31
...

Exercise H Prepare journal entries to record each of the following transactions for Sanchez
Company
...
Include an explanation for each entry
...
Capital stock was issued for cash, USD 300,000
...
Purchased trucks by signing a note bearing no interest, USD 210,000
...
Earned service revenue on account, USD 4,800
...
Collected the account receivable resulting from transaction (c), USD 4,800
...
Paid the note payable for the trucks purchased, USD 210,000
...
Paid utilities for the month in the amount of USD 1,800
...
Paid salaries for the month in the amount of USD 7,500
...
Incurred supplies expenses on account in the amount of USD 1,920
...
Purchased another truck for cash, USD 48,000
...
129 of 433

j
...

Exercise I Using the data in the previous problem, post the entries to T-accounts
...
Determine a balance for each account
...
Assume the date of
the trial balance is 2010 March 31
...
He also
maintains his own accounting records and was about to prepare financial statements for the year 2010
...
What are the possible reasons why the
totals of the debits and credits are out of balance? How would you normally proceed to find an error if
the two trial balance columns do not agree?
Exercise L Refer to the Consolidated Balance Sheets of The Limited in the Annual Report
Appendix located in the back of this text
...
comment on the
results
...


3
...
5

Problems

Problem A The transactions of Lightning Package Delivery Company for March 2010 follow:
Mar
...

2 Paid USD 6,000 as the rent for March on a completely furnished building
...

6 Paid USD 4,000 as the rent for March on two forklift trucks
...

12 Performed delivery services for customers who promised to pay USD 27,000 at a later date
...

21 Received a bill for USD 1,200 for advertising in the local newspaper in March
...
130 of 433

27 Paid cash for gas and oil consumed in March, USD 450
...

31 Received an order for services at USD 12,000
...

31 Paid cash dividend, USD 1,000
...

Problem B Economy Laundry Company had the following transactions in August 2010:
Aug
...

3 Borrowed USD 40,000 from the bank on a note
...

6 Performed services for customers who promised to pay later, USD 16,000
...

10 Collections were made for the services performed on August 6, USD 3,200
...

17 A bill for USD 400 was received for utilities for this month
...

31 Paid employee salaries, USD 6,000
...

a
...

b
...
Enter the account number in the Posting Reference
column of the journal as you post each amount
...

No
...
Prepare a trial balance as of 2010 August 31
...
131 of 433

Problem C Clean-Sweep Janitorial, Inc
...
The following account numbers and titles constitute the chart of accounts for the
company:
Acct
...

100
103
150
160
170
200
201
300
310
320
400
506
507
511
512
515
518

Account Title
Cash
Accounts receivable
Trucks
Office equipment
Equipment
Accounts payable
Notes payable
Capital stock
Retained earnings
Dividends
Service revenue
Gas and oil expense
Salaries expense
Utilities expense
Insurance expense
Rent expense
Supplies expense

July 1 The company issued USD 600,000 of capital stock for cash
...

8 Desks and chairs were purchased for the office on account, USD 28,800
...

15 Purchased trucks for USD 150,000, paying USD 120,000 cash and giving a 60-day note to the
dealer for USD 30,000
...

23 Received USD 17,280 cash as service revenue
...

30 Paid for gasoline and oil used by the truck in July, USD 576
...

31 Paid salaries for July, USD 51,840
...

31 Paid cash dividends, USD 9,600
...
Prepare general ledger accounts for all of these accounts except Retained Earnings
...

b
...

c
...

p
...
Prepare a trial balance as of 2010 July 31
...
, is a lawn care company
...
Trim Lawn's trial balance at the end of the first 11 months of the year follows:
TRIM LAWN, INC
...

No
...
2 Paid rent for December, USD 3,000
...

8 Paid advertising for December, USD 1,500
...

13 Purchased USD 240 of supplies on account for use in December
...

20 Paid for customer entertainment, USD 450
...

26 Paid for gasoline used in the trucks in December, USD 270
...

30 Paid for more December supplies, USD 12,000
...


p
...
(The Dividends account is No
...
)
a
...
Place the word Balance in the explanation space of each account
...
320
...
Prepare entries in the general journal for the preceding transactions for December 2010
...
Post the journal entries to three-column general ledger accounts
...
Prepare a trial balance as of 2010 December 31
...
The trial balance did not balance
...

No
...
In searching back through the accounting records, Miller found that the following
errors had been made:
 One entire entry that included a USD 10,000 debit to Cash and a USD 10,000 credit to

Accounts Receivable was never posted
...

 In preparing the trial balance, the Retained Earnings account balance was shown as USD

80,000
...

 One debit of USD 2,400 to the Dividends account was posted as a credit to that account
...
134 of 433

 Office equipment of USD 12,000 was debited to Office Furniture when purchased
...

Also, write a description of the effect(s) of each error
...
12
...
, entered into the following transactions in
August 2010:
Aug
...

3 Paid rent for August on a building and laundry equipment rented, USD 3,000
...

8 Secured an order from a customer for laundry services of USD 7,000
...

13 Performed laundry services for USD 6,300 on account for various customers
...

23 Cash collected from customers on account, USD 2,600
...

31 Received the electric and gas bill for August, USD 385, but did not pay it at this time
...

Prepare journal entries for these transactions in the general journal
...
,
for April 2010:
Apr
...

3 Rent was paid for April, USD 3,500
...

7 Office equipment was purchased on account from Wagner Company for USD 76,800
...

15 USD 28,000 was received for services performed
...

23 A note was arranged with the bank for USD 80,000
...

29 Purchased trucks for USD 73,600 by signing a note
...

p
...
Prepare journal entries for these transactions
...
Post the journal entries to T-accounts
...
Use the following account numbers:
Acct
...

100
150
172
200
201
300
400
506
507
515

Account Title
Cash
Trucks
Office equipment
Accounts payable
Notes payable
Capital stock
Service revenue
Gas and oil expense
Salaries expense
Rent expense

c
...

Alternate problem C Rapid Pick Up & Delivery, Inc
...
Its chart of
accounts is as follows:
Acct
...

100
103
150
160
172
200
201
300
310
400
506
507
511
512
515
530

Account title
Cash
Accounts receivable
Trucks
Office furniture
Office equipment
Accounts payable
Notes payable
Capital stock
Retained earnings
Service revenue
Gas and oil expense
Salaries expense
Utilities expense
Insurance expense
Rent expense
Repairs expense

Jan
...

2 Paid garage rent for January, USD 6,000
...

6 Purchased delivery trucks for USD 280,000; payment was made by giving cash of USD 150,000
and a 30-day note for the remainder
...
The cost of the policy, USD 800, was
paid in cash
...
136 of 433

15 Received and paid January utilities bills, USD 960
...

17 Cash received for delivery services to date amounted to USD 1,800
...

23 Purchased delivery trucks for cash, USD 108,000
...

27 Purchased a copy machine on account, USD 3,600
...

31 Sales of delivery services on account amounted to USD 11,400
...

a
...
The Retained
Earnings account has a beginning balance of zero and maintains this balance throughout the period
...
Journalize the transactions given for 2010 January in the general journal
...
Post the journal entries to ledger accounts
...
Prepare a trial balance as of 2010 January 31
...
, at the end of the first 11
months of its fiscal year follows:

p
...

Trial Balance
2010 November 30
Acct
...

100

Account Title
Cash

Debits
$71,180

Credits

103

Accounts Receivable

81,750

130

Land

60,000

200

Accounts Payable

$18,750

201

Notes Payable

15,000

300

Capital Stock

50,000

310

Retained Earnings, 2010 January 1

53,700

413

Membership and Lesson Revenue

505

Advertising Expense

21,000

507

Salaries Expense

66,000

511

Utilities Expense

2,100

515

Rent Expense

33,000

518

Supplies Expense

2,250

530

Repairs Expense

1,500

531

Entertainment Expense

870

540

Interest Expense

300

202,500

$339,950

$339,950

Dec
...

2 Paid vendors on account, USD 18,000
...

7 Sold memberships on account for December, USD 27,000
...

13 Cash collections from customers on account, USD 36,000
...

24 Paid the December utilities bill, USD 180
...

29 Paid the equipment repair bill received on the 19th, USD 225
...

30 Paid salaries, USD 6,000
...

30 Costs paid in entertaining customers in December, USD 350
...
(The Dividends account is No
...
)

p
...
Open three-column general ledger accounts for each of the accounts in the trial balance
...
Also
open an account for Dividends, No
...

b
...

c
...

d
...

Alternate problem E Bill Baxter prepared a trial balance for Special Party Rentals, Inc
...
The trial balance did not balance
...

Trial Balance
2010 December 31
Acct
...


Account Title

Debits

Credits

100

Cash

$ 74,000

103

Accounts Receivable

50,800

170

Equipment

160,000

200

Accounts Payable

$ 34,000

300

Capital Stock

130,000

310

Retained Earnings

320

Dividends

400

Service Revenue

505

Advertising Expense

1,200

507

Salaries Expense

176,000

511

Utilities Expense

44,800

515

Rent Expense

64,000

44,000
16,000
432,000

$ 586,800

$ 640,000

In trying to f ind out why the trial balance did not balance, Baxter discovered the following errors:
Equipment was understated (too low) by USD 12,000 because of an error in addition in
determining the balance of that account in the ledger
...

A debit of USD 16,000 for a semiannual dividend was posted as a credit to the Capital Stock
account
...


p
...
568), with a balance of USD 3,200, was omitted from the trial
balance
...
Also, write a description of the effect(s) of
each error
...
12
...
Jacobs had been making USD 50,000 per year
...

The following is a summary of the transactions of the business during the first three months of
operations in 2010:
Jan
...

Feb
...
The
homeowner purchased all of the building materials
...
5 Paid cash for an advertisement that appeared in the local newspaper, USD 150
...
10 Received USD 7,000 for converting a room over a garage into an office for a college
professor
...

11 Paid gas and oil expenses for automobile, USD 900
...

15 Paid dividends of USD 2,000
...
Prepare journal entries for these transactions
...
Post the journal entries to T-accounts
...
How profitable is this new venture? Should Jacobs stay in this business?
Annual report analysis B Refer to the Annual Report of The Limited, Inc
...
Perform horizontal and vertical analyses of the liabilities and stockholder's equity sections
of the balance sheets for the two most recent years shown
...

Vertical analysis involves showing the percentage of total liabilities and stockholder's equity that each
account represents as of the balance sheet dates
...


p
...

Few great achievements—in business or in any aspect of life—are reached and sustained without the support
and involvement of large numbers of people committed to shared values and goals they deem worthy
...

Frankly, the biggest difference between The Home Depot and our competitors is not the products on our
shelves, it is our people and their ability to forge strong bonds of loyalty and trust with our customers
...
Contrary to conventional management wisdom, those at the top of organization charts are not the source of
all wisdom
...
We encourage our
employees to challenge senior management directives if they feel strongly enough about their dissenting
opinions
...
We want our people to be themselves and to be bold enough to apply their talents as individuals
...
Thus, we go to great lengths to empower our employees to be
mavericks, to express differences of opinion without fear of being fired or demoted
...
An
organization can, after all, accomplish more when people work together instead of against each other
...
Do you think The Home Depot management regards its employees more as expenses or assets?
Explain
...
What does The Home Depot regard as its most valuable asset? Explain your answer
...
Is The Home Depot permitted to list its human resources as assets on its balance sheet? Why or
why not?
d
...

Ethics case – Writing experience D Refer to "An ethical perspective: Financial deals, Inc
...
What motivated Larry to go along with unethical and illegal actions? Explain
...
141 of 433

b
...

c
...

d
...

Group project E In teams of two or three students, interview in person or by speakerphone a new
staff member who has worked for a CPA firm for only one or two years
...
Also, inquire about the nature of the work
and the training programs offered by the firm for new employees
...
The heading of the memorandum should
contain the date, to whom it is written, from whom, and the subject matter
...
Pacioli was a Franciscan monk
who wrote a book on double-entry accounting in 1494
...
(If you do not know how to do this, ask your instructor
...
12
...
roberthalf
...
Read the information and write a memo to your instructor about your search
and what you learned about certain jobs in accounting
...
sec
...
Write a memo to your instructor about your search
...
12
...
12
...
1

Answers to self-test
True-false

False
...
The first three steps are
performed throughout the accounting period
...
The journal is the book of original entry
...

p
...
The left side of any account is the debit side
...
These accounts are all increased by credits
...
Since dividends reduce stockholders' equity, the Dividends account is increased by debits
...
An entire journal entry may not have been posted, or a debit or credit might have been
posted to the wrong account
...
12
...
2

Multiple-choice

c
...

b
...
The credit is to Cash
...
The receipt of cash before services are performed creates a liability, Unearned Delivery Fees
...
Cash is debited to increase its balance
...
Cash is increased by the debit, and Delivery Service Revenue is increased by the credit
...
Dividends is increased by the debit, and Cash is decreased by the credit
...
143 of 433

4 Adjustments for financial reporting
4
...




Identify the reasons why adjusting entries must be made
...




Prepare adjusting entries
...




Analyze and use the financial results and trend percentages
...
2 A career as a tax specialist
While most students are aware that accountants frequently assist their clients with tax returns and
other tax issues, few are aware of the large number of diverse and challenging careers available in the
field of taxation
...
With over 155 million individual tax returns filed in the US every year, it is not surprising
that many individuals and most businesses need assistance in dealing with the incredibly complex US
and international tax laws
...
As a
tax specialist, you will show individual clients how to reduce their taxes while simultaneously helping
them make decisions about investing, buying a house, funding their children’s education, and planning
their retirement
...
In fact, it is safe to say that very few significant
business transactions take place without the careful guidance of a tax specialist
...
Because there are so many types of
taxes impacting so many aspects of our lives, tax specialists act as consultants in a large number of
fields
...
Nearly all companies provide some sort of pension or other retirement plan for their
employees, as well as health care benefits
...
In response to the amazing
complexity of our tax laws, many schools offer masters degrees specializing in tax
...
In a recent survey of 1,400 chief financial officers, the top two responses to the
p
...
These
responses reflect the indisputable fact that as the US demographic includes more wealthy, and older,
Americans than ever before, professional tax guidance will be in ever-increasing demand
...
For example, are you concerned that a traditional tax accounting job may be too tame
for you? Special agents of the IRS routinely participate in criminal investigations and arrests, working
closely with other federal law enforcement agencies
...
If you think you may be interested
in a career as a tax specialist, be sure to consult with one of your school’s tax professors about the many
job opportunities this field provides
...
You learned how these transactions are entered into the journal
and posted to the ledger accounts
...
The purpose of the accounting process is to
produce accurate financial statements so they may be used for making sound business decisions
...
Detailed coverage of the
statement of cash flows appears in Chapter 16
...
It is any written or printed evidence that describes the
essential facts of a business transaction
...
The giving, receiving, or creating of
source documents triggered the journal entries made in Chapter 2
...
The arrival of the end of the
accounting period triggers adjusting entries
...
In this chapter, you learn the difference
between the cash basis and accrual basis of accounting
...


4
...
The cash basis of accounting recognizes revenues
p
...
For example, under the cash
basis, a company would treat services rendered to clients in 2010 for which the company collected cash
in 2011 as 2011 revenues
...
Under the “pure” cash basis,
even the purchase of a building would be debited to an expense
...
Normally the “modified” cash basis is
used by those few individuals and small businesses that use the cash basis
...
The cash basis is acceptable in practice only under
those circumstances when it approximates the results that a company could obtain under the accrual
basis of accounting
...

Under certain circumstances, companies may use the cash basis for income tax purposes
...
The accrual basis of accounting
recognizes revenues when sales are made or services are performed, regardless of when cash is
received
...
For instance,
assume a company performs services for a customer on account
...
Later, when the
company receives the cash, no revenue is recorded because the company has already recorded the
revenue
...
In Exhibit 14, shown below, we show when
revenues and expenses are recognized under the cash basis and under the accrual basis
...
146 of 433

4
...
An income statement that does not report all revenues
and expenses is incomplete, inaccurate, and possibly misleading
...
Each adjusting entry has a dual purpose: (1) to make the income statement report the
proper revenue or expense and (2) to make the balance sheet report the proper asset or liability
...

January
February
March
April
May
June
July
August
September
October
November
Subtotal
December
Total Companies

30
9
16
8
18
49
8
14
42
17
13
224
376
600

Source' American Institute of Certified Public Accountants

Accounting Trends & Techniques (New York' AICPA, 2004) p39

Exhibit 15: Summary-fiscal year ending by month
Since those interested in the activities of a business need timely information, companies must
prepare financial statements periodically
...
These time periods are usually equal in length and are called accounting
periods
...
An accounting year,
or fiscal year, is an accounting period of one year
...
The
fiscal year may or may not coincide with the calendar year, which ends on December 31
...
In 2008, the comparable figure for publicly-traded companies in the US was 65 per cent
...
For
instance many retail stores end their fiscal year on January 31 to avoid closing their books during their
peak sales period
...

Periodic reporting and the matching principle necessitate the preparation of adjusting entries
...
147 of 433

financial statements are to be prepared to bring about a proper matching of revenues and expenses
...
The matching principle is one of the
underlying principles of accounting
...
Adjusting entries
reflect unrecorded economic activity that has taken place but has not yet been recorded
...
A second reason is that no
source document concerning that activity has yet come to the accountant’s attention
...
That is, adjusting entries convert the amounts that are
actually in the general ledger accounts to the amounts that should be in the general ledger accounts for
proper financial reporting
...
For example, assume a company purchased a three-year insurance policy
costing USD 600 at the beginning of the year and debited USD 600 to Prepaid Insurance
...
Failure to
do so misstates assets and net income on the financial statements
...
148 of 433

Companies continuously receive benefits from many assets such as prepaid expenses (e
...
prepaid
insurance and prepaid rent)
...

Typically, firms do not make the entry until financial statements are to be prepared
...
By custom, and in
some instances by law, businesses report to their owners at least annually
...
Remember, however, that the entry transferring an amount
from an asset account to an expense account should transfer only the asset cost that has expired
...
Computers will be fed the facts concerning activities that would normally
result in adjusting entries and instructed to seek any necessary information from their
own databases or those of other computers to continually adjust the accounts
...
5 Classes and types of adjusting entries
Adjusting entries fall into two broad classes: deferred (meaning to postpone or delay) items and
accrued (meaning to grow or accumulate) items
...
These entries involve the transfer of data already
recorded in asset and liability accounts to expense and revenue accounts, respectively
...
These entries involve the initial, or first, recording of assets and liabilities and the related
revenues and expenses (see Exhibit 16)
...
For example, prepaid insurance and prepaid rent are assets until they
are used up; then they become expenses
...

Accrued items consist of two types of adjusting entries: asset/revenue adjustments and
liability/expense adjustments
...
The accountant records this transaction as an asset in the form of a
receivable and as revenue because the company has earned a revenue
...
149 of 433

its employees salaries not yet paid
...

MICROTRAIN COMPANY
Trial Balance
2010 December 31
Acct
...

100

Account Title
Cash

Debits
$ 8,250

Credits

103

Accounts Receivable

5,200

107

Supplies on Hand

1,400

108

Prepaid Insurance

2,400

112

Prepaid Rent

1,200

150

Trucks

40,000

200

Accounts Payable

$ 730

216

Unearned Service Fees

4,500

300

Capital Stock

320

Dividends

400

Service Revenue

505

Advertising Expense

50

506

Gas and Oil Expense

680

507

Salaries Expense

3,600

511

Utilities Expense

150
$65,930

50,000
3,000
10,700

$65,930

Exhibit 17: Trial balance
In this chapter, we illustrate each of the four types of adjusting entries: asset/expense,
liability/revenue, asset/revenue, and liability/expense
...
As you can see, MicroTrain must adjust several accounts
before it can prepare accurate financial statements
...

In making adjustments for MicroTrain Company, we must add several accounts to the company’s
chart of accounts shown in Chapter 2
...

No
...
The total depreciation
expense taken on trucks since the
acquisition date
...

The amount of salaries earned
by employees but not yet paid
by the company
...
150 of 433

Trucks

*Accountants deduct the balance of a contra asset from the balance of the related reasons for using a
contra asset account later in the chapter
...

The cost of insurance incurred
in the current period
...

The cost of supplies used in
the current period
...

asset account on the balance sheet
...
If
you find the process confusing, review the beginning of this chapter so you clearly understand the
purpose of adjusting entries
...
In fact, websites have become an important link between companies and their
investors
...
As an example, check out
the Gap, Incs website at:
http://www
...
com
Browse the Gap site and see for yourself the comprehensiveness of the financial
information available there
...
6 Adjustments for deferred items
This section discusses the two types of adjustments for deferred items: asset/expense adjustments
and liability/revenue adjustments
...
In the liability/revenue group, you learn how to prepare
adjusting entries for unearned revenues
...
A
prepaid expense is an asset awaiting assignment to expense, such as prepaid insurance, prepaid
rent, and supplies on hand
...

Prepaid insurance When a company pays an insurance policy premium in advance, the purchase
creates the asset, prepaid insurance
...
151 of 433

receive insurance coverage in the future
...
The portion that has expired becomes an expense
...
The journal entry made on 2010 December 1, to record the
purchase of the policy was:
2010
Dec
...


The two accounts relating to insurance are Prepaid Insurance (an asset) and Insurance Expense (an
expense)
...
The Insurance Expense account has a zero balance on 2010 December 1, because no
time has elapsed to use any of the policy’s benefits
...
)
2010

Prepaid Insurance

Dec
...


(Cr)

(Dr
...
1
2,400

Bal
...
Therefore, part of
the service potential (or benefit obtained from the asset) has expired
...
We recognize this reduction by treating
the cost of the services received from the asset as an expense
...
Since the policy provides the same services
for every month of its one-year life, we assign an equal amount (USD 200) of cost to each month
...
The
adjusting journal entry is:
2010
Dec
...
152 of 433

To record insurance expense for December
...
)

(Cr)

Prepaid Insurance

2010
Dec
...
31 Adjustment 1

Decreased by $200

Bal
...
)
Insurance Expense
Increased by
$200

2010
31
Adjustment 1

200

2,200

(Cr
...
Instead, they use three-column ledger accounts that
have the advantage of showing a balance after each transaction
...


Debit

1

Purchased on Account

G1

2400

31

Dec
...


200

2200 Dr
...
2010

Explanation
31

Post Ref
...


*Assumed page number

Before this adjusting entry was made, the entire USD 2,400 insurance payment made on 2010
December 1, was a prepaid expense for 12 months of protection
...
On the income statement for the year ended 2010
December 31, MicroTrain reports one month of insurance expense, USD 200, as one of the expenses it
incurred in generating that year’s revenues
...
The USD 2,200 prepaid expense represents 11 months of
insurance protection that remains as a future benefit
...
Assume a company pays rent in advance to cover more than one accounting period
...
153 of 433

the date it pays the rent, the company debits the prepayment to the Prepaid Rent account (an asset
account)
...
Thus, the
expenditure creates an asset
...
Generally, the rental contract specifies the
amount of rent per unit of time
...
Notice that the amount charged is the same each month even though some
months have more days than other months
...
The journal entry would be:
2010
Dec
...


The two accounts relating to rent are Prepaid Rent (an asset) and Rent Expense
...

(Dr
...
1
Bal
...
)
2010

(Cr)

Rent Expense

Dec
...


-0-

On 2010 December 31, MicroTrain must prepare an adjusting entry
...
The required adjusting entry is:
2010
Dec
...
154 of 433

After posting this adjusting entry, the T-accounts appear as follows:
(Dr
...
)
Increased by
$400

Prepaid Rent

2010
Dec
...
after adjustment

Rent Expense

2010
Dec
...
31
Adjustment 2

(Cr)
Decreased

400

800

by $400

(Cr)

The USD 400 rent expense appears in the income statement for the year ended 2010 December 31
...
Thus, the adjusting entries have accomplished their purpose of maintaining the accuracy
of the financial statements
...
It may classify supplies
simply as supplies (to include all types of supplies), or more specifically as office supplies (paper,
stationery, floppy diskettes, pencils), selling supplies (gummed tape, string, paper bags, cartons,
wrapping paper), or training supplies (transparencies, training manuals)
...
These supplies are an asset until the company uses them
...
Even though these terms indicate a prepaid expense, the firm
does not use prepaid in the asset’s title
...


4

Supplies on Hand
Cash
To record the purchase of supplies for future use
...
After this entry is posted, the Supplies on Hand account shows a debit balance of USD 1,400
and the Supplies Expense account has a zero balance as shown in the following T-accounts:
(Dr
...
4
Bal
...
)

(Dr
...
4
Bal
...
)

-0-

An actual physical inventory (a count of the supplies on hand) at the end of the month showed only
USD 900 of supplies on hand
...


p
...
The
adjusting entry recognizes the reduction in the asset (Supplies on Hand) and the recording of an
expense (Supplies Expense) by transferring USD 500 from the asset to the expense
...
So
MicroTrain makes the following adjusting entry:
2010
Dec
...


Adjustment
500

3—Supplies

After posting this adjusting entry, the T-accounts appear as follows:
(Dr
...
)
Increased by
$500

(Cr)

Supplies on Hand

2010
Dec
...
after
900 adjustment
Supplies Expense

2010
Dec 31 Adjustment 3

2010
Dec
...
)
500

The entry to record the use of supplies could be made when the supplies are issued from the
storeroom
...

Accountants make adjusting entries for supplies on hand, like for any other prepaid expense, before
preparing financial statements
...
Supplies on hand is
an asset in the balance sheet
...
If so, an
expense account is usually debited at the time of purchase rather than debiting an asset account
...
Sometimes,
too, a company debits an expense even though the asset will benefit more than the current period
...
For instance, assume that on January 1, a company paid USD 1,200 rent to cover
a three-year period and debited the USD 1,200 to Rent Expense
...
To simplify our approach, we will consistently debit the
asset when the asset will benefit more than the current accounting period
...
156 of 433

Depreciation Just as prepaid insurance and prepaid rent indicate a gradual using up of a
previously recorded asset, so does depreciation
...
Also,
a prepaid expense generally involves a fairly small amount of money
...

A depreciable asset is a manufactured asset such as a building, machine, vehicle, or piece of
equipment that provides service to a business
...
Since companies gradually use up
these assets over time, they record depreciation expense on them
...
The process of recording
depreciation expense is called depreciation accounting
...
The asset cost is the amount that a company paid to purchase the depreciable asset
...
The estimated residual value (scrap value) is the amount

that the company can probably sell the asset for at the end of its estimated useful life
...
The estimated useful life of an asset is the estimated time that a

company can use the asset
...
However, sometimes the useful life is determined by company policy (e
...

keep a fleet of automobiles for three years)
...
The method illustrated here is the
straight-line method
...
Straight-line depreciation
assigns the same amount of depreciation expense to each accounting period over the life of the asset
...
The journal entry was:
2010
Dec
...


p
...
The company estimated the useful life of each truck to
be four years
...
Thus,
depreciation expense for December is USD 9,000 ÷ 12 = USD 750
...
To satisfy the matching principle, the firm must allocate the depreciable amount as an
expense to the various periods in the asset’s useful life
...
MicroTrain’s depreciation on its delivery trucks for December is
USD 750
...


31 Depreciation Expense – Trucks

750

Accumulated Depreciation - Trucks

750

Adjusted 4Depreciation

To record depreciation expense for December
...
)

Depreciation Expense—Trucks

Increased by
$750

2010
Dec 31 Adjustment 4

(Dr
...
)

Increased by $750
(book value of asset
decreased)

2010
Dec
...
And it reports accumulated
depreciation in the balance sheet as a deduction from the related asset
...
158 of 433

The accumulated depreciation account is a contra asset account that shows the total of all
depreciation recorded on the asset from the date of acquisition up through the balance sheet date
...
The
purpose of a contra asset account is to reduce the original cost of the asset down to its remaining
undepreciated cost or book value
...
The undepreciated cost of the asset is the debit balance
in the asset account (original cost) minus the credit balance in the accumulated depreciation contra
account
...
Thus, book value is the cost not yet allocated to an expense
...
Companies use contra accounts when they want
to show statement readers the original amount of the account to which the contra account relates
...
Therefore, the asset account shows the
original cost
...
By having both original cost and the accumulated
depreciation amounts, a user can estimate the approximate percentage of the benefits embodied in the
asset that the company has consumed
...
Then, the benefits would be approximately three-fourths
consumed, and the company may have to replace the asset soon
...
In the preceding
example for adjustment 4, the balance sheet at 2010 December 31, would show the asset and contra
asset as follows:

Trucks
Less: Accumulated deprecation

Assets

USD 40,000
750
USD 39,250

p
...

A liability/revenue adjustment involving unearned revenues covers situations in which a customer
has transferred assets, usually cash, to the selling company before the receipt of merchandise or
services
...
The
firm debits such receipts to the asset account Cash and credits a liability account
...
The seller must either provide the services or return the customer’s money
...

Companies receive advance payments for many items, such as training services, delivery services,
tickets, and magazine or newspaper subscriptions
...

Unearned service fees On December 7, MicroTrain Company received USD 4,500 from a
customer in payment for future training services
...


7

Cash
Unearned Service Fees
To record the receipt of cash from a customer in payment
for future training services
...
These accounts appear as follows on 2010 December 31 (before adjustment):
(Dr
...
)
2010
Dec
...
)
*The $10,700 balance came

Service Revenue
(Cr
...
before adjustment
10,700*
from transactions discussed in Chapter 2
...
Before
MicroTrain prepares its financial statements, it must make an adjusting entry to transfer the amount of
the services performed by the company from a liability account to a revenue account
...
160 of 433

MicroTrain earned one-third of the USD 4,500 in the Unearned Service Fees account by December 31,
then the company transfers USD 1,500 to the Service Revenue account as follows:
2010
Dec
...


1,500
1,500

After posting the adjusting entry, the T-accounts would appear as follows:
Decreased by
$1,500

(Dr
...
)

Unearned Service Fees

2010

2010

2010 Dec
...
7 Cash received
in advance
Bal
...
)

4,500
3,000

(Cr
...
before adjustment Dec
...
after adjustment

10,700
1,500

Increased — by
$1,500

12,200

MicroTrain reports the service revenue in its income statement for 2010
...
In 2011,
the company will likely earn the USD 3,000 and transfer it to a revenue account
...
For instance, assume that MicroTrain could not perform the
remaining USD 3,000 of training services and would have to refund the money
...


Thus, the company must either perform the training services or refund the fees
...

p
...
They also make adjusting entries for accrued items, which we discuss in
the next section, for business data not yet recorded in the accounting records
...

According to recent surveys, the market for accounting graduates remains brisk
...
As
a result of the low unemployment rate, employers—especially small accounting firms
with limited recruiting budgets—are doing whatever they can to grab qualified
candidates
...
7 Adjustments for accrued items
Accrued items require two types of adjusting entries: asset/revenue adjustments and
liability/expense adjustments
...

Accrued assets are assets, such as interest receivable or accounts receivable, that have not been
recorded by the end of an accounting period
...
To present an accurate picture of the affairs of the business
on the balance sheet, firms recognize these rights at the end of an accounting period by preparing an
adjusting entry to correct the account balances
...
We also call these adjustments accrued revenues
because the revenues must be recorded
...
Rarely is payment
of the interest made on the last day of the accounting period
...
The adjusting entry at the end of the
accounting period debits a receivable account (an asset) and credits a revenue account to record the
interest earned and the asset owned
...
On 2010
December 31, the money on deposit has earned one month’s interest of USD 600, althoug h the
p
...
An entry must show the amount of interest earned by 2010
December 31, as well as the amount of the asset, interest receivable (the right to receive this interest)
...


31 Interest Receivable

600

6—Interest

Interest Revenue

revenue accrued

To record one month's interest revenue
...
)
Increased by
$600

2010
Dec 31

Interest Receivable
Adjustment 6

(Cr
...
)

Interest

Revenue

(Cr
...
31 Adjustment 6 600
...
This asset accumulates gradually with the passage of time
...
Recall that in recording
revenue under accrual basis accounting, it does not matter whether the company collects the actual
cash during the year or not
...

Unbilled training fees A company may perform services for customers in one accounting period
while it bills for the services in a different accounting period
...
Since it takes time to do the paper work, MicroTrain will bill the client for the services in
January
...


31

Accounts Receivable (or Service Fees Receivable)
Service Revenue

1,000

1,000

To record unbilled training services performed in
December
...
163 of 433

After posting the adjusting entry, the T-accounts appear as follows:
(Dr
...


(Cr
...
31 Adjustment 7 1,000*_
Bal
...

(Dr
...
)

Bal
...
31 Adjustment
5—previously
unearned
revenue
...
31 Adjustment 7

1,000

Bal
...

Accrued liabilities are liabilities not yet recorded at the end of an accounting period
...
At the end of the accounting period, the company recognizes these obligations by preparing an
adjusting entry including both a liability and an expense
...

Salaries The recording of the payment of employee salaries usually involves a debit to an expense
account and a credit to Cash
...

MicroTrain Company paid USD 3,600 of salaries on Friday, 2010 December 28, to cover the first
four weeks of December
...


28 Salaries Expense
Cash

3,600
3,600

Paid training employee salaries for the first four weeks of
December
...
164 of 433

Assuming that the last day of December 2010 falls on a Monday, this expense account does not
show salaries earned by employees for the last day of the month
...
The T-accounts pertaining to salaries appear as follows
before adjustment:
(Dr
...

28

Salaries Expense
3,600

(Cr)

(Dr
...
28 Bal
...
For a five-day workweek,
daily salaries are USD 180
...


31 Salaries Expense

180

Salaries Payable

180

To accrue one day's salaries that were earned but not paid
...
)

2010
Dec
...

Dec
...
after adjustment

(Dr
...
31 Adjustment 8
Failure to Recognize

1
...
)
180
Effect on Net Income

Increased by
$180
Effect on Balance Sheet Items

Overstates net income

Overstates assets Overstates retained earnings

2
...


Accrual of assets

Understates net income

4
...
The credit to Salaries Payable records the USD 180
salary liability to employees
...


p
...
The debit would be to Interest Expense, and the credit would be to Interest Payable
...


4
...

You can see the effect of failing to record each of the major types of adjusting entries on net income and
balance sheet items in Exhibit 18
...
Later chapters explain
other examples of adjusting entries
...
9 Analyzing and using the financial results—trend percentages
It is sometimes more informative to express all the dollar amounts as a percentage of one of the
amounts in the base year rather than to look only at the dollar amount of the item in the financial
statements
...
The last column expresses these dollar
amounts as a percentage of the 2001 amount
...
609
1,995
2,333
2,681
2,740
3,056
3,526
4,430
5,377
6,295

100 %
125
155
181
208
212
237
273
343
416
488

p
...
The 2010 net income is over 4 times as much as the 2001 amount
...

In the first three chapters of this text, you have learned most of the steps of the accounting process
...


An accounting perspective: Uses of technology
The Internet sites of the Big-4 accounting firms are as follows:
Ernst & Young

http://www
...
com

Deloitte Touche Tohmatsu

http://www
...
com

KPMG

http://www
...
com

PricewaterhouseCoopers

http://www
...
com

You might want to visit these sites to learn more about a possible career in accounting
...
10 Understanding the learning objectives


The cash basis of accounting recognizes revenues when cash is received and recognizes

expenses when cash is paid out
...



The accrual basis is more generally accepted than the cash basis because it provides a better

matching of revenues and expenses
...



Adjusting entries reflect unrecorded economic activity that has taken place but has not yet

been recorded
...


Adjusting entries in this class normally involve moving data from asset and liability accounts to
expense and revenue accounts
...



Accrued items consist of adjusting entries relating to activity on which no data have been

previously recorded in the accounts
...
167 of 433

liabilities and the related revenues and expenses
...



This chapter illustrates entries for deferred items and accrued items
...




For a particular item such as sales or net income, select a base year and express all dollar

amounts in other years as a percentage of the base year dollar amount
...
10
...
An inventory count of the supplies actually on hand at December 31 totaled USD
2,400
...

The annual depreciation for the buildings is based on the cost shown in the Buildings account less
an estimated residual value of USD 10,000
...

The salaries expense of USD 124,000 does not include USD 6,000 of unpaid salaries earned since
the last payday
...

Delivery services of USD 600 were performed for a customer, but a bill has not yet been sent
...
Prepare the adjusting journal entries for December 31, assuming adjusting entries are prepared
only at year-end
...
Based on the adjusted balance shown in the Accumulated Depreciation—Buildings account, how
many years has Korman Company owned the building?

p
...
10
...
31

Supplies Expense

Post
...


Debit

Credit
3 6 0 0

Supplies on Hand

3 6 0 0

To record supplies expense ($6,000 - $2,400)
...

31

Depreciation Expense—Buildings

4 7 5 0

Accumulated Deprecation—Buildings

4 7 5 0

To record depreciation ($200,000 - $10,000 / 40 years)
...

31

Unearned Delivery Fees

1 0 0 0

Service Revenue

1 0 0 0

To record delivery fees earned
...


Eight years; computed as:
Total accumulated deprecation
USD 33,250+USD 4,750
=
Annual deprecation expense
USD 4,750

4
...
3

Key Terms

Accounting period A time period normally of one month, one quarter, or one year into which
an entity’s life is arbitrarily divided for financial reporting purposes
...
The accounting year may or may not
coincide with the calendar year
...
Recognizes expenses as incurred, whether or not
cash has been paid out
...
169 of 433

Accrued assets and liabilities Assets and liabilities that exist at the end of an accounting
period but have not yet been recorded; they represent rights to receive, or obligations to make,
payments that are not legally due at the balance sheet date
...

Accrued items Adjusting entries relating to activity on which no data have been previously
recorded in the accounts
...

Accrued revenues and expenses Other names for accrued assets and liabilities
...

Adjusting entries Journal entries made at the end of an accounting period to bring about a
proper matching of revenues and expenses; they reflect economic activity that has taken place
but has not yet been recorded
...

Book value For depreciable assets, book value equals cost less accumulated depreciation
...

Cash basis of accounting Recognizes revenues when cash is received and recognizes
expenses when cash is paid out
...

Deferred items Adjusting entries involving data previously recorded in the accounts
...
Examples are
prepaid expenses, depreciation, and unearned revenues
...

Depreciable asset A manufactured asset such as a building, machine, vehicle, or equipment
on which depreciation expense is recorded
...

Depreciation expense The amount of asset cost assigned as an expense to a particular time
period
...

Estimated useful life The estimated time periods that a company can make use of the asset
...
For example, a company may have an accounting, or fiscal, year that runs
from April 1 of one year to March 31 of the next
...

Prepaid expense An asset awaiting assignment to expense
...

Assets such as cash and accounts receivable are not prepaid expenses
...
The future services that assets
can render make assets “things of value” to a business
...

p
...

Since the revenue has not been earned, it is a liability, often called revenue received in advance
or advances by customers
...
10
...
10
...
1

Self-test
True-false

Indicate whether each of the following statements is true or false:
Every adjusting entry affects at least one income statement account and one balance sheet account
...

The accumulated depreciation account is an asset account that shows the amount of depreciation
for the current year only
...

If all of the adjusting entries are not made, the financial statements are incorrect
...
10
...

An insurance policy premium of USD 1,200 was paid on 2010 September 1, to cover a one-year
period from that date
...
Adjusting entries are prepared once a year, at
year-end
...
Prepaid insurance
Insurance expense
b
...
Prepaid insurance
Insurance expense
d
...
The actual amount of
supplies on hand at the end of the period was USD 400
...
Supplies expense
Supplies on hand
b
...
Supplies on hand
Supplies expense
d
...
171 of 433

A company purchased a truck for USD 20,000 on 2010 January 1
...
Adjusting entries are prepared only at
year-end
...
Deprecation expense – Trucks
Accumulated
b
...
Deprecation expense – Trucks
Accumulated deprecation – Trucks
d
...
A liability account was credited when the cash was received
...
The company prepares adjusting
entries at the end of each month because it prepares financial statements each month
...
Unearned subscription fees

6,000

Subscription fee revenue
b
...
Unearned subscription feeds

6,000
2,000
2,000
18,000

Subscription fee revenue
d
...

b
...

d
...
172 of 433

If USD 3,000 has been earned by a company’s workers since the last payday in an accounting
period, the necessary adjusting entry would be:
a
...

b
...

c
...

d
...

Now turn to “Answers to self test” at the back of the book to check your answers
...
10
...




Why are adjusting entries necessary? Why not treat every cash disbursement as an
expense and every cash receipt as a revenue when the cash changes hands?



“Adjusting entries would not be necessary if the ‘pure’ cash basis of accounting were
followed (assuming no mistakes were made in recording cash transactions as they
occurred)
...
It is the use of the accrual basis of accounting, where an effort is
made to match expenses incurred against the revenues they create, that makes adjusting
entries necessary
...




Give an example of a journal entry for each of the following:


Equal growth of an expense and a liability
...




Equal growth of an asset and a revenue
...


p
...
When an amount is paid for future rent
or insurance services, a firm that is using the cash basis debits an expense account while
a firm that is using the accrual basis debits an asset account
...
How would you determine the extent to which this account
needs adjustment?



Some assets are converted into expenses as they expire and some liabilities become
revenues as they are earned
...
Give examples of asset and liability accounts to which the statement
does not apply
...




What does the term accrued liability mean?



What is meant by the term service potential?



When assets are received before they are earned, what type of an account is credited? As
the amounts are earned, what type of account is credited?



What does the word accrued mean? Is there a conceptual difference between interest
payable and accrued interest payable?



Matching expenses incurred with revenues earned is more difficult than matching
expenses paid with revenues received
...
, in the
Annual report appendix
...
10
...

(b) Recognizes expenses as incurred
...

(d) Recognizes revenues when cash is received and recognizes expenses when incurred
...
174 of 433

The accrual basis of accounting:
(a) Recognizes revenues only when cash is received
...

(c) Recognizes expenses only when cash is paid out
...

Exercise B Select the correct response for each of the following multiple-choice questions:
The least common accounting period among the following is:
(a) One month
...

(c) Three months
...

The need for adjusting entries is based on:
(a) The matching principle
...

(c) The cash basis of accounting
...

Exercise C Select the correct response for each of the following multiple-choice questions:
Which of the following types of adjustments belongs to the deferred items class?
(a) Asset/revenue adjustments
...

(c) Asset/expense adjustments
...

Which of the following types of adjustments belongs to the accrued items class?
(a) Asset/expense adjustments
...

(c) Asset/liability adjustments
...


p
...

Exercise E Assume that rent of USD 12,000 was paid on 2010 September 1, to cover a one-year
period from that date
...
If financial statements are prepared only on
December 31 of each year, what adjusting entry is necessary on 2010 December 31, to bring the
accounts involved to their proper balances?
Exercise F At 2010 December 31, an adjusting entry was made as follows:
Rent Expense

1,500

Prepaid Rent

1,500

You know that the gross amount of rent paid was USD 4,500, which was to cover a one-year period
...
The opening date of the year to which the USD 4,500 of rent applies
...
The entry that was made on the date the rent was paid
...
Show how this
purchase would be recorded
...

Exercise H Assume that a company acquired a building on 2010 January 1, at a cost of USD
1,000,000
...
What adjusting entry is needed on 2010 December 31, to record the depreciation for the
entire year 2010?

p
...
, received a total of USD
120,000 as payment in advance for one-year subscriptions to a monthly magazine
...
By the end of the year, one-third of the magazines paid for in
advance had been delivered
...

Exercise J On 2010 April 15, Rialto Theater sold USD 90,000 in tickets for the summer musicals
to be performed (one per month) during June, July, and August
...
It was too
late to find another group qualified to perform the musicals
...
Show the
appropriate journal entries to be made on April 15, June 30, and July 20
...

Exercise K Guilty & Innocent, a law firm, performed legal services in late December 2010 for
clients
...
Give the adjusting
entry that is necessary on 2010 December 31, if financial statements are prepared at the end of each
month
...
By December 31, USD 300 of interest
had been incurred
...

Exercise M Convenient Mailing Services, Inc
...

The last payday in January is Friday, January 27
...
Financial statements are prepared monthly
...

Exercise N State the effect that each of the following independent situations would have on the
amount of annual net income reported for 2010 and 2011
...

b
...
The services are performed in 2011
...
177 of 433

Exercise O In the following table, indicate the effects of failing to recognize each of the indicated
adjustments by writing “O” for overstated and “U” for understated
...


Liabilities

Equity

Consumption of supplies on hand

3
...


Stockholders'

Net Income

Failure to Recognize

The earning of ticket revenue
received in advance

4
...


Salaries incurred by unpaid

Exercise P The following data regarding net income (loss) are for Perkins Parts, a medium-sized
automotive supplier, for the period 2004–2009
...


...


...


...


...


...


...


...


...


...


...


...


...


4
...
8

Problems

Problem A Among other items, the trial balance of Filmblaster, Inc
...
Of the prepaid insurance in the trial balance, USD 4,000 is for coverage during the months after
December 31 of the current year
...
The balance in the Prepaid Rent account is for a 12-month period that started October 1 of the
current year
...
USD 300 of interest has been earned but not received
...
178 of 433

d
...

Prepare the annual year-end adjusting journal entries at December 31
...
, has the following account balances, among others, in its trial
balance at December 31 of the current year:
Debits
Supplies on Hand
...


Credits

$3,720
7,200

Unearned Subscription Fees
...

Salaries Expense
...

 The balance in the Prepaid Rent account is for a one-year period starting October 1 of the

current year
...

 Since the last payday, the employees of the company have earned additional salaries in the

amount of USD 5,430
...
Prepare the year-end adjusting journal entries at December 31
...
Open ledger accounts for each of the accounts involved, enter the balances as shown in the trial
balance, post the adjusting journal entries, and calculate year-end balances
...
, adjusts and closes its books each December 31
...
Following are some of the
company’s account balances prior to adjustment on 2010 December 31:
HILLSIDE APARTMENTS, INC
...
179 of 433

The Prepaid Insurance account balance represents the remaining cost of a four-year insurance
policy dated 2011 June 30, having a total premium of USD 12,000
...

The building was originally acquired on 1994 January 1, at which time management estimated that
the building would last 40 years and have a residual value of USD 15,000
...

Interest earned but not collected on a savings account during the year amounts to USD 400
...

Prepare the annual year-end adjusting entries indicated by the additional data
...
, for calendar years
2010 and 2011 were USD 200,000 and USD 222,000, respectively
...
The Prepaid Insurance account was debited at the date of purchase
...
The Unearned Subscription Fees account was credited when the
payments were received
...

On 2011 January 12, salaries of USD 9,600 were paid to employees
...
One-third of the amount paid was earned by employees in December of 2010
...
In your answer, start with the reported net
income
...
When the
corrections are added to or deducted from the reported net income amounts, the result should be the
correct net income amounts
...
180 of 433

Correct expense in 2011

-1,200

Problem E Jupiter Publishing Company began operations on 2010 December 1
...
Consequently, the bookkeeper recorded all
cash receipts and disbursements for items relating to operations in revenue and expense accounts
...

Dec
...

3 Received USD 144,000 for magazine subscriptions to run for two years from this date
...

4 Paid for advertising to be run in a national periodical for six months (starting this month)
...

7 Purchased for cash an insurance policy to cover a two-year period beginning December

15,

USD 24,000
...

15 Received USD 216,000 cash for two-year subscriptions starting with the December issue
...
Beginning as of this date,
salaries will be paid on the 5th and 20th of each month for the preceding two-week period
...

23 Supplies purchased for cash, USD 21,600
...
)
27 Printing costs applicable equally to the next six issues beginning with the December issue
were paid in cash, USD 144,000
...

31 Unpaid salaries for the period December 16–31 amounted to USD 22,000
...

a
...

b
...
Where the
entry is the same as under the cash basis, merely indicate “same”
...


Ignore

explanations
...
181 of 433

4
...
9

Alternate problems

Alternate problem A The trial balance of Caribbean Vacation Tours, Inc
...

Prepaid Rent
...


Credits

$24,000
188,000

Accumulated Depreciation—Buildings
...


$31,600
200,000

The balance in the Prepaid Insurance account is the advance premium for one year from September
1 of the current year
...

Salaries incurred but not paid as of December 31 amount to USD 8,400
...

Prepare the annual year-end adjusting journal entries at December 31
...
, at December 31 of the current year are the following:

Supplies on hand
Prepaid insurance
Buildings
Accumulated deprecation and buildings

Debits
$10,000
6,000
168,000

Credits

$ 39,000

The inventory of supplies on hand at December 31 amounts to USD 3,000
...

Depreciation for the buildings is based on the cost shown in the Buildings account, less residual
value estimated at USD18,000
...

a
...

b
...

p
...
To get this location, the company rented a store larger than needed and
subleased (rented) a portion of the area to Max’s Restaurant
...
Salaries of employees amount to USD 300 per day and were last paid through Wednesday,
December 27
...
The store is closed Sundays
...
An analysis of the Camping Equipment account disclosed:
Balance, 2010 January 1
Addition, 2010 July 1
Balance, 2010 December 31, per trial balance

$128,000
48,000
$176,000

The company estimates that all equipment will last 20 years from the date they were acquired and
that the residual value will be zero
...
The store carries one combined insurance policy, which is taken out once a year effective August
1
...

d
...

e
...

f
...

Prepare the annual year-end entries required by the preceding statement of facts
...
183 of 433

Alternate problem D The reported net income amounts for Safety Waste Control Company were
2010, USD 200,000; and 2011, USD 230,000
...
A building was rented on 2010 April 1
...
Prepaid Rent was debited
...
The balance in the Office Supplies on Hand account on 2010 December 31, was USD 6,000
...
No new supplies were purchased during 2011
...

c
...

d
...
The USD 24,000 bill for these services
was not sent until January 2011
...

Calculate the correct net income for 2010 and 2011
...
Then show the effects of each correction (adjustment) using a plus or a minus to
indicate whether reported income should be increased or decreased as a result of the correction
...
The answer format should be as follows:
Explanation of Corrections

2010

2011

Reported net income
To correct error in accounting for:

$200,000

$230,000

Prepaid rent:
Correct expense in 2010
Correct expense in 2011

-5,400
-7,200

Alternate problem E On 2010 June 1, Richard Cross opened a swimming pool cleaning and
maintenance service, Cross Pool Company
...

At the end of June, he prepared an income statement for the month of June, but he had the feeling that
he had not proceeded correctly
...
John immediately noted that his brother had kept his records on a cash
basis
...
184 of 433

June 1 Received cash of USD 28,000 from various customers in exchange for service agreements to
clean and maintain their pools for June, July, August, and September
...
The payment covered the entire period
...

10 Received an advance of USD 9,000 from a Florida building contractor in exchange for an
agreement to help service pools in his housing development during October through May
...

17 Paid USD 900 for advertising to be run in a local newspaper for two weeks in June and four
weeks in July
...

26 Purchased USD 5,400 of supplies for cash
...
)
29 Billed various customers for services rendered, USD 16,000
...

30 Received a bill for USD 600 for gas and oil used in June
...
Prepare the entries for the transactions as Richard must have recorded them under the cash basis
of accounting
...
Prepare journal entries as they would have been prepared under the accrual basis
...
Where possible, record the original
transaction so that no adjusting entry would be necessary at the

end

of

the

month
...


4
...
10 Beyond the numbers—Critical thinking
Business decision case A You have just been hired by Top Executive Employment Agency, Inc
...
It becomes obvious to you that
management does not seem to have much of an understanding about the necessity or adjusting entries
or which accounts might possibly need adjustment
...
Only those ledger accounts that had end-of-year
balances are included in the trial balance
...
185 of 433

Debits
Cash
Accounts Receivable

28,000

Supplies on Hand

3,000

Prepaid Insurance

2,700

Office Equipment

Credits

$ 80,000

120,000

Accumulated Depreciation—Office Equipment
Buildings

$ 45,000
360,000

Accumulated Depreciation—Buildings

105,000

Accounts Payable

9,000

Loan Payable (Bank)

15,000

Unearned Commission Fees

30,000

Capital Stock

160,000

Retained Earnings

89,300

Commissions Revenue

270,000

Advertising Expense

6,000

Salaries Expense

112,500

Utilities Expense

7,500

Miscellaneous Expense

3,600
$723,300

$723,300

a
...

b
...

Business decision case B A friend of yours, Jack Andrews, is quite excited over the opportunity
he has to purchase the land and several miscellaneous assets of Drake Bowling Lanes Company for
USD 400,000
...
The annual rent on the building and equipment is USD 54,000
...
Andrews
believes an annual profit of USD 100,000 on an investment of USD 400,000 is a really good deal
...
You agree and discover the following:
Drake has computed his annual profit for 2010 as the sum of his cash dividends plus the increase in
the Cash account: Dividends of USD 60,000 + Increase in Cash account of USD 40,000 = USD
100,000 profit
...
The land was acquired at a cost of USD 624,000 seven years ago
...
186 of 433

Rental revenues received

$465,000

Cash paid out in 2010 for—
Salaries paid to employees

$260,000

Utilities paid

18,000

Advertising expenses paid

15,000

Supplies purchased and used

24,000

Interest paid on loan

18,000

Loan principal paid

30,000

Cash dividends
In crease in cash balance for the year

60,000

425,000
$ 40,000

You also find that the annual rent of USD 54,000, a December utility bill of USD 4,000, and an
advertising bill of USD 6,000 have not been paid
...
Prepare a written report for Andrews giving your appraisal of Drake Bowling Lanes Company as
an investment
...

b
...

Group project C In teams of two or three students, go to the library to locate one company’s
annual report for the most recent year
...
Calculate trend percentages for revenues, expenses, and profits using the oldest year as the base
year
...
The heading of the memorandum should contain the date, to whom it is
written, from whom, and the subject matter
...
106, “Accounting for Postretirement Benefits Other
Than Pensions”
...
Companies
had to record an expense and a liability to account for these costs on an accrual basis
...
Be sure to cite your sources and treat direct quotes properly
...
Generally accepted accounting principles do not allow “human assets” to

p
...
Why is this? Be sure to cite your sources and to treat
direct quotes properly
...
10
...
pwcglobal
...
Write a brief report to your instructor summarizing your findings
...
10
...
10
...
1 True-false
True
...

True
...
A
calendar year, however, must end on December 31, so it does not include fiscal years that end on any
date other than December 31 (such as June 30)
...
The accumulated depreciation account is a contra asset that shows the total of all
depreciation recorded on an asset from its acquisition date up through the balance sheet date
...
The Unearned Delivery Fees account is a liability
...

True
...


4
...
12
...
One-third of the benefits have expired
...

a
...

c
...
The debit is to Depreciation Expense—Trucks, and the credit is to Accumulated
Depreciation—Trucks, a contra asset account
...
188 of 433

b
...

b
...

a
...


p
...
1 Learning objectives
After studying this chapter, you should be able to:


Summarize the steps in the accounting cycle
...




Prepare an income statement, statement of retained earnings, and balance sheet using

information contained in the work sheet
...




Prepare a post-closing trial balance
...




Prepare a classified balance sheet
...


5
...
The information used by
businesses, as well as the technology that supports that information, represents some of the most
valuable assets for organizations around the world
...

As companies become ever more reliant on technology, the need for well-educated Management
Information Systems (MIS) auditors and control professionals increases
...
At the same time, companies face constant challenges in
selecting and implementing these new technologies
...

Graduates with special interests and skills in computing and technology have expansive
opportunities
...
In public accounting, technology has impacted the auditing profession by
p
...

With management consulting practices growing and information systems becoming a larger
percentage of public accounting revenue, MIS professionals are in high demand
...
A dual major in
accounting and MIS is one of the most desirable undergraduate degree combinations in the workforce
...
In addition, we briefly discuss the evolution of accounting systems and present a
classified balance sheet
...
After completing this chapter, you will understand how accounting begins with source
documents that are evidence of a business entity's transactions and ends with financial statements that
show the solvency and profitability of the entity
...
3 The accounting cycle summarized
In Chapter 1, you learned that when an event is a measurable business transaction, you need
adequate proof of this transaction
...
In Chapters 2 and 3, you performed other steps in
the accounting cycle
...
As a review, study the diagram of the eight steps in the accounting
cycle in Exhibit 19
...
The next section explains how to use the work sheet to facilitate the completion of
the accounting cycle
...
4 The work sheet
The work sheet is a columnar sheet of paper or a computer spreadsheet on which accountants
summarize information needed to make the adjusting and closing entries and to prepare the financial
statements
...
A work sheet
is only an accounting tool and not part of the formal accounting records
...
Other work sheets
are prepared on personal computers with spreadsheet software
...


p
...
Each set has a debit and a credit column
...
)
Accountants use these initial steps in preparing the work sheet
...

 Enter the titles and balances of ledger accounts in the Trial Balance columns
...

 Enter adjusted account balances in the Adjusted Trial Balance columns
...

 Extend any balances in the Retained Earnings and Dividends accounts to the Statement of

Retained Earnings columns
...

Instead of preparing a separate trial balance as we did in Chapter 2, accountants use the Trial
Balance columns on a work sheet
...
Usually, only those accounts
with balances as of the end of the accounting period are listed
...
) Assume you are MicroTrain's accountant
...
Next, you enter the balances of the ledger accounts in the Trial Balance
columns
...
Then, total the columns
...

As you learned in Chapter 3, adjustments bring the accounts to their proper balances before
accountants prepare the income statement, statement of retained earnings, and balance sheet
...
Also, you cross-reference the
debits and credits of the entries by placing a key number or letter to the left of the amounts
...
For example, the number (1) identifies the adjustment
debiting Insurance Expense and crediting Prepaid Insurance
...
192 of 433

the Insurance Expense account title is below the trial balance totals because the Insurance Expense
account did not have a balance before the adjustment and, therefore, did not appear in the trial
balance
...
Although these explanations are optional, they provide valuable information for those who
review the work sheet later
...

 Entry (2) records the expiration of USD 400 of prepaid rent in December
...

 Entry (4) records USD 750 depreciation expense on the trucks for the month
...


p
...

 Entry (6) records USD 600 of interest earned in December
...

 Entry (8) records the USD 180 accrual of salaries expense at the end of the month
...
The following steps are
helpful:
 Examine adjusting entries made at the end of the preceding accounting period
...

 Examine the account titles in the trial balance
...

 Examine various business documents (such as bills for services received or rendered) to

discover other assets, liabilities, revenues, and expenses that have not yet been recorded
...
For example: "Were any services performed during the month that have not yet been
billed?"

p
...


Statement of
Retained
Earnings

Trial Balance

Adjustments

Adjusted Trail
Balance

Income
Statement

No
...
195 of 433

(1) To record insurance expenses for December
...

(3) To record supplies expenses for December
...

(5) To transfer fees for service provided in December from the liability account to the revenue
account
...

(7) To record unbilled training services performed in December
...

After all the adjusting entries are entered in the Adjustments columns, total the two columns
...

After MicroTrain's adjustments, compute the adjusted balance of each account and enter these in
the Adjusted Trial Balance columns
...
107) had an
unadjusted balance of USD 1,400
...
This amount is a debit in the Adjusted Trial Balance columns
...
Note carefully
how the rules of debit and credit apply in determining whether an adjustment increases or decreases
the account balance
...
507) has a USD 3,600 debit balance
in the Trial Balance columns
...

Some account balances remain the same because no adjustments have affected them
...
200) does not change and is simply extended to the
Adjusted Trial Balance columns
...
The totals must be equal before
taking the next step in completing the work sheet
...
The Adjusted Trial Balance columns make the next step of sorting the amounts
to the Income Statement, the Statement of Retained Earnings, and the Balance Sheet columns much
easier
...
Since revenues carry credit balances, extend them
to the credit column
...
MicroTrain's
total expenses are USD 6,510 and total revenues are USD 13,800
...
196 of 433

USD 7,290 (USD 13,800—USD 6,510)
...
You would record a net loss in the opposite manner; expenses (debits)
would have been larger than revenues (credits) so a net loss would be entered in the credit column to
make the columns balance
...
Enter the USD 7,290 net income
amount for December in the credit Statement of Retained Earnings column
...
Net income appears in the Statement of Retained Earnings credit column
because it causes an increase in retained earnings
...
As a result, the ending
balance of the Retained Earnings account is USD 4,290
...
Extend asset amounts as debits and liability and capital stock amounts
as credits
...
The ending retained earnings amount
is a debit in the Statement of Retained Earnings columns to balance the Statement of Retained
Earnings columns
...
(Retained earnings
would have a debit ending balance only if cumulative losses and dividends exceed cumulative
earnings
...

When the Balance Sheet column totals do not agree on the first attempt, work backward through
the process used in preparing the work sheet
...
197 of 433

MICROTRAIN COMPANY
Income Statement
For the Month Ended 2010 December 31

Revenues:
Service Revenue

$13,200

Interest Revenue

600

Total Revenue

$13,800

Expenses:
Advertising Expense

$ 50

Gas and Oil Expense

680

Salaries Expense

3,780

Utilities Expense

150

Insurance Expense

200

Rent Expense

400

Supplies Expense

500

Depreciation Expense—Trucks

750

Total Expense

6,510

Net Income

$ 7,290

Exhibit 21: Income statement
 Re-total the two Balance Sheet columns to see if you made an error in addition
...

 Re-total the Statement of Retained Earnings columns and determine whether you entered the

correct amount of retained earnings in the appropriate Statement of Retained Earnings and
Balance Sheet columns
...


An accounting perspective: Uses of technology
Electronic spreadsheets have numerous applications in accounting
...
The blocks created by the intersection of the rows and columns are
cells; each cell can hold one or more words, a number, or the product of a
mathematical formula
...
The most popular spreadsheet program is Microsoft

p
...
Free spreadsheet programs are also available from companies such as Google
and Zoho
...
5 Preparing financial statements from the work sheet
When the work sheet is completed, all the necessary information to prepare the income statement,
statement of retained earnings, and balance sheet is readily available
...

The information you need to prepare the income statement in Exhibit 21 is in the work sheet's
Income Statement columns in Exhibit 20
...
Look at Exhibit 22, MicroTrain Company's
statement of retained earnings for the month ended 2010 December 31
...
310), add the net income (or deduct
the net loss), and then subtract the Dividends (Account No
...
Carry the ending Retained Earnings
balance forward to the balance sheet
...
It does this by indicating how net income
on the income statement relates to retained earnings on the balance sheet
...
199 of 433

MICROTRAIN COMPANY
Balance Sheet
2010 December 31
Assets

Cash
Accounts receivable
Supplies on hand
Prepaid insurance
Prepaid rent
Interest receivable
Trucks

$ 40,000

Less: Accumulated depredation 750
Total assets
Liabilities and Stockholders' Equity

$ 8,250
6,200
900
2,200
800
600
39,250
$ 58,200

Liabilities:
Accounts payable
Unearned service fees
Salaries payable
Total liabilities
Stockholders' equity:
Capital stock

$ 730
3,000
180
$ 3,910
$ 50,000

Retained earnings 4,290
Total stockholders' equity
Total liabilities and stockholders' equity

54,290
$ 58,200

Exhibit 23: Balance sheet
The information needed to prepare a balance sheet comes from the Balance Sheet columns of
MicroTrain's work sheet (Exhibit 20)
...
See the completed balance sheet for
MicroTrain in Exhibit 23
...
6 Journalizing adjusting entries
After completing MicroTrain's financial statements from the work sheet, you should enter the
adjusting entries in the general journal and post them to the appropriate ledger accounts
...
The preparation of a work sheet does not eliminate the need to prepare
and post adjusting entries because the work sheet is only an informal accounting tool and is not part of
the formal accounting records
...
The Adjustments columns show each entry with
its appropriate debit and credit
...
200 of 433

MICROTRAIN COMPANY
General Journal
Date

Account Titles and Explanation

2010
Dec
...
Debit
Ref
...

31

Rent Expense (-SE)

515

Prepaid Rent (-A)

4 0 0

112

4 0 0

To record rent expense for December
...

31

Depreciation Expense—Trucks (-SE)

521

Accumulated Depredation—Trucks (-A)

7 5 0

151

7 5 0

To record depreciation expense for December
...

31

Interest Receivable (+A)

121

Interest Revenue (+SE)

418

6 0 0
6 0 0

To record one month's interest revenue
...

31

Salaries Expense (-SE)

507

Salaries Payable (+L)

206

1 8 0
1 8 0

To accrue one day's salaries that were earned by are unpaid
...
7 The closing process
In Chapter 2, you learned that revenue, expense, and dividends accounts are nominal (temporary)
accounts that are merely subclassifications of a real (permanent) account, Retained Earnings
...
The closing process
transfers (1) the balances in the revenue and expense accounts to a clearing account called Income
p
...
The closing process reduces revenue, expense, and Dividends account balances to
zero so they are ready to receive data for the next accounting period
...

The Income Summary account is a clearing account used only at the end of an accounting
period to summarize revenues and expenses for the period
...
Closing or transferring the balance in the Income Summary account
to the Retained Earnings account results in a zero balance in Income Summary
...
We close the Dividends account directly to the
Retained Earnings account and not to Income Summary because dividends have no effect on income or
loss for the period
...
Remember that only
revenue, expense, and Dividend accounts are closed—not asset, liability, Capital Stock, or Retained
Earnings accounts
...

 Closing the expense accounts—transferring the balances in the expense accounts to a

clearing account called Income Summary
...

 Closing the Dividends account—transferring the balance of the Dividends account to the

Retained Earnings account
...
The two revenue
accounts in the Income Statement credit column for MicroTrain Company are service revenue of USD
13,200 and interest revenue of USD 600 (Exhibit 20)
...
When you
debit Service Revenue and Interest Revenue, credit Income Summary (Account No
...
Enter the
account numbers in the Posting Reference column when the journal entry has been posted to the
ledger
...


p
...


MICROTRAIN COMPANY
General Journal

Closing Entries

31

Page 4

Post
...


Service Revenue

400

1 3 2 0 0

Interest Revenue

418

6 0 0

Income Summary

600

Credit

1 3 8 0 0

To close the revenue accounts in the Income Statement credit
column to Income Summary
...
Note that the accounts now have zero balances
...
31

2010
Dec
...
400
Bal
...
after closing
Interest Revenue
Account No
...
before
closing
To close to
Income
Summary 600
Bal
...
)
13,200

—0—
(Cr
...

We show the Income Summary account in Step 3
...
MicroTrain Company
has eight expenses in the Income Statement debit column
...
Since expense accounts have debit balances, credit each account to
bring it to a zero balance
...
Thus, to close the expense accounts, MicroTrain makes the following entry:

p
...


Account Titles and Explanation

31 Income Summary

Post
...

600

Debit

Credit

6 5 1 0

Advertising Expense

505

5 0

Gas and Oil Expense

506

6 8 0

Salaries Expense

507

3 7 8 0

Utilities Expense

511

1 5 0

Insurance Expense

512

2 0 0

Rent Expense

515

4 0 0

Supplies Expense

518

5 0 0

Depreciation Expense—Trucks

521

7 5 0

To close the expense accounts appearing in the Income

The debit of USD 6,510 to the Income Summary account agrees with the Income Statement debit
column subtotal in the work sheet
...
If the debit in the preceding entry was made
for a different amount than the column subtotal, the company would have an error in the closing entry
for expenses
...
Note that each
account has a zero balance after closing
...
204 of 433

(Dr)

Bal
...
505

■ 50

Summary
Bal
...
)

Bal
...
)

2010 ■ ■
Dec
...
506

680

(Cr
...
31 To close to
Income
Summary
680

Bal
...
)

Bal
...
)

Bal
...
507

3,780

(Cr
...
31 To close to
Income

3,780

(Dr
...
before
closing

Decreased
by $3,780

—0—
Utilities Expense
Account No
...
)

2010
Dec
...
after
closing

Decreased
by $680

—0—

Summary
Bal
...
512

200

(Cr
...
31 To close to
Income
Summary
200

Decreased
by $200

p
...
after
closing
(Dr
...
before
closing

—0—
Rent Expense
Account No
...
)

2010
Dec
...
after
closing
(Dr
...
before
closing

—0—
Supplies Expense
Account No
...
)

2010
Dec
...
after
closing

■ 750'

(Cr
...
31 To close to
Income
Summary
750

Bal
...
)
Account No
...
before
closing

Decreased
by $400

Decreased
by $750

—0—

The expense accounts could be closed before the revenue accounts; the end result is the same
...


If total expenses exceed
total revenues,
the account has a debit
balance, which is the net
loss for the period

Income Summary
Total expenses
Total revenues
w

If total revenues exceed
total expenses,
the account has a credit
balance, which is the net
income for the period
...


p
...
31 the expense
accounts
(Dr)

(Cr
...
31 From closing
the revenue
accounts
Bal
...
The journal
entry to do this is:
MICROTRAIN COMPANY
General Journal

Date
2010 Dec
...
Ref
...


After its Income Summary account is closed, the company's Income Summary and Retained
Earnings accounts appear as follows:
Income Summary
(Dr
...
600

2010
Dec
...
31 To close this
account to Retain ed
Earnings

(Cr
...
31 From
closing
The revenue
accounts
Bal
...
after closing

—0—

Retained Earnings
(Dr)

Account No
...
)

Bal
...
31 From Income
Summary

7,290

Decreased by
$7,290

The last closing entry closes MicroTrain's Dividends account
...
To close the account, credit the Dividends account and debit the Retained Earnings
account
...
207 of 433

does not enter into income determination
...


Account Titles and Explanation
31 Retained Earnings (-SE)

Page 4

Post
...
Debit
310
3 0 0 0

Dividends (+SE)

Credit

320

3 0 0 0

To close the Dividends account to the Retained Earnings
account
...
)

Account No
...
)

Bal
...
31 To close to
Retained
Earning

3000

Decreased
by $3,000
Bal
...
)

2010

Account No
...
)

Dec
...
before closing
process -02010
Dec
...
after closing
process is complete 4,290

After you have completed the closing process, the only accounts in the general ledger that have not
been closed are the permanent balance sheet accounts
...
The
preparation of a post-closing trial balance serves as a check on the accuracy of the closing process and
ensures that the books are in balance at the start of the new accounting period
...


p
...

The only accounts that should be open are assets, liabilities, capital stock, and Retained Earnings
accounts
...

Look at Exhibit 24, a post-closing trial balance for MicroTrain Company as of 2010 December 31
...

The next section briefly describes the evolution of accounting systems from the one-journal, oneledger manual system you have been studying to computerized systems
...


An accounting perspective: Uses of technology
If you are studying in the US, you may want to visit the American Institute of Certified
Public Accountants website at: http://www
...
org
You will find information about the CPA exam, about becoming a CPA, hot accounting
topics, and various other topics, such as the US states that have passed a 150-hour
requirement to sit for the CPA exam
...
These forms of organization serve to place limits on accountants' liability
...
Browse around this site to investigate
anything else that is of interest
...


5
...
Gradually, some manual systems
evolved to include multiple journals and ledgers for increased efficiency
...
Still recorded in the general journal are adjusting
and closing entries and any other entries that do not fit in one of the special journals
...
209 of 433

payable showing how much each customer owes and how much is owed to each supplier
...

Another innovation in manual systems was the "one write" or pegboard system
...
These systems permit the writing of a check and the simultaneous recording of the
check in the cash disbursements journal
...

During the 1950s, companies also used bookkeeping machines to supplement manual systems
...
They posted transactions to
the general ledger and subsidiary ledger accounts and computed new balances
...
They were quite expensive, and computers
easily outperformed them
...

Early accounting applications were in payroll, accounts receivable, accounts payable, and inventory
...
Until the 1980s, small
and medium-sized companies either continued with a manual system, rented time on another
company's computer, or hired a service bureau to perform at least some accounting functions
...

No
...
210 of 433

Exhibit 24: Post closing trial balance

An accounting perspective: Business insight
Imagine a company with an Accounts Receivable account and an Accounts Payable
account in its general ledger and no Accounts Receivable Subsidiary Ledger or
Accounts Payable Subsidiary Ledger
...

Here is how the general ledger and subsidiary ledgers might look:
Subsidiary
Accounts
Receivable
Ledger
JOHN JONES
200 1
SYLVIA SMITH
300

1

General Ledger

Subsidiary Accounts
Payable Ledger

ACCOUNTS RECEIVABLE

BELL CORPORATION

900

100

ACCOUNTS PAYABLE

600

GRANGER CORPORATION
1,000

JAMES WELLS
400

1

WONG CORPORATION
300

When a sale on account is made to John Jones, the debit is posted to both the control
account, Accounts Receivable, in the General Ledger and the subsidiary account, John
Jones, in the Subsidiary Accounts Receivable Ledger
...
At the end of the accounting
period, the balances in each of the control accounts in the General Ledger must agree
with the totals of the accounts in their respective subsidiary ledgers as shown above
...


A broader perspective: Skills for the long haul

p
...
But you can not help wondering if you have the right
skills both for short and long-term success in public accounting
...
But it is important for
the beginner to realize that different skills are emphasized at different points in a
public accountant's career
...

Staff accountant—Enthusiastic learner
Let us travel with Tracy as she begins her career at the staff level
...
Her duties include
documenting work papers, interacting with client accounting staff, clerical tasks and
discussing questions that arise with her senior
...
She will be
introduced to various industries and accounting systems
...

Senior accountant—Organizer and teacher
As a senior accountant, Tracy will be responsible for the day-to-day management of
several audit engagements during the year
...
She will also
perform much of the final wrap-up work, such as preparing checklists, writing the
management letter and reviewing or drafting the financial statements
...

The two most critical skills needed at the senior level are (1) the ability to organize and
control an audit and (2) the ability to teach staff accountants how to audit
...
212 of 433

Upon promotion to manager, Tracy will begin the transformation from auditor to
executive
...
She will handle many important client
meetings and closing conferences
...
Finally, outside of her client service and administrative duties,
Tracy will be evaluated to a large extent on her community involvement and ability to
assist the partners in generating new business for the firm
...

Partner—Leader and expert
As a partner in the firm, Tracy will have many broad responsibilities
...
Besides serving as the engagement
partner on several audits, she will have ultimate responsibility for the quality of service
provided to each of her clients
...
She
will be expected to serve as a positive example to those who work for her and will train
others in her areas of expertise
...

In the meantime
Those planning on a public accounting career should do more than just learn
accounting
...
It is never too early to start
building the skills for long-term success
...
Hermanson and Heather M
...
24-26, © 1990, New DuBois Corporation
...
The number and
p
...
Soon small
and medium-sized businesses could maintain all accounting functions on a PC
...
However, some small business owners
still use manual systems because they are familiar and meet their needs, and the persons keeping the
records may not be computer literate
...
The computer automatically
performs some of the steps in the accounting cycle, such as posting journal entries to the ledger
accounts, closing the books, and preparing the financial statements
...


An accounting perspective: The impact of technology
Results from a recent survey of 1,400 chief financial officers (CFOs) indicate that
tomorrow's accounting professionals will be called upon to bridge the gap between
technology and business
...


As we show in Exhibit 25, an accounting system is a set of records and the procedures and
equipment used to perform the accounting functions
...
Computerized accounting systems consist of accounting software, computer files, computers,
and related peripheral equipment such as printers
...
Both internal and external users tell
accountants their information needs
...
As internal and external users make
decisions that become economic events, the cycle of information, decisions, and economic events
begins again
...
214 of 433

The primary focus of the first four chapters has been on how you can use an accounting system to
prepare financial statements
...
Later chapters also show how to prepare information and how that information helps users
to make informed decisions
...
These users
understand not only the limitations of the information but also its relevance for decision making
...
One example of this analysis is the current ratio and its use in
analyzing the short-term debt-paying ability of a company
...
For instance, general journal entries
are made in the general ledger module, and this module contains all of the company's
accounts
...
215 of 433

purchases from suppliers and payments made to those suppliers
...


5
...
As shown in Exhibit
23, an unclassified balance sheet has three major categories: assets, liabilities, and stockholders'
equity
...

Exhibit 26, shows a slightly revised classified balance sheet for The Home Depot, Inc
...
1 Note that The Home Depot classified balance sheet is in a vertical format (assets
appearing above liabilities and stockholders' equity) rather than the horizontal format (assets on the
left and liabilities and stockholders' equity on the right)
...

The Home Depot classified balance sheet subdivides two of its three major categories
...
The company subdivides its liabilities into current liabilities and long-term liabilities
(including deferred income taxes)
...
Stockholders' equity is
the same in a classified balance sheet as in an unclassified balance sheet
...

We discuss the individual items in the classified balance sheet later in the text
...
Some of these items are not
in The Home Depot's balance sheet
...
The company has more than 1,000 full-service warehouse
stores
...

p
...
AND SUBSIDIARIES
Consolidated Balance Sheet
2001 January 28
(amounts in millions, except share data)

January 28,
2001
Assets
Current Assets:
Cash and Cash Equivalents

$

167

Short-Term Investments, including current maturities of long-term investments

10

Receivables, net

835

Merchandise Inventories

6,556

Other Current Assets

209

Total Current Assets

$

7,777

Property and Equipment, at cost:
Land

$

4,230

Buildings

6,167

Furniture, Fixtures and Equipment

2,877

Leasehold Improvements

665

Construction in Progress

1,032

Capital Leases

261
$

Less: Accumulated Depreciation and Amortization
Net Property and Equipment

15,232
2,164

$

13,068

Long-Term Investments

15

Notes Receivable

77

Cost in Excess of Fair Value of Net Assets Acquired, net of accumulated amortization
of $41 at January 25, 2001 and $33 at January 30, 2000

314

Other

134

Total assets

13,608
$

21,385

Liabilities and Stockholders' Equity
Current Liabilities:
Accounts Payable

$

1,976

Accrued Salaries and Related Expenses

627

Sales Taxes Payable

298

Other Accrued Expenses

1,402

Income Taxes Payable

78

Current Installments of Long-Term Debt

4

Total Current Liabilities
Long-Term Debt, excluding current installments

$4,385
$

1,545

Other Long-Term Liabilities

245

Deferred Income Taxes

195

Minority Interest

1,985
11

Stockholders' equity:

p
...
05
...
An operating cycle is
the time it takes to start with cash, buy necessary items to produce revenues (such as materials,
supplies, labor, and/or finished goods), sell services or goods, and receive cash by collecting the
resulting receivables
...
Companies in some manufacturing industries, such as distilling
and lumber, have operating cycles longer than one year
...
Common current assets in a service business include cash, marketable securities, accounts
receivable, notes receivable, interest receivable, and prepaid expenses
...

Cash includes deposits in banks available for current operations at the balance sheet date plus cash
on hand consisting of currency, undeposited checks, drafts, and money orders
...
The term cash normally includes cash equivalents
...
Examples are Treasury bills, short-term notes
maturing within 90 days, certificates of deposit, and money market funds
...
Such investments do not qualify as cash equivalents
...

Accounts receivable (also called trade accounts receivable) are amounts owed to a business by
customers
...
Customers normally provide no written evidence of indebtedness on sales invoices or delivery

p
...
Notice the term net in the balance sheet of The Home Depot (Exhibit
26)
...
In the balance sheet, the accounts receivable amount is the sum of the individual accounts
receivable from customers shown in a subsidiary ledger or file
...
Chapter 6 begins our discussion of
merchandise inventories
...
A note receivable appears on the balance sheet of the company to which the note is
given
...
Chapter 9 discusses notes at length
...
Interest receivable
arises when a company has earned but not collected interest by the balance sheet date
...
Prepaid expenses include rent, insurance, and supplies that have been
paid for but all the benefits have not yet been realized (or consumed) from these expenses
...

Furthermore, prepaid expenses are considered assets because they have service potential
...

Examples include property, plant, and equipment; long-term investments; and intangible assets
...
(These assets are called property and
equipment in The Home Depot's balance sheet
...
To agree with the order in the heading, balance sheets generally list
property first, plant next, and equipment last
...
We describe several types of property, plant, and equipment next
...
Land
owned for investment is not a plant asset because it is a long-term investment
...
Again, the buildings that a
company owns as investments are not plant assets
...

Office equipment includes computers, copiers, FAX machines, and phone answering machines
...
219 of 433

Leasehold improvements are any physical alterations made by the lessee to the leased property
when these benefits are expected to last beyond the current accounting period
...
(The lessee is the one obtaining the rights to possess
and use the property
...

Accumulated depreciation is a contra asset account to depreciable assets such as buildings,
machinery, and equipment
...

On the balance sheet, companies deduct the accumulated depreciation (as a contra asset) from its
related asset
...
The long-term
investment classification in the balance sheet does not include those securities purchased for shortterm purposes
...
Occasionally, long-term investments include funds accumulated for specific purposes,
rental properties, and plant sites for future use
...
Companies must charge the costs of intangible assets to expense over the period
benefited
...
Other intangible assets include leaseholds and goodwill
...

A copyright granted by the federal government gives the owner the exclusive privilege of
publishing written material for a specified time
...

Goodwill is an intangible value attached to a business, evidenced by the ability to earn larger net
income per dollar of investment than that earned by competitors in the same industry
...
Normally, companies record goodwill only
at the time of purchase and then only at the price paid for it
...

Accumulated amortization is a contra asset account to intangible assets
...

p
...
The
payment of current liabilities normally requires the use of current assets
...

Examples of current liabilities follow
...

Accounts payable are generally due in 30 or 60 days and do not bear interest
...

Notes payable are unconditional written promises by the company to pay a specific sum of money
at a certain future date
...
Generally, only notes payable
due in one year or less are included as current liabilities
...
The company has not
paid these salaries by the balance sheet date because they are not due until later
...

Other accrued expenses might include taxes withheld from employees, income taxes payable, and
interest payable
...
The company plans to pay these
amounts to the proper governmental agencies within a short period
...
Interest payable is
interest that the company has accumulated on notes or bonds but has not paid by the balance sheet
date because it is not due until later
...
Since the corporation has not paid these declared dividends by the balance
sheet date, they are a liability
...
These
unearned revenues represent a liability to perform the agreed services or other contractual
requirements or to return the assets received
...
The remaining portion continues to be reported as a long-term liability
...
221 of 433

Long-term liabilities are debts such as a mortgage payable and bonds payable that are not due
for more than one year
...
Normally, the liabilities with the earliest due dates are listed first
...

Bonds payable are long-term liabilities and are evidenced by formal printed certificates
sometimes secured by liens (claims) on property, such as mortgages
...

The deferred income taxes on The Home Depot's balance sheet result from a difference between
income tax expense in the accounting records and the income tax payable on the company's tax return
...
This interest is equal to the
amount contributed plus the income left in the business
...
Paid-in capital shows the capital paid into the
company as the owners' investment
...
Cumulative translation
adjustments result from translating foreign currencies into US dollars (a topic discussed in advanced
accounting courses)
...

The next section shows how two categories on the classified balance sheet relate to each other
...


5
...
To find the current
ratio, we divide current assets by current liabilities
...

Thus,
its
current
ratio
was:
Current liabilities
USD 7,777,000,000
=1
...
77:1 for The Home Depot means that it has almost twice as many current
assets as current liabilities
...

In evaluating a company's short-term debt-paying ability, you should also examine the quality of
the current assets
...
222 of 433

and unsalable inventory, even a 2:1 current ratio may be inadequate to allow the company to pay its
current liabilities
...

The current assets, current liabilities, and current ratios of some other companies as of the third
quarter of 2001 were:
Current
Company
Wal-Mart Stores, Inc
...
99:1
1
...
31:1
1
...
54:1

We described each of these companies earlier in the text
...
An old rule of thumb is
that the current ratio should be at least 2:1
...
For instance, companies in the airline industry are able to
generate huge amounts of cash on a daily basis and may be able to pay their current liabilities even if
their current ratio is less than 1:1
...
A
company with the lowest current ratio in its industry may be unable to pay its short-term obligations
on a timely basis, unless it can borrow funds from a bank on a line of credit
...

The next chapter describes the assumptions, concepts, and principles that constitute the accounting
theory underlying financial accounting
...


5
...

 Journalize transactions in the journal
...

 Prepare a trial balance of the accounts and complete the work sheet
...

 Journalize and post adjusting entries
...

 Prepare a post-closing trial balance
...
223 of 433

 The work sheet is a columnar sheet of paper on which accountants summarize information

needed to make the adjusting and closing entries and to prepare the financial statements
...
The work sheet illustrated in the chapter has 12 columns—

two each for trial balance, adjustments, adjusted trial balance, income statement, statement of
retained earnings, and balance sheet
...
Net income for the period is the amount needed to balance the two
Income Statement columns in the work sheet
...
The ending Retained Earnings balance is carried
forward to the balance sheet
...

 As explained in Chapter 3, adjusting entries are necessary to bring the accounts to their

proper balances before preparing the financial statements
...

 Revenue accounts are closed by debiting them and crediting the Income Summary account
...

 The balance in the Income Summary account represents the net income or net loss for the

period
...

 To close the Dividends account, the balance is transferred to the Retained Earnings account
...

 All revenue, expense, and Dividends accounts have zero balances and are not included in the

post-closing trial balance
...

 The ease of accounting with a PC has encouraged even small companies to convert to

computerized systems
...
For instance,

a classified balance sheet subdivides assets into current assets; long-term investments;
property, plant, and equipment; and intangible assets
...
224 of 433

liabilities and long-term liabilities
...

 The current ratio gives some indication of the short-term debt-paying ability of a company
...


5
...
1

Demonstration problem

This problem involves using a work sheet for Green Hills Riding Stable, Incorporated, for the
month ended 2010 July 31, and performing the closing process
...

No
...
Accrued salaries on July 31 are USD 300
...
Prepare a 12-column work sheet for the month ended 2010 July 31
...
Journalize the adjusting entries
...
Journalize the closing entries
...
11
...
See the work sheet below
...
225 of 433

GREEN HILLS RIDING STABLE, INCORPORATE
Work Sheet
For the Month Ended 2010 July 31
Acct
...


Trial Balance

Debit Credit

Debit

Debit

Cash
Accounts Receivable
Land
Buildings
Accounts Payable
Notes Payable
Capital Stock
Retained Earnings
2010 July 1
Dividends
Horse Boarding Fees
Revenue
Riding and Lesson
Fees Revenue
Salaries Expense

10,700
S,100
40,000
24,000

513
540
563

Feed Expense
Interest Expense
Miscellaneous
Expense

1,100
200
300

520

Depreciation Expense
—Buildings
Accumulated
DepreciationBuildings

Credit

320
402
404
507

141

206

1,000

10,700
3,100
40,000
24,000

1,100
40,000
35,000
3,100

Credit

1,100
40,0 0 0
35,000
3,100

Debit

Credit

1,100
40,000
35,000

3,100
1,000

4,500

4,500

3,600

3,500

Balance Sheet

10,700
8,100
40,000
24,000

1,000

4,500

1,400

Credit

Statement of
Retained
Earnings
Debit
Credit

3,600

(2)
300

1,700

1,700

1,100
200
SOO

1,100
200
SOO

(1)
200

200

200

87,300 37,300

Salaries Payable
EOO
Net Income
Retained Earnings,
2010 July 31

(1)
200
(2)
300
5oo

200
300
87,500

200
300

37,300
4,000
4,100
8,100

8,100
8,100

1,000
6,200
7,200

4,100
7,200
7,200

82,300 76,600
6,200
S2,S00 32,800

Adjustments:
(i)
To record depreciation of
building for July
...


b
...
226 of 433

GREEN HILLS RIDING STABLE, INCORPORATED

Page

General Journal

4
Date

Account Titles and
Explanation

Post
...


Adjusting Entries
201
0
July 3 Depredation Expense—
520
1 Buildings (-SE)
Accumulated Depreciation— 141
Buildings (-A)
To record depreciation
expense
...


c
...
Debt

Credit

Ref
...

31 Income Summary

600

4 0 0 0

Salaries Expense

507

1 7 0 0

Feed Expense

513

1 1 0 0

Interest Expense

540

2 0 0

Miscellaneous Expense

568

8 0 0

Depreciation Expense—Buildings

520

2 0 0

To close expense accounts
...

31 Retained Earnings
Dividends

310
320

1 0 0 0
1 0 0 0

To close dividends account
...
227 of 433

5
...
3

Key terms*

Accounting cycle Series of steps performed during the accounting period to analyze, record,
classify, summarize, and report useful financial information for the purpose of preparing
financial statements
...

Accounting system A set of records and the procedures and equipment used to perform
accounting functions
...

Accounts receivable Amounts due from customers for services performed or merchandise
sold on credit
...

Accumulated depreciation A contra account to depreciable assets such as buildings,
machinery, and equipment
...

Buildings Structures used to carry on the business
...

Cash equivalents Highly liquid, short-term investments acquired with temporarily idle cash
...
Assets may be divided into current assets; long-term investments; property, plant,
and equipment; and intangible assets
...

Closing process The act of transferring the balances in the revenue and expense accounts to a
clearing account called Income Summary and then to the Retained Earnings account
...

Construction in progress Represents the partially completed stores or other buildings that a
company plans to occupy when completed
...

Current assets Cash and other assets that a business can convert into cash or use up in one
year or one operating cycle, whichever is longer
...
The
payment of current liabilities normally requires the use of current assets
...

Dividends payable Amounts declared payable to stockholders and that represent a
distribution of income
...

Income Summary account A clearing account used only at the end of an accounting period
to summarize revenues and expenses for the period
...
228 of 433

Income taxes payable Are the taxes payable to the state and federal governments by a
corporation based on its income
...

Interest payable Interest that has accumulated on debts, such as notes or bonds
...

Interest receivable Arises when interest has been earned but not collected at the balance
sheet date
...
Land could include ground on which
the company locates its business buildings and that used for outside storage space or a parking
lot
...

Leaseholds Rights to use rented properties
...

Examples include long-term investments; property, plant, and equipment; and intangible assets
...

Long-term liabilities Debts such as a mortgage payable and bonds payable that are not due
for more than one year
...

Merchandise inventory Goods held for sale
...

Notes payable Unconditional written promises by a company to pay a specific sum of money at
a certain future date
...

Office furniture Includes file cabinets, desks, chairs, and shelves
...

Paid-in capital Shows the capital paid into the company as the owners' investment
...

Post-closing trial balance A trial balance taken after the closing entries have been posted
...
Items such as rent, insurance, and
supplies that have been paid for but from which all of the benefits have not yet been realized (or
consumed)
...

Property, plant, and equipment Assets with useful lives of more than one year that a
company acquired for use in a business rather than for resale; also called plant assets or fixed
assets
...
229 of 433

Retained earnings Shows the cumulative income of the company less the amounts distributed
to the owners in the form of dividends
...

Sales taxes payable Are taxes a company has collected from customers but has not remitted to
the taxing authority, usually the state
...

Taxes withheld from employees Items such as federal income taxes, state income taxes, and
social security taxes withheld from employees' paychecks
...

Unearned revenues (revenues received in advance) Result when payment is received for
goods or services before revenue has been earned
...

*Some of these terms have been defined in earlier chapters but are included here for your
convenience
...
11
...
11
...
1

Self-test
True-false

Indicate whether each of the following statements is true or false
...


•

The amounts in the Adjustments columns are always added to the amounts in the Trial
Balance columns to determine the amounts in the Adjusted Trial Balance columns
...


•

After the closing process is complete, no balance can exist in any revenue, expense,
Dividends, or Income Summary account
...


•

All accounting systems currently in use are computerized
...
11
...
2

Multiple-choice

Select the best answer for each of the following questions
...


o

Land
...


p
...


o
•

If the Balance Sheet columns do not balance, the error is most likely to exist in the:
o
o

General ledger
...


o
•

General journal
...


Net income for a period appears in all but which one of the following?
o
o

Statement of Retained Earnings credit column of the work sheet
...


o
•

Income Statement debit column of the work sheet
...


Which of the following statements is false regarding the closing process?
o
o

The closing of expense accounts results in a debit to Income Summary
...


o
•

The Dividends account is closed to Income Summary
...


Which of the following statements is true regarding the classified balance sheet?
o

Current assets include cash, accounts receivable, and equipment
...


o

Current liabilities include accounts payable, salaries payable, and notes receivable
...


Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
11
...
3

Questions



At which stage of the accounting cycle is a work sheet usually prepared?



Why are the financial statements prepared before the adjusting and closing entries are
journalized and posted?



Describe the purposes for which the work sheet is prepared
...
At
the end of the first accounting period, you have partially completed the work sheet by
entering the proper ledger accounts and balances in the Trial Balance columns
...
231 of 433

the adjusting entries?" The manager indicates there is no such list
...
) How would you
obtain the information for this real-life situation? What are the consequences of not
making all of the required adjustments at the end of the accounting period?


How are the amounts in the Adjusted Trial Balance columns of a work sheet
determined?



The work sheet for Bridges Company shows net income of USD 40,000
...




Depreciation of building, USD 10,000
...


Salaries accrued, USD 3,000
...
In which columns of the work
sheet would net income appear?



Is it possible to prepare monthly financial statements without journalizing and posting
adjusting and closing entries? How?



What is the purpose of a post-closing trial balance?



Describe some of the ways in which the manual accounting system has evolved
...




How is a classified balance sheet different than an unclassified balance sheet?



Real world question Refer to "A broader perspective: Skills for the long haul" to
answer the following true-false questions:


The same skills are needed at each level in a CPA firm
...

p
...




Partners become increasingly involved in technical matters and have less and less
interaction with people
...




Real world question Referring to the Annual report appendix in your text, identify
the classifications (or categories) of liabilities used by The Limited in its balance sheet
...
11
...
4

Exercises

Exercise A List the steps in the accounting cycle
...
Determine under which major column headings each of the following
items would appear and whether it would be a debit or credit
...
)

a
...

c
...

e
...

g
...


Account Titles
Accounts Receivable
Accounts Payable
Interest Revenue
Advertising Expense
Capital Stock
Retained Earnings (Beg
...
Illustrate how these would appear in the Statement of Retained Earnings
columns and Balance Sheet columns in the work sheet
...


p
...
He
calculated the net income to be USD 50,000
...
What was the probable cause of this
difference? If this was not the cause, what should he do to find the error?
Exercise F The Trial Balance of the Printer Repair Company at 2010 December 31, contains the
following account balances listed in alphabetical order to increase your skill in sorting amounts to the
proper work sheet columns
...
Arrange the accounts in their approximate usual order
...

 The balance in the Prepaid Insurance account represents the cost of a two-year insurance

policy covering the period from 2010 January 1, through 2011 December 31
...


No salvage values are anticipated
...
For the year 2010, net income was USD 50,000 and dividends declared and paid were
USD 24,000
...

Exercise H Rubino Company reported net income of USD 100,000 for the current year
...
234 of 433

 Accrued salaries were USD 6,000 at December 31
...


Based on this information, (a) what adjusting journal entries should have been made at December
31, and (b) what is the correct net income?
Exercise I Refer to the work sheet prepared in the Printer Repair Company exercise
...

Exercise J The Income Statement column totals on a work sheet prepared at 2010 December 31,
are debit, USD 500,000; and credit, USD 900,000
...
Identify what each posting
represents
...
00

Rental revenue

960000

Salaries expense

$336,000
...

(You do not need to show the closing journal entries
...
Key the postings from the first closing entry with the number (1), the second with the number
(2), and so on
...
235 of 433

Exercise L The following account balances appeared in the Income Statement columns of the work
sheet entries prepared for Liu Company for the year ended 2010 December 31:
Account Titles

Income Statement
Debit
Credit

Service Revenue

330,000

Advertising Expense

1,350

Salaries Expense

130,000

Utilities Expense

2,250

Insurance Expense

900

Rent Expense

6,750

Supplies Expense

2,250

Depreciation Expense—Equipment

4,500

Interest Expense

562

Interest Revenue

1,125
148,552

Net Income

331,125

182,553
331,125

331,125

Prepare the closing journal entries
...
236 of 433

Exercise N Using the legend at the right, determine the category (number) into which you would
place each of these items
...

b
...

d
...

f
...

h
...


Land
...

Notes payable, due in three years
...

Patents
...

Unearned subscription fees
...

Notes payable, due in six months
...


1
...

3
...

5
...

7
...

Long-term investments
...

Intangible assets
...

Long-term liabilities
...


Accumulated depreciation
...
This company markets a broad range of laundry, cleaning, paper, beauty care,
health care, food, and beverage products in more than 140 countries around the world
...
The dollar amounts are in
millions
...
Comment on whether the trend is favorable or
unfavorable
...
237 of 433

5
...
4
...


p
...
, follows:
DENVER ARCHITECTS, INC
...
Prepare an income statement
...
Prepare a statement of retained earnings
...
Prepare a classified balance sheet
...
Prepare the closing journal entries
...
Show the post-closing trial balance assuming you had posted the closing entries to the general
ledger
...
239 of 433

Problem C The following trial balance and additional data are for Sure Sale Reality Company
SURE SALE REALTY COMPANY
Trial Balance
2010 December 31
Debits

Cash
Accounts Receivable

117,120

Prepaid Rent

46,080

Equipment

Credits

$ 62,800

173,760

Accumulated Depreciation—Equipment

$ 21,120

Accounts Payable

62,400

Capital Stock

96,000

Retained Earnings, 2010 January 1
Dividends

49,920
46,080

Commissions Revenue

653,200

Salaries Expense

321,600

Travel Expense

96,480

Miscellaneous Expense

18,720
$ 882,640

$ 882,640

The prepaid rent is for the period 2010 July 1, to 2011 June 30
...

Accrued salaries are USD 11,520
...
Prepare a 12-column work sheet for the year ended 2010 December 31
...

b
...

c
...


p
...
:
SOUTH SEA TOURS, INC
...

The buildings have an expected life of 50 years with no salvage value
...

Accrued interest on notes receivable is USD 450
...

Accrued salaries are USD 2,100
...

Expired prepaid advertising is USD 16,500
...
241 of 433

a
...
You need not include
account numbers
...

b
...

Problem E The following trial balance and additional data are for Florida Time-Share Property
Management Company:
FLORIDA TIME-SHARE PROPERTY MANAGEMENT COMPANY
Trial Balance
2010 December 31
Debits

Cash
Prepaid Rent

28,800

Prepaid Insurance

7,680

Supplies on Hand

2,400

Office Equipment

Credits

$ 424,000

24,000

Accumulated Depreciation—Office Equipment
Automobiles

$ 5,760
64,000

Accumulated Depreciation—Automobiles

16,000

Accounts Payable

2,880

Unearned Management Fees

12,480

Capital Stock

360,000

Retained Earnings, 2010 January 1
Dividends

120,640
28,000

Commissions Revenue

260,000

Management Fee Revenue

19,200

Salaries Expense

199,840

Advertising Expense

2,400

Gas and Oil Expense

14,240

Miscellaneous Expense

1,600
$ 796,960

$ 796,960

Insurance expense for the year, USD 3,840
...

Depreciation expense: office equipment, USD 2,880; and automobiles, USD 12,800
...

Supplies on hand at December 31, USD 1,000
...
The advance
payment covered six months' management of an apartment building
...
242 of 433

a
...
You need not include
account numbers or explanations of adjustments
...
Prepare an income statement
...
Prepare a statement of retained earnings
...
Prepare a classified balance sheet
...
Prepare adjusting and closing entries
...
11
...
6

Alternate problems

Alternate problem A The following adjusted trial balance is for Dream Home Realty Company:
DREAM HOME REALTY COMPANY
Adjusted Trial Balance
2010 June 30
Debits

Cash

$ 98,000

Accounts Receivable

40,000

Office Equipment

Credits

35,000

Accumulated Depreciation—Office Equipment

$ 14,000

Automobiles

40,000

Accumulated Depreciation—Automobiles

20,000

Accounts Payable

63,000

Capital Stock

75,000

Retained Earnings, 2009 July 1

54,700

Dividends

5,000

Commissions Revenue

170,000

Salaries Expense

25,000

Commissions Expense

120,000

Gas and Oil Expense

4,000

Rent Expense

14,800

Supplies Expense

1,400

Utilities Expense

2,000

Depreciation Expense—Office Equipment

3,500

Depreciation Expense—Automobiles

8,000
$

396,700

$ 396,700

Prepare the closing journal entries at the end of the fiscal year, 2010 June 30
...
243 of 433

Alternate problem B The adjusted trial balance for Penrod Insurance Consultants, Inc
...

Adjusted Trial Balance
2010 December 31

Debits

Cash
Accounts Receivable

68,000

Interest Receivable

400

Notes Receivable

20,000

Prepaid Insurance

2,400

Supplies on Hand

1,800

Land

32,000

Buildings

Credits

$ 107,200

190,000

Accumulated Depreciation—Buildings
Office Equipment

$ 40,000
28,000

Accumulated Depreciation—Office Equipment

8,000

Accounts Payable

48,000

Salaries Payable

8,500

Interest Payable

900

Notes Payable (due 2011)

64,000

Capital Stock

120,000

Retained Earnings, 2010 January 1
Dividends

42,800
40,000

Commissions Revenue

392,520

Advertising Expense

24,000

Commissions Expense

75,440

Travel Expense

12,880

Depreciation Expense—Buildings

8,500

Salaries Expense

98,400

Depreciation Expense—Office Equipment

2,800

Supplies Expense

3,800

Insurance Expense

3,600

Repairs Expense

1,900

Utilities Expense

3,400

Interest Expense

1,800

Interest Revenue

1,600
$ 726,320

$ 726,320

a
...

b
...

c
...


p
...
Prepare the closing journal entries
...
Show the post-closing trial balance assuming you had posted the closing entries to the general
ledger
...

The equipment is expected to last 10 years with no salvage value
...

Accrued commissions payable total USD 3,000 at December 31
...
Prepare a 12-column work sheet for the year ended 2010 December 31
...

b
...

c
...


p
...

BEST-FRIEND PET HOSPITAL, INC
...

Prepaid fire insurance is USD 600 as of the end of the year
...

Prepaid rent is USD 2,625 as of the end of the year
...

Accrued salaries are USD 2,625
...
Prepare a 12-column work sheet for the year ended 2010 December 31
...
Briefly explain the entries in the Adjustments columns at the bottom of the work
sheet, as was done in Exhibit 20
...
Prepare the 2010 December 31, closing entries
...
246 of 433

Alternate problem E The following trial balance and additional data are for Roswell Interior
Decorators, Inc
...

Rent expense for 2010 is USD 10,000
...

Insurance expense for 2010 is USD 2,400
...

Accrued interest on notes payable is USD 150
...

a
...
You need not include
account numbers or explanations of adjustments
...
Prepare an income statement
...
Prepare a statement of retained earnings
...
Prepare a classified balance sheet
...
247 of 433

e
...


5
...
4
...
After their marriage, they decided to earn
some extra income by doing small jobs involving canvas, vinyl, and upholstered products
...
To do this, they invested USD
120,000 cash in their business
...
They undertook
only custom work, with the customers purchasing the required materials, to avoid stocking any
inventory other than supplies
...

The business seemed successful from the start, as the Holts received orders from many customers
...
They worked hard and charged competitive prices
...

Summarized, the checkbook of the business for 2010, their second year of operations, showed:
Balance, 2010 January 1

$

99,200

Cash received from customers:
For work done in 2009

$

36,000

For work done in 2010

200,000

For work to be done in 2011

48,000

284,000
$

383,200

Cash paid out:
Two-year insurance policy dated 2010 January 1

$

19,200

Utilities

48,000

Supplies

104,000

Other Expenses

72,000

Taxes, including sales taxes

26,400

Dividends

40,000

Balance, 2010 December 31

309,600
$

73,600

Considering how much they worked, the Holts were concerned that the cash balance decreased by
USD 25,600 even though they only received dividends of USD 40,000
...
They were seriously considering giving up their business
and going back to work for the auto manufacturer
...
You discovered the
following:
p
...

Work completed in 2010 and billed to customers for which cash had not yet been received by yearend amounted to USD 40,000
...
(Hint: Prepare an income statement for 2010 and include it in your report
...
Write a summary of the results of your calculations
...
For instance, look at the
net income for the last three years
...
Write a description of a career in public accounting broader perspective at each level within
the firm
...

Group project D In teams of two or three students, interview a management accountant
...
Seek information on the advantages and disadvantages of working
as a management accountant
...
As a team, write a memorandum to the instructor summarizing the results of
the interview
...

Group project E With a small group of students, obtain an annual report of a company in which
you have some interest
...
Describe the nature of each item on the classified balance sheet
...
Also, calculate the current ratio for the most recent
two years and comment
...

Group project F With a small group of students and using library sources, write a paper
comparing the features of three different accounting software packages (such as Peachtree Complete,
Quikbooks Pro, DacEasy, MYOB Business Essentials, NetSuite Small Businee and Cougar Mountain )
...
Cite sources for the information and treat direct quotes
properly
...
11
...
8

Using the Internet—A view of the real world

Visit the following Internet site:
p
...
merck
...
In a short report to your instructor, describe how you got to the
balance sheet and identify the major headings used in the balance sheet
...
Also, calculate the current ratio
...
kodak
...
Identify the major headings within the balance sheet and
calculate the current ratio for the most recent year
...


5
...
4
...
The three trial balances are the unadjusted trial balance, the adjusted trial balance, and the
post-closing trial balance
...

False
...

True
...
Then the loss appears in the Statement of Retained Earnings debit column
because it reduces Retained Earnings
...
All of these accounts are closed, or reduced to zero balances, as a result of the closing
process
...
All revenue and expense accounts have zero balances after closing
...
Some manual accounting systems are still in use
...
The other accounts are very likely to be adjusted
...

c
...
Therefore, if the Balance
Sheet columns do not balance, the error is likely to exist in the last six columns of the work sheet
...
250 of 433

d
...
It does appear in all of the
other places listed
...
The Dividends account is closed to the Retained Earnings account rather than to the Income
Summary account
...
Plant, property, and equipment is one of the long-term asset categories
...
Response (c) should not include notes receivable
...


5
...
4
...

No
...

Account Title
Cash
Accounts Receivable
Supplies on Hand
Prepaid Insurance
Prepaid Rent
Buildings
Accumulated Depreciation—Buildings
Trucks
Accumulated Depreciation—Trucks
Accounts Payable
Salaries Payable
Capital Stock

No
...

No
...
251 of 433

The transactions for June 2010 were as follows:
June 1 Performed delivery services for customers on account, USD 60,000
...

4 Purchased a USD 20,000 truck on account
...

8 Paid USD 16,000 of the accounts payable
...
The asset account for supplies was debited
...

20 Paid the utilities bills for June, USD 1,200
...

28 Paid salaries of USD 28,000 for June
...

 Depreciation expense on the trucks for June is USD 400
...

 A physical count showed USD 12,000 of supplies on hand on June 30
...

 The prepaid rent of USD 12,000 applies to a one-year period beginning 2010 June 1
...

a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...


i
...


p
...
1 Learning objectives
After studying this chapter, you should be able to:


Identify and discuss the underlying assumptions or concepts of accounting
...




Identify and discuss the modifying conventions (or constraints) of accounting
...




Discuss the nature and content of a company's summary of significant accounting policies in

its annual report
...
2 A career as an accounting professor
Do you enjoy college life? Do you enjoy teaching others? If so, you might want to consider a career
as a college professor
...
A college professor can make a real difference
in the lives of hundreds, even thousands, of students over a career
...
The work of a college professor is a
valuable investment in our nation's most valuable resource—people
...
This is because most college faculty have at least two additional important responsibilities:
research and service
...
It represents arriving at new knowledge by discovering things that previously
were unknown
...
This illustrates the
importance of accounting numbers and has resulted in a large stream of discovery called Capital
Markets research
...
Accounting faculty are involved in service to the university, the accounting profession, and to
the general public
...

The demand for college professors varies greatly by discipline
...
However, in applied fields such
p
...
The
opportunities for professors in these applied fields are excellent, and the chance to make a real
difference in the lives of others is exciting
...
In this chapter,
we discuss accounting theory in greater depth
...
Accounting
theory is "a set of basic concepts and assumptions and related principles that explain and guide the
accountant's actions in identifying, measuring, and communicating economic information"
...
Understanding the
theory behind the accounting process, however, helps one make decisions in diverse accounting
situations
...

The first part of the chapter describes underlying accounting assumptions or concepts, the
measurement process, the major principles, and modifying conventions or constraints
...
The next part of the chapter describes the development of the Financial Accounting
Standards Board's (FASB) conceptual framework for accounting
...

Presenting the traditional body of theory first and the conceptual framework second gives you a sense
of the historical development of accounting theory
...
The final part of the chapter discusses significant accounting policies contained in annual reports
issued by companies and illustrates them with an actual example from an annual report of the Walt
Disney Company
...
3 Traditional accounting theory
Traditional accounting theory consists of underlying assumptions, rules of measurement, major
principles, and modifying conventions (or constraints)
...


1American Accounting Association, A Statement of Basic Accounting Theory (Sarasota, Fla
...
1-2
...
254 of 433

6
...
This section
discusses the effects of these assumptions on the accounting process
...
The
business entity concept assumes that each business has an existence separate from its owners,
creditors, employees, customers, interested parties, and other businesses
...

Therefore, financial statements are identified as belonging to a particular business entity
...

A business entity may be made up of several different legal entities
...
For reporting purposes, however, the corporations may be considered as one
business entity because they have a common ownership
...

When accountants record business transactions for an entity, they assume it is a going concern
...
The termination of an entity occurs when a
company ceases business operations and sells its assets
...
If liquidation appears likely, the going-concern assumption is no longer valid
...
Market values are of less significance to an entity using its assets
rather than selling them
...

The economic activity of a business is normally recorded and reported in money terms
...
Using a particular monetary unit provides accountants with a common unit of
measurement to report economic activity
...

Financial statements identify their unit of measure (such as the dollar in the United States) so the
statement user can make valid comparisons of amounts
...


p
...
Under the stable dollar assumption, the dollar is accepted as a
reasonably stable unit of measurement
...

Using the stable dollar assumption creates a difficulty in depreciation accounting
...
Thus, the
depreciation deducted in 2008 is the same as the depreciation deducted in 1975
...
Both
dollars are treated as equal monetary units of measurement despite substantial price inflation over the
30-year period
...

According to the periodicity (time periods) assumption, accountants divide an entity's life
into months or years to report its economic activities
...
Although these time-period reports provide useful
and timely financial information for investors and creditors, they may be inaccurate for some of these
time periods because accountants must estimate depreciation expense and certain other adjusting
entries
...
These time periods are usually of equal length so
that statement users can make valid comparisons of a company's performance from period to period
...
For instance, so far, the
income statements in this text were for either one month or one year
...

Accrual basis and periodicity Chapter 3 demonstrated that financial statements more
accurately reflect the financial status and operations of a company when prepared under the accrual
basis rather than the cash basis of accounting
...
Under the accrual basis, however, we record revenues when
services are rendered or products are sold and expenses when incurred
...
Without
the periodicity assumption, a business would have only one time period running from its inception to
its termination
...
256 of 433

because all revenues and all expenses would be recorded in that one time period and would not have to
be assigned to artificially short periods of one year or less
...
Uncertainty about future events prevents precise measurement and
makes estimates necessary in accounting
...


6
...
We discuss
these basic accounting concepts next
...
In contrast, accountants
can gather special-purpose financial information for a specific decision, usually on a one-time basis
...
Since special-purpose financial information must be specific, this information is best
obtained from the detailed accounting records rather than from the financial statements
...
For example, a contract that is legally a lease may, in fact, be equivalent to a purchase
...
At
the end of the lease period, the company receives title to the auto after paying a nominal sum (say, USD
1)
...
Thus,
under the substance-over-form concept, the auto is an asset on the balance sheet and is depreciated
instead of showing rent expense on the income statement
...

Consistency generally requires that a company use the same accounting principles and reporting
practices through time
...
However, consistency does not prohibit a
change in accounting principles if the information needs of financial statement users are better served
by the change
...

p
...
Under the double-entry approach, every transaction has a two-sided effect on each party
engaging in the transaction
...
The total debits equal the total credits in each journal entry
...
For example, we carry the amount of
net income from the income statement to the statement of retained earnings
...

In Exhibit 27 we summarize the underlying assumptions or concepts
...


6
...
2
In this section, we focus on the measurement process of accounting
...
By assigning the effects of these changes to particular time periods (periodicity),
they can find the net income or net loss of the accounting entity for those periods
...
They measure cash at its
specified amount
...
They measure
inventories, prepaid expenses, plant assets, and intangibles at their historical costs (actual amounts
paid)
...
After the acquisition date, they carry plant assets and intangibles at original cost less
accumulated depreciation or amortization
...

Accountants can easily measure some changes in assets and liabilities, such as the acquisition of an
asset on credit and the payment of a liability
...
The accountant must determine when a change has taken place and the amount of

2Ibid
...
1
...
258 of 433

the change
...


Assumption or Concept
Business entity

Description
Each business has an existence separate
from its owners, creditors, employees,
customers, other interested parties, and
other businesses
...

Each business uses a monetary unit of
Money measurement
measurement, such as the dollar, instead of
physical or other units of measurement
...


Periodicity (time periods)

An entity's life can be subdivided into
months or years to report its economic
activities
...


Substance over form

Accountants should record the economic
substance of a transaction rather than its
legal form
...


Double entry

Every transaction has a two-sided effect on
each company or party engaging in the
transaction
...


Importance
Defines the scope of the business such as a horse
stable or physical fitness center
...

Allows a company to continue carrying plant assets
at their historical costs in spite of a change in their
market values
...
This concept
permits us to add an d subtract items on the
financial statements
...

This assumption works fairly well in the United
States because of our relatively low rate of
inflation
...
Thus, we know how well a business is
performing before it terminates its operations
...

Allows companies to prepare only one set of
financial statements instead of a separate set for
each potential type of user of those statements
...

Encourages the accountant to record the true
nature of a transaction rather than its apparent
nature
...
" An apparent lease transaction
that has all the characteristics of a purchase should
be recorded as a purchase
...
The inventory and
depreciation chapters (Chapters 7 and 10) both
mention the importance of this concept
...
When the debits do not
equal the credits, this inequality immediately
signals us to stop and find the error
...
For instance, earning
revenue increases net income on the income
statement, retained earnings on the statement of
retained earnings, and assets and retained
earnings on the balance sheet
...


Exhibit 27: The underlying assumptions or concepts

6
...
A standardized presentation format enables users to compare the
p
...
Generally accepted accounting principles
have been either developed through accounting practice or established by authoritative organizations
...
This section
explains the following major principles:
 Exchange-price (or cost) principle
...

 Matching principle
...

 Full disclosure principle
...
The
exchange-price (or cost) principle requires an accountant to record transfers of resources at
prices agreed on by the parties to the exchange at the time of exchange
...

As applied to most assets, this principle is often called the cost principle
...
Historical cost is the
amount paid, or the fair market value of the liability incurred or other resources surrendered, to
acquire an asset and place it in a condition and position for its intended use
...

Accountants prefer the term exchange-price principle to cost principle because it seems inappropriate
to refer to liabilities, stockholders' equity, and such assets as cash and accounts receivable as being
measured in terms of cost
...

SFAS 157 defines “fair value” as “the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at the measurement date”
...
260 of 433

It is also defined as “an exit price from the perspective of a market participant that holds the asset
or owes the liability”, whether or not the business plans to hold the asset/liability for investment, or
sell it
...
15
...
Beginning in 2009, the standard will apply
to other non-financial assets
...

“SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an
asset or liability
...

 Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock

exchanges
...

 Level 3 are unobservable inputs to be used in situations where markets do not exist or are

illiquid such as the present credit crisis
...
”
Fair value accounting has been a contentious topic since it was introduced, For example, “banks and
investment banks have had to reduce the value of the mortgages and mortgage-backed securities to
reflect current prices”
...
Despite debate over the proper implementation
of fair market value accounting, International Financial Reporting Standards utilize this approach
much more than the Generally Accepted Accounting Principles of the United States
...
aicpa
...
htm), the source used for the explanation of this topic
...
These secret
reserves arise from a company not reporting all of its profits when it has a very good year
...
261 of 433

year; if all profits were reported, the stockholders might vote to pay the entire amount out as
dividends
...


Revenue is not difficult to define or measure; it is the inflow of assets from the sale of goods and
services to customers, measured by the cash expected to be received from customers
...
Under the revenue recognition
principle, revenues should be earned and realized before they are recognized (recorded)
...
Many activities may have preceded the actual receipt of cash from a customer,
including (1) placing advertisements, (2) calling on the customer several times, (3) submitting samples,
(4) acquiring or manufacturing goods, and (5) selling and delivering goods
...
Although revenue was actually being earned by these activities, accountants do
not recognize revenue until the time of sale because of the requirement that revenue be substantially
earned before it is recognized (recorded)
...

Realization of revenue Under the realization principle, the accountant does not recognize
(record) revenue until the seller acquires the right to receive payment from the buyer
...
Legally, a sale of merchandise occurs when title to the
goods passes to the buyer
...
As a practical matter, accountants
generally record revenue when goods are delivered
...
As discussed
later, the disadvantage of recognizing revenue at the time of sale is that the revenue might not be
recorded in the period during which most of the activity creating it occurred
...

These examples illustrate the effect that the business environment has on the development of
accounting principles and standards
...
262 of 433

Cash collection as point of revenue recognition Some small companies record revenues and
expenses at the time of cash collection and payment, which may not occur at the time of sale
...
The cash basis is acceptable primarily in service enterprises
that do not have substantial credit transactions or inventories, such as business entities of doctors or
dentists
...
Companies make these sales in spite of the doubtful collectibility of
the account because their margin of profit is high and the goods can be repossessed if the payments are
not received
...
Thus, the gross margin recognized in a period is equal to the cash received
times the gross margin percentage (gross margin divided by selling price)
...
The facts of the sale are:
Date of sale

Selling price

Cost

Gross margin (Selling price –
Cost)

Gross margin percentage (Gross
margin/Selling price)

2010 Oct
...
If the company receives three monthly payments in 2010, the total amount of cash
received in 2010 is USD 150 (3 X USD 50)
...
263 of 433

The company collects the other installments when due so it receives a total of USD 350 in 2011 from
2010 installment sales
...
350 70%
$500 100%

$ 60 30%
140 70%
$200 100%

Because the installment basis delays some revenue recognition beyond the time of sale, it is
acceptable for accounting purposes only when considerable doubt exists as to collectibility of the
installments
...
The completed-contract method does not recognize
any revenue until the project is completed
...
Thus, the completed-contract method recognizes
revenues at the time of sale, as is true for most sales transactions
...

Some accountants argue that waiting so long to recognize any revenue is unreasonable
...
The
percentage-of-completion method recognizes revenue based on the estimated stage of completion
of a long-term project
...

To illustrate, assume that a company has a contract to build a dam for USD 44 million
...
You calculate the estimated gross margin as follows:
Sales price of dam

Estimated costs of construct
dam

Estimated gross margin (sales price –
estimated costs)

USD 44 million

USD 40 million

(44 million – 40 million) – 4 million

p
...
The formula to
recognize revenue is:
Actualconstruction costs incurred during the period
x Total sales price= Revenue recognized for period
Total estimated construction costs for the entire project
Suppose that by the end of the first year (2010), the company had incurred actual construction costs
of USD 30 million
...
Under the percentage-of-completion method, the firm would
use the 75 per cent figure to assign revenue to the first year
...
In 2012, it incurs the final USD 4 million of construction costs
...
6 million

X

$44 million =

$4
...
0 million
6
...
4
$44
...
0 million
- 6
...
0
$40
...
0 million
= 0
...
4
$4
...
432

Exhibit 28: Methods of accounting for long-term contracts
This company would deduct other costs incurred in the accounting period, such as general and
administrative expenses, from gross margin to determine net income
...


p
...
The matching principle states that expenses should be recognized (recorded)
as they are incurred to produce revenues
...
Firms voluntarily incur expense to produce revenue
...
Similarly, the cost of services such as labor are voluntarily incurred to
produce revenue
...
Therefore, they measure a depreciation expense resulting from the
consumption of those assets by the historical costs of those assets
...

The timing of expense recognition The matching principle implies that a relationship exists
between expenses and revenues
...
However, when a direct relationship cannot be seen,
we charge the costs of assets with limited lives to expense in the periods benefited on a systematic and
rational allocation basis
...

Product costs are costs incurred in the acquisition or manufacture of goods
...
For manufacturing companies, product costs include all costs of materials, labor, and
factory operations necessary to produce the goods
...
We charge product costs
to expense when the goods are sold
...

Period costs are costs not traceable to specific products and expensed in the period incurred
...

The gain and loss recognition principle states that we record gains only when realized, but
losses when they first become evident
...
This
principle is related to the conservatism concept
...
Firms
should not recognize gains until they are realized through sale or exchange
...

Losses consume assets, as do expenses
...

Losses are usually involuntary, such as the loss suffered from destruction by fire on an uninsured
p
...
A loss on the sale of a building may be voluntary when management decides to sell the
building even though incurring a loss
...
Depending on its nature,
companies should disclose this information either in the financial statements, in notes to the financial
statements, or in supplemental statements
...
Many lawsuits against CPAs and
their clients have resulted from inadequate or misleading disclosure of the underlying facts
...


An accounting perspective: Business insight
The accounting model involves reporting revenues earned and expenses incurred by
the company
...
Suppose, for instance, that a company is dumping
toxic waste into a river and this action causes cancer among the citizens downstream
...
8 Modifying conventions (or constraints)
In certain instances, companies do not strictly apply accounting principles because of modifying
conventions (or constraints)
...
Three
modifying conventions are cost-benefit, materiality, and conservatism
...
Users tend
to think information is cost free since they incur none of the costs of providing the information
...
The benefits of using information should exceed
the costs of providing it
...

Materiality Materiality is a modifying convention that allows accountants to deal with immaterial
(unimportant) items in an expedient but theoretically incorrect manner
...
If not, the
p
...
For
instance, because inexpensive items such as calculators often do not make a difference in a statement
user's decision to invest in the company, they are immaterial (unimportant) and may be expensed
when purchased
...
Accountants should record all material items in a theoretically correct manner
...
For example, they may debit the cost of a wastebasket to an expense account
rather than an asset account even though the wastebasket has an expected useful life of 30 years
...

The FASB defines materiality as "the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have been changed or influenced by the omission
or misstatement"
...
A USD 10,000 error in an expense in a company with
earnings of USD 30,000 is material
...

Materiality involves more than the relative dollar amounts
...
For example, it may be quite significant to know that a company is paying bribes or making
illegal political contributions, even if the dollar amounts of such items are relatively small
...
Such overstatements can mislead potential investors in the company
and creditors making loans to the company
...
Accountants must realize a fine line exists between
conservative and incorrect accounting
...

The next section of this chapter discusses the conceptual framework project of the Financial
Accounting Standards Board
...
2, "Qualitative Characteristics of
Accounting Information" (Stamford, Conn
...
xv
...
S
...
Quoted (or excerpted)
with permission
...

p
...
We present only the portions of
the project relevant to this text
...


resources at an objectively determinable amount at
the time of the exchange
...

Informs accountant that revenues generally should
be recognized when services are performed or
goods are sold
...

Indicates that expenses are to be recorded as soon
as they are incurred rather than waiting until some
future time
...


Matching

Expenses should be recognized (recorded)
as they are incurred to produce revenues
...


Full disclosure

Information important enough to influence
the decisions of an informed user of the
financial statements should be disclosed
...
Gains can only be
recognized when they have been realized through
sale or exchange
...
Thus, potential
losses can be recorded, but only gains that have
actually been realized can be recorded
...
A good rule to follow is—if in doubt,
disclose
...


Exhibit 29: The major principles
Modifying
Convention
Cost-benefit

Materiality

Conservatism

Description

Importance

Optional information should be
included financial statements only if
the benefits providing it exceed its
costs
...
An example may be companies going
to the expense of providing information on the effects of inflation when the
inflation rate is low and/or users do not seem to benefit significantly from the
information
...
For instance, a wastebasket can be
material (important) and must be
expensed rather than capitalized and depreciated even though it may last for 30
reported in a theoretically correct way
...

Transactions should be recorded so
Warns accountants that assets and net income are not to be overstated
...

is common advice under this constraint
...


Exhibit 30: Modifying conventions

6
...
The debate continues today despite numerous references to generally

p
...
To date, all attempts to present a concise statement of GAAP
have received only limited acceptance
...
The
belief is that if a person (1) carefully studies the environment, (2) knows what objectives are sought, (3)
can identify certain qualitative traits of accounting information, and (4) can define the basic elements
of financial statements, that person can discover the principles and standards leading to the stated
objectives
...
4 Addressing the
fourth goal are concepts statements entitled "Elements of Financial Statements of Business
Enterprises" and "Elements of Financial Statements"
...
10 Objectives of financial reporting
Financial reporting objectives are the broad overriding goals sought by accountants engaging
in financial reporting
...
The
information should be comprehensible to those who have a reasonable understanding of
business and economic activities and are willing to study the information with
reasonable diligence
...
1, "Objectives of Financial Reporting by
Business Enterprises" (Stamford, Conn
...
2, "Qualitative Characteristics of Accounting Information" (Stamford, Conn
...
Copyright
© by the Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905,
U
...
A
...
Copies of the complete documents are available from
the FASB
...
3, "Elements of Financial Statements of
Business Enterprises" (Stamford, Conn
...
6, "Elements of Financial Statements" (Stamford, Conn
...
Copyright © by the Financial
Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905, U
...
A
...
Copies of the complete documents are available from the FASB
...
1, p
...

p
...
Financial reporting should provide information to all who are willing to learn to use it
properly
...
Since investors' and creditors' cash flows
are related to enterprise cash flows, financial reporting should provide information to
help investors, creditors, and others assess the amounts, timing, and uncertainty of
prospective net cash inflows to the related enterprise
...
Enterprise cash inflows are the source of cash for
dividends, interest, and the redemption of maturing debt
...
8
We can draw some conclusions from these three objectives and from a study of the environment in
which financial reporting is carried out
...

 Focus on earnings and its components, despite the emphasis in the objectives on cash flows
...
)
On the other hand, financial reporting does not seek to:
 Measure the value of an enterprise but to provide information useful in determining its value
...

7Ibid
...

p
...
1
...
9 How successful the Board will be in the approach adopted remains to be seen
...
11 Qualitative characteristics
Accounting information should possess qualitative characteristics to be useful in decision
making
...
The usefulness of accounting information in a given
instance depends not only on information characteristics but also on the capabilities of the decision
makers and their professional advisers
...
Therefore, they
direct their attention to the characteristics of accounting information
...
The information must
make a difference to someone who does not already have it
...
Note that information need not be a prediction to be useful in
developing, confirming, or altering expectations
...
For example, any attempt to predict future earnings of a company would quite likely start with a
review of present and past earnings
...

Critics have alleged that certain types of accounting information lack relevance
...
Such criticism has encouraged research into the types of information relevant to users
...

Predictive value and feedback value Since actions taken now can affect only future events,
information is obviously relevant when it possesses predictive value, or improves users' abilities to
predict outcomes of events
...
Feedback reports on past activities and can make a difference in

9Ibid
...
i
...
2, p
...

p
...
For example, a report on the first
quarter's earnings of a company reduces the uncertainty surrounding the amount of such earnings,
confirms or refutes the predicted amount of such earnings, and provides a possible basis on which to
predict earnings for the full year
...
Making predictions is a function performed by the
decision maker
...
Utility of information decreases with age
...

If information is to be of any value in decision making, it must be available before the decision is made
...
In determining what constitutes timely information,
accountants consider the other qualitative characteristics and the cost of gathering information
...
Timeliness alone cannot make information relevant, but potentially relevant information can
be rendered irrelevant by a lack of timeliness
...
273 of 433

In addition to being relevant, information must be reliable to be useful
...
Thus, accounting information is
reliable if users can depend on it to reflect the underlying economic activities of the organization
...
The
information must also be complete and free of bias
...
When it shows
roads and bridges where roads and bridges actually exist, a map possesses representational
faithfulness
...

Similarly, representational faithfulness exists when accounting statements on economic activity
correspond to the actual underlying activity
...

 Effects of bias
...
Accountants create bias in accounting measurements by choosing the wrong measurement
method or introducing bias either deliberately or through lack of skill
...
To be free from bias, information must be sufficiently complete to ensure that

it validly represents underlying events and conditions
...
Firms can reduce
the relevance of information by omitting information that would make a difference to users
...

Also required in annual reports of corporations are statements of changes in stockholders' equity
which contain information included in a statement of retained earnings
...
Required disclosures may be made in (1) the body of the financial
statements, (2) the notes to such statements, (3) special communications, and/or (4) the
president's letter or other management reports in the annual report
...
11 Disclosure should include unusual activities (loans to officers), changes in expectations (losses
on inventory), depreciation expense for the period, long-term obligations entered into that are not
recorded by the accountant (a 20-year lease on a building), new arrangements with certain groups
(pension and profit-sharing plans for employees), and significant events that occur after the date of the
11APB, APB Opinion No
...

p
...
Firms must also disclose accounting policies (major principles
and their manner of application) followed in preparing the financial statements
...

Verifiability Financial information has verifiability when independent measurers can
substantially duplicate it by using the same measurement methods
...
The requirement that financial information be based on objective evidence arises from the
demonstrated needs of users for reliable, unbiased financial information
...
If the information is verifiable, this enhances the reliability of information
...
Canceled checks and invoices support some measurements
...
Thus, financial information in many instances is verifiable only in that it represents a
consensus of what other accountants would report if they followed the same procedures
...
The primary concern should be relevance and reliability of the information that results
from application of the principle, not the effect that the principle may have on a particular interest
...
For example, a
particular form of measurement might favor stockholders over creditors, or vice versa
...
" 13
Accounting standards are not like tax regulations that deliberately foster or restrain certain types of
activity
...

When comparability exists, reported differences and similarities in financial information are real
and not the result of differing accounting treatments
...

Consistency requires that a company use the same accounting principles and reporting practices
through time
...
22, "Disclosure of Accounting Policies" (New York: AICPA, April 1972)
...
2, par
...

p
...
Comparability between companies is more difficult because they may account for the
same activities in different ways
...
A high
degree of inter-company comparability in accounting information does not exist unless accountants
are required to account for the same activities in the same manner across companies and through time
...
First, the benefits secured from the information must be
greater than the costs of providing that information
...
We
discussed cost-benefit and materiality earlier in the chapter
...
fasb
...
You can investigate facts about the FASB, press
releases, exposure drafts, publications, emerging issues, board actions, forthcoming
meetings, and many other topics
...
12 The basic elements of financial statements
Thus far we have discussed objectives of financial reporting and qualitative characteristics of
accounting information
...
The FASB identified and defined the basic
elements of financial statements in Concepts Statement No
...
Later, Concepts Statement No
...
We defined most of the terms earlier in this text in a less technical way; the
more technical definitions follow
...
)
Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events
...

Equity or net assets is the residual interest in the assets of an entity that remains after deducting
its liabilities
...
In a not-for-profit
p
...

Comprehensive income is the change in equity of a business enterprise during a period from
transactions and other events and circumstances from non-owner sources
...

Revenues are inflows or other enhancements of assets of any entity or settlements of its liabilities
(or a combination of both) from delivering or producing goods, rendering services, or other activities
that constitute the entity's ongoing major or central operations
...

Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity
and from all other transactions and other events and circumstances affecting the entity except those
that result from revenues or investments by owners
...

Investments by owners are increases in equity of a particular business enterprise resulting from
transfers to it from other entities of something valuable to obtain or increase ownership interests (or
equity) in it
...

Distributions to owners are decreases in equity of a particular business enterprise resulting
from transferring assets, rendering services, or incurring liabilities by the enterprise to owners
...
14

14FASB, Statement of Financial Accounting Concepts No
...

p
...
However, they expense expenditures
on human resources for hiring and training that benefit future periods
...
However, when the
president of the company dies, they record no loss
...
13 Recognition and measurement in financial statements
In December 1984, the FASB issued Statement of Financial Accounting Concepts No
...
15 The recognition criteria established in the Statement are fairly consistent with
those used in current practice
...


6
...

These policies assist users in interpreting the financial statements
...
Companies must follow generally accepted accounting
principles in preparing their financial statements
...
After each, the chapter of this text where we
discuss that particular policy is in parentheses
...

15FASB, Statement of Financial Accounting Concepts No
...
, 1984)
...
S
...

Copies of the complete document are available from the FASB
...
4, it pertains to accounting for
not-for-profit organizations and is, therefore, not relevant to this text
...
278 of 433

An ethical perspective: Maplehurst company
Maplehurst Company manufactures large spinning machines for the textile industry
...

The company's accountant recorded the tools in an asset account and was going to
write them off over 20 years
...
Management's goal was to smooth out income rather than
showing sharp increases and decreases
...
Since amounts under USD 20,000 are considered
immaterial for this company, all of the tools could then be charged to expense this year
...
She doubts that she could
successfully defend management's position if the auditors challenge the expensing of
these items
...
15 Significant accounting policies
6
...
1

Principles of consolidation

The consolidated financial statements of the Company include the accounts of The Walt Disney
Company and its subsidiaries after elimination of inter-company accounts and transactions
...
(Chapter 14)

6
...
2

Accounting changes

The Company changed its method of accounting for pre-opening costs (see Note 12)
...

The pro forma amounts presented in the consolidated statement of income reflect the effect of
retroactive application of expensing pre-opening costs
...
15
...
Television licensing revenues are recorded when the program material is available for
p
...
Revenues from video sales are
recognized on the date that video units are made widely available for sale by retailers
...
(Chapter 5)

6
...
4

Cash, cash equivalents and investments

Cash and cash equivalents consist of cash on hand and marketable securities with original
maturities of three months or less
...
Debt securities that the Company has the positive intent and ability to hold to
maturity are classified as "held-to-maturity" and reported at amortized cost
...
(Chapter 14)

6
...
5

Merchandise inventories

Carrying amounts of merchandise, materials and supplies inventories are generally determined on a
moving average cost basis and are stated at the lower of cost or market
...
15
...
Estimates of total gross revenues are reviewed periodically and amortization is
adjusted accordingly
...
(Chapter 11)

6
...
7

Theme parks, resorts and other property

Theme parks, resorts and other property are carried at cost
...
(Chapter 3)

6
...
8

Other assets

Rights to the name, likeness and portrait of Walt Disney, goodwill and other intangible assets are
amortized over periods ranging from two to forty years
...
280 of 433

6
...
9

Risk management contracts

In the normal course of business, the Company employs a variety of off-balance-sheet financial
instruments to manage its exposure to fluctuations in interest and foreign currency exchange rates,
including interest rate and cross-currency swap agreements, forward and option contracts, and interest
rate exchange-traded futures
...
Differences paid or received on
swap agreements are recognized as adjustments to interest income or expense over the life of the
swaps, thereby adjusting the effective interest rate on the underlying investment or obligation
...
Gains and losses arising
from interest rate futures, forwards and option contracts, and foreign currency forward and option
contracts are recognized in income or expense as offsets of gains and losses resulting from the
underlying hedged transactions
...

(Chapter 16)
The Company classifies its derivative financial instruments as held or issued for purposes other
than trading
...
15
...
Common equivalent shares are excluded from the
computation in periods in which they have an antidilutive effect
...
In Chapter 6, for instance, we discuss why sales revenue is recognized and
recorded only after goods have been delivered to the customer
...
Chapter 6 introduces merchandising operations
...


p
...
16 Understanding the learning objectives
 The major underlying assumptions or concepts of accounting are (1) business entity, (2) going

concern (continuity), (3) money measurement, (4) stable dollar, (5) periodicity, and (6) accrual
basis and periodicity
...

 The major principles include exchange-price (or cost), revenue recognition, matching, gain and

loss recognition, and full disclosure
...

 Modifying conventions include cost-benefit, materiality, and conservatism
...

 Financial reporting objectives are the broad overriding goals sought by accountants engaging in

financial reporting
...
The two primary qualitative characteristics are relevance and reliability
...

 Pervasive constraints include cost-benefit analysis and materiality
...

 The FASB has also described revenue recognition criteria and provided guidance as to the timing

and nature of information to be included in financial statements
...

 To a large extent, accounting theory determines the nature of those policies
...
16
...
For
each violation, give the entry to correct the improper accounting assuming the books have not been
closed
...
282 of 433

 Had its buildings appraised
...
The accountant debited the Buildings and Accumulated
Depreciation—Buildings accounts for USD 15,000 each and credited Paid-in Capital—From
Appreciation
...

 Purchased new electric pencil sharpeners for its offices at a total cost of USD 60
...


6
...
1
...
Such

write-ups simply are not looked on with favor in accounting
...
As a practical matter, the USD 60
could have been expensed on materiality grounds
...
16
...

Bias Exists when accounting measurements are consistently too high or too low
...

Business entities have a separate existence from owners, creditors, employees, customers, other
interested parties, and other businesses
...

Completed-contract method A method of recognizing revenue on long-term projects under
which no revenue is recognized until the period in which the project is completed; similar to
recognizing revenue upon the completion of a sale
...

Conservatism Being cautious or prudent and making sure that net assets and net income are
not overstated
...


p
...

Cost principle See Exchange-price principle
...

Exchange-price (or cost) principle Transfers of resources are recorded at prices agreed on
by the parties at the time of the exchange
...

Financial reporting objectives The broad overriding goals sought by accountants engaging
in financial reporting
...

Gain and loss recognition principle Gains may be recorded only when realized, but losses
should be recorded when they first become evident
...

Going-concern (continuity) assumption The assumption that an entity will continue to
operate indefinitely unless strong evidence exists that the entity will terminate
...

Installment basis A revenue recognition procedure in which the percentage of total gross
margin recognized in a period on an installment sale is equal to the percentage of total cash from
the sale that is received in that period
...

Losses Asset expirations that are usually involuntary and do not create revenues
...

Materiality A modifying convention that allows the accountant to deal with immaterial
(unimportant) items in an expedient but theoretically incorrect manner; also a qualitative
characteristic specifying that financial accounting report only information significant enough to
influence decisions or evaluations
...

Money measurement Use of a monetary unit of measurement, such as the dollar, instead of
physical or other units of measurement—feet, inches, grams, and so on
...

Percentage-of-completion method A method of recognizing revenue based on the
estimated stage of completion of a long-term project
...

Period costs Costs that cannot be traced to specific products and are expensed in the period
incurred
...
284 of 433

Periodicity (time periods) assumption An assumption of the accountant that an entity's
life can be divided into time periods for reporting its economic activities
...

Product costs Costs incurred in the acquisition or manufacture of goods
...

Qualitative characteristics Characteristics that accounting information should possess to be
useful in decision making
...

Relevance A qualitative characteristic requiring that information be pertinent to or affect a
decision
...

Representational faithfulness A qualitative characteristic requiring that accounting
statements on economic activity correspond to the actual underlying activity
...

Stable dollar assumption An assumption that the dollar is a reasonably stable unit of
measurement
...

Verifiability A qualitative characteristic of accounting information; information is verifiable
when it can be substantially duplicated by independent measurers using the same measurement
methods
...
16
...

o

The business entity concept assumes that each business has an existence separate from all
parties except its owners
...


o

The matching principle is fundamental to the accrual basis of accounting
...


o

Immaterial items do not have to be recorded at all
...

p
...

The underlying assumptions of accounting includes all the following except:
a
...

b
...

c
...

d
...

The concept that requires companies to use the same accounting practices and reporting practices
through time is:
a
...

b
...

c
...

d
...

Which of the following statements is false regarding the revenue recognition principle?
a
...

b
...

c
...

d
...

Assume the following facts regarding the construction of a bridge:
Construction costs this period
...
10,000,000
Total sales price
...
USD 3,000,000
...
USD 4,500,000
...
USD 5,000,000
...
286 of 433

d
...

Modifying conventions include all of the following except:
a
...

b
...

c
...

d
...

Which of the following is not part of the conceptual framework project?
a
...

b
...

c
...

d
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
16
...
Comment
on the validity of the stable unit of measurement assumption during periods of high
inflation
...
What principles guide the recognition of expense?
p
...




What are the two primary qualitative characteristics?



Real world question A recent annual report of the American Ship Building Company
stated:

Revenues, costs, and profits applicable to construction and conversion contracts are included
in the consolidated statements of operations using the
...
The completed contract method was used for income tax reporting in the years this
method was allowed
...
Expenditures that relate to an existing condition caused by past
operations, and do not contribute to current or future revenue generation, are expensed
...
288 of 433

6
...
5

Exercises

Exercise A Match the items in Column A with the proper descriptions in Column B
...


a
...


Consistency
...
Concerned with relative dollar amounts
...


c
...


Periodicity
...
Required if the accounting treatment differs
from that previously used for a particular item
...


e
...


Stable dollar
...
None of these
...


g
...


Materiality
...
An assumption that the life of an entity can be
subdivided into time periods for reporting purposes
...


i
...


Business entity
...
Requires separation of personal from business
activities in the recording and reporting processes
...
289 of 433

Exercise B Parker Clothing Company sells its products on an installment sales basis
...

Cost of goods sold on installment sales
...

Cash collected from 2010 sales
...


2010
$800,000
560,000
120,000
480,000

2011
$960,000
720,000
160,000
240,000
640,000

a
...

b
...

Exercise C A company has a contract to build a ship at a price of USD 500 million and an
estimated cost of USD 400 million
...
Under the percentage-ofcompletion method, how much revenue would be recognized?
Exercise D A company follows a practice of expensing the premium on its fire insurance policy
when the policy is paid
...
In 2010, a premium of USD 5,400
was charged to expense on the same policy for the period 2010 July 1, to 2010 July 30
...
State the principle of accounting that was violated by this practice
...
Compute the effects of this violation on the financial statements for the calendar year 2010
...
State the basis on which the company's practice might be justified
...
290 of 433

Exercise E Match the descriptions in Column B with the accounting qualities in Column A
...

Column A: Accounting qualities

Column B: Descriptions

Relevance
...
Users of accounting information
...


b
...


Decision makers
...
User-specific qualities
...


d
...


Reliability
...
Ingredients of primary qualities
...


f
...


Benefits exceed costs
...
Threshold for recognition
...

Timeliness
...

Verifiability
...

Neutrality
...


6
...
6

Problems

Problem A Select the best answer to each of the following questions:
The assumption that each business has an existence separate from its owners, creditors, employees,
customers, other interested parties, and other businesses is the:
p
...
Going-concern assumption
...
Business entity concept
...
Separate entity concept
...
Corporation concept
...
There are changes in the value of the dollar
...
The periodicity assumption is applied
...
The company is not a going concern and will be dissolved
...
The accrual basis of accounting is not used
...
The
company chose to report the item as prepaid advertising and includes it among the assets on the
balance sheet
...
This practice is
a violation of:
a
...

b
...

c
...

d
...

Recording revenue only after the seller has obtained the right to receive payment from the buyer for
merchandise sold or services performed is called the:
a
...

b
...

c
...

d
...

Problem B Ramirez Video, Inc
...
Following are data for the first three years of
the company's operations:

2008
Gross margin rate 30%
Cash collected in 2010:
From sales in
...

From sales in
...

a
...


p
...
Compute net income for 2010, using the installment method of accounting for sales and gross
margin
...

Costs incurred prior to 2010
...

Estimated costs to be incurred
in future years
...
3,700,000

...

a
...

b
...

Problem D For each of the following numbered items, state the letter or letters of the principle(s),
assumption(s), or concept(s) used to justify the accounting procedure followed
...

a
...

b
...

c
...

d
...

e
...

f
...

g
...

h
...

i
...

Inventory is recorded at the lower of cost or market value
...

The collection of USD 40,000 of cash for services to be performed next year was reported as a
current liability
...

No entry was made to record the company's receipt of an offer of USD 800,000 for land carried in
its accounts at USD 435,000
...
293 of 433

A supply of printed stationery, checks, and invoices with a cost of USD 8,500 was treated as a
current asset at year-end even though it had no value to others
...

The company paid and charged to expense the USD 4,200 paid to Craig Nelson for rent of a truck
owned by him
...

Problem E Match the descriptions in Column B with the proper terms in Column A
...

2
...

4
...

6
...

8
...

10
...

12
...

14
...

Qualitative
characteristics
...

Predictive value
...

Timeliness
...

Representational
faithfulness
...

Neutrality
...

Consistency
...

Materiality
...
16
...

b
...

d
...

f
...

h
...

j
...

l
...

n
...

The benefits exceed the costs
...

The information can be substantially duplicated by independent measurers
using the same measurement methods
...

Broad overriding goals sought by accountants engaging in financial reporting
...

The characteristics that accounting information should possess to be useful
in decision making
...

When accounting statements on economic activity correspond to the actual
underlying activity
...

When information faithfully depicts for users what it purports to represent
...

When reported differences and similarities in information are real and not
the result of differing accounting treatments
...
Accounting theory
...
Accounting rules
...
Accrual basis
...
Matching concept
...
Several separate legal entities properly may be considered to be one accounting entity
...
The stable dollar assumption is used only when the dollar is absolutely stable
...
Publicly held corporations generally prepare monthly financial statements for internal
management and publish quarterly and annual financial statements for users outside the company
...
Without the periodicity assumption, a business would have only one time period running from
the inception of the business to its termination
...
294 of 433

Which of the following statements is true?
a
...

b
...

c
...

d
...

Which of the following statements is true?
a
...

b
...

c
...

d
...

Which of the following statements is false?
a
...

b
...

c
...

d
...

Alternate problem B Nevada Real Estate Sales Company sells lots in its development in Dry
Creek Canyon under terms calling for small cash down payments with monthly installment payments
spread over a few years
...

Cash collected in 2010 from
sales of lots made in
...
45%

2009
48%

2010
50%


...

a
...

b
...

p
...
Assume that the
general and administrative expenses are not to be treated as a part of the construction cost
...
Compute net income for 2010 using the completed-contract method
...
Compute net income for 2010 using the percentage-of-completion method
...
Indicate whether you agree or disagree with the accounting practice employed and state
the assumptions, concepts, or principles that justify your position
...

No entry was made to record the belief that the market value of the land owned (carried in the
accounts at USD 800,000) had increased
...

A truck acquired at the beginning of the year was reported at year-end at 80 per cent of its
acquisition price even though its market value then was only 65 per cent of its original acquisition
price
...
One
...
Two
...
Three
...
Four
...
Predictive value and feedback value
...
Timeliness and verifiability
...
Comparability and neutrality
...
296 of 433

d
...

A pervasive constraint of accounting information is that:
a
...

b
...

c
...

d
...

To be reliable, information must (identify the incorrect quality):
a
...

b
...

c
...

d
...

The basic elements of financial statements consist of:
a
...

b
...

c
...

d
...


6
...
8

Beyond the numbers—Critical thinking

Business decision case A Jim Casey recently received his accounting degree from State
University and went to work for a Big-Four CPA firm
...
He was not very confident of
his knowledge at this early point in his career
...

Study each of the following facts to see if the auditors should challenge the financial accounting
practices used or the intentions of management
...

This problem can serve as an opportunity to apply accounting theory to situations with which you
are not yet familiar and as a preview of future chapters
...
After each item, we have given an indication of the chapter in which that item is discussed
...
Alternatively, you could use your present
knowledge of accounting theory to determine whether or not Casey should challenge each of the
p
...
Realize, however, that some generally accepted accounting
practices were based on compromise and seem to differ with accounting theory as described in this
chapter
...
He said that the cash in the Accumulated Depreciation account would be used to
pay for the furniture
...
3)
The company held the books open at the end of 2010 so they could record some early 2011 sales as
2010 revenue
...
(Ch
...
The appraised values were USD
10,000,000 higher than the book value
...
(Ch
...
(Ch
...
The
goods were not included in ending inventory because the goods had not yet arrived
...
5, 6)
The company counted some items twice in taking the physical inventory at the end of the year
...
(Ch
...
The preceding year it had
switched from the weighted-average method to FIFO
...
No indication of this switch was to appear in the financial
statements
...
5, 7)
Since things were pretty hectic at year-end, the accountant made no effort to reconcile the bank
account
...
The bank balance was lower
than the book balance, so the accountant debited Miscellaneous Expense and credited Cash for the
difference
...
8)
When a customer failed to pay the amount due, the accountant debited Allowance for Uncollectible
Accounts and credited Accounts Receivable
...
(Ch
...
298 of 433

A completely depreciated machine was still being used
...
(Ch
...
This year USD
200,000 of these costs were charged to expense
...
11)
An old truck was traded for a new truck
...
(Ch
...
The accountant is amortizing the asset over 60 years
...
11)
The company leases a building and has a nonrenewable lease that expires in 15 years
...
Since the improvements will last 30 years, they are being
written off over 30 years
...
11)
Annual report analysis B Refer to the "Summary of significant accounting policies" in the
annual report of The Limited, Inc
...
For each of the policies, explain in
writing what the company is trying to communicate
...
Write out the answers to the following questions:
Is management being ethical in this situation? Explain
...

What would you do if you were the accountant? Describe in detail
...
(As an alternative, annual reports can be downloaded from the
SEC's EDGAR site at www
...
gov/edgar
...
As
a team, write a memorandum to the instructor detailing the significant accounting policies of the
company
...

Group project E With one or two other students and using library sources, write a paper on the
history and achievements of the Financial Accounting Standards Board
...
It
was formed in 1973 and took over the rule setting function from the Accounting Principles Board of the
p
...
Be sure to cite sources used and to
treat direct quotes properly
...
Your
library might have a copy
...
019303, Order
Department, AICPA, Harborside Financial Center, 201 Plaza Three, Jersey City, NJ 07311- 3881] [Toll
free number 1-800-862-4272; FAX 1-800-362-5066]
...
Be sure to cite sources used and treat direct quotes properly
...
16
...
ge
...

Print a copy of the summary of Significant Accounting Policies
...

Visit the following Internet site for Oracle
...
oracle
...
Examine the notes
on the financial statements for the latest quarter
...


6
...
10 Answers to self-test
True-false
False
...

True
...

True
...

False
...

False
...
g
...


p
...
Relevance and reliability are the two primary characteristics
...
The matching concept is one of the major principles of accounting rather than an assumption
...
The consistency concept requires that a company use the same accounting principles and
reporting practices through time
...
Usually, the accountant does not recognize revenue until the seller acquires the right to receive
payment from the buyer
...

b
...
Periodicity is an underlying assumption rather than a modifying convention
...
The category, quantitative characteristics, is not part of the conceptual framework
project
...
301 of 433

7 Introduction to inventories and the classified
income statement
7
...




Describe briefly cost of goods sold and the distinction between perpetual and periodic

inventory procedures
...




Describe the freight terms and record transportation costs
...




Prepare a classified income statement
...




Prepare a work sheet and closing entries for a merchandising company (Appendix)
...
2 A career as a CEO
Are you a leader? Would you enjoy someday becoming the president or chief executive officer
(CEO) of the company you work for? Then you should consider a degree in accounting
...
Accounting students with the most job offers
and the highest starting salaries are also likely to be the ones who best demonstrate an ability to lead
others
...
e
...
e
...

Fortunately, you do not have to run a company to demonstrate leadership abilities to college
recruiters
...
If you do not have a resume yet, stop by the career placement center at your college and
ask them to assist you in preparing one
...
A well-prepared resume will be important for
securing internship opportunities and part-time work in the business field, as well as for landing that
first job upon graduation
...
302 of 433

Did you know that the chief executive officers (CEO) of many of the largest manufacturing,
merchandising, and service organizations in the United States have degrees in accounting? James
Dimon of JPMorgan Chase, Gary C
...
Mulva of
ConocoPhillips, and Indra K
...
It is really not that
surprising that accounting majors are so successful, as accounting provides an excellent foundation in
business
...

Your study of accounting began with service companies as examples because they are the least
complicated type of business
...
Although the fundamental accounting concepts for service
businesses apply to merchandising businesses, merchandise accounting requires some additional
accounts and techniques to record sales and purchases
...
After
performing certain functions, such as packaging or labeling, wholesalers sell the goods to retailers
...
The two middle boxes in the diagram represent
merchandising companies
...

This chapter begins by comparing the income statement of a service company with that of a
merchandising company
...
Finally, in the appendix we explain
the work sheet and the closing process for a merchandising company
...
303 of 433

SERVICE COMPANY

MERCHANDISING COMPANY

Income Statement

Income Statement

For the Year Ended 2010 December 31

Service revenues

For the Year Ended 2010 December 31

$13,200

Sales revenues

$262,000

Cost of goods sold

159,000

Gross Margin

$103,000

Expenses

6,510

Expenses

74,900

Net income

$ 6,690

Net income

$ 28,100

Exhibit 32: Condensed income statements of a service company and a merchandising company
compared

7
...
To determine profitability or net income, a service company
deducts total expenses incurred from revenues earned
...

As shown in Exhibit 32, merchandising companies must deduct from revenues the cost of the goods
they sell to customers to arrive at gross margin
...
The income
statement of a merchandising company has three main divisions: (1) sales revenues, which result from
the sale of goods by the company; (2) cost of goods sold, which is an expense that indicates how much
the company paid for the goods sold; and (3) expenses, which are the company's other expenses in
running the business
...
The third division (expenses) is similar to expenses for a service company,
which we illustrated in preceding chapters
...


7
...
The seller of the goods transfers them to the buyer in
exchange for cash or a promise to pay at a later date
...
304 of 433

transaction
...

In Exhibit 32, we show a condensed income statement to emphasize its major divisions
...
The merchandising
company that we use to illustrate the income statement is Hanlon Retail Food Store
...
Then, we explain how to
record two deductions from sales revenues—sales discounts and sales returns and allowances (Exhibit
33)
...
The formula for determining net sales is:
Net sales = Gross sales - (Sales discounts + Sales returns and allowances)
HANLON RETAIL FOOD STORE
Partial income Statement
For the Year Ended 2010 December 31

Operating revenues:
Gross sales
Less: Sales discounts

$282,000
$ 5,000

Sales returns and allowances 15,000
Net sales

20,000
$262,000

Exhibit 33: Partial income statement of merchandising company
Invoice No
...
19,

BRYAN WHOLESALE CO
...
: 218
Sold to:

Baier Company

Address:

2255 Hannon Street

Big Rapids, Michigan 48106
Terms:

Date Shipped: 2010 Dec
...


Description

Item Number

Quantity

Price per Unit

Total Amount

True-tone stereo radio

Model No
...

Usually, the physical delivery of the goods occurs at the same time as the sale of the goods
...

p
...
The invoice
contains the details of a sale, such as the number of units sold, unit price, total price billed, terms of
sale, and manner of shipment
...
A wholesale
company, which supplies goods to retailers, prepares the invoice after the shipping department notifies
the accounting department that it has shipped the goods to the retailer
...

Using the invoice as the source document, a wholesale company records the revenue from the sale
at the time of the sale for the following reasons:
 The seller has passed legal title of the goods to the buyer, and the goods are now the

responsibility and property of the buyer
...

 The seller has completed its obligation
...

 The seller can determine the costs incurred in selling the goods
...
This revenue increases a revenue
account called Sales
...
Therefore, the firm credits
the Sales account for the amount of the sale
...
When a sale is for cash, the company credits the Sales
account and debits Cash
...


When a sale is on account, it credits the Sales account and debits Accounts Receivable
...


Usually, a seller quotes the gross selling price, also called the invoice price, of goods to the buyer
...
In this
latter situation, the buyer must calculate the gross selling price
...
Merchandising companies that sell goods use the gross selling price as the
credit to sales
...
306 of 433

An accounting perspective: Uses of technology
A database management system stores related data—such as monthly sales data
(salespersons, customers, products, and sales amounts)—independent of the
application
...


A trade discount is a percentage deduction, or discount, from the specified list price or catalog
price of merchandise
...
A seller can use a catalog for a longer time by printing list

prices in the catalog and giving separate discount sheets to salespersons whenever prices change
...

 Allow quotation of different prices to various customers, such as retailers and wholesalers
...
However, sellers do not record trade discounts in
their accounting records because the discounts are used only to calculate the gross selling price
...
To illustrate, assume an invoice contains the
following data:
List price, 200 swimsuits at $24
Less: Trade discount, 30%
Gross selling price (invoice price)

$4,800
1,440
$3,360

The seller records a sale of USD 3,360
...
Thus,
neither the seller nor the purchaser enters list prices and trade discounts on their books
...
Chain discounts exist, for example, when a wholesaler receives two trade discounts
for services performed, such as packaging and distributing
...
If a product has a list price of USD
100 and is subject to trade discounts of 20 per cent and 10 per cent, the gross selling price (invoice
price) would be USD 100 - 0
...
1(USD 80) = USD 72, computed as
follows:
List price

$100

p
...
The complement of 20 per cent is 80 per cent because 20 per cent + 80 per cent =
100 per cent
...
Thus, the gross selling price is USD 100 X 0
...
9 = USD 72
...
Sellers record these deductions in contra revenue accounts to the Sales account
...
For
example, since the Sales account normally has a credit balance, the Sales Discounts account and Sales
Returns and Allowances account have debit balances
...

Sales discounts Whenever a company sells goods on account, it clearly specifies terms of payment
on the invoice
...

Net 30 is sometimes written as "n/30"
...
In Exhibit 34, if the terms had read "n/10/EOM"
(EOM means end of month), the buyer could not take a discount, and the invoice would be due on the
10th day of the month following the month of sale—or 2011 January 10
...

In some industries, credit terms include a cash discount of 1 per cent to 3 per cent to induce early
payment of an amount due
...
A cash discount differs from a trade discount in that a
cash discount is a deduction from the gross selling price for the prompt payment of an invoice
...
Sellers call a cash discount a sales discount and buyers call it a purchase discount
...
If payment is not made within the discount period, the
entire invoice price is due 30 days from the invoice date
...
308 of 433

 2/EOM, n/60—means a buyer who pays by the end of the month of purchase may deduct a 2

per cent discount from the invoice price
...

 2/10/EOM, n/60—means a buyer who pays by the 10th of the month following the month of

purchase may deduct a 2 per cent discount from the invoice price
...

Sellers cannot record the sales discount before they receive the payment since they do not know
when the buyer will pay the invoice
...
The following entries show how to record a sale and a subsequent sales discount
...
On July 21 (nine days after invoice date), the business received a USD 1,960 check in payment of
the account
...


The Sales Discounts account is a contra revenue account to the Sales account
...
Sellers use the Sales
Discounts account (rather than directly reducing the Sales account) so management can examine the
sales discounts figure to evaluate the company's sales discount policy
...
Rather, the purpose of the account is to
reduce recorded revenue to the amount actually realized from the sale
...
In fact, when their policy is satisfaction guaranteed,
some companies allow customers to return goods simply because they do not like the merchandise
...
Sellers and buyers regard a sales return as a
cancellation of a sale
...
309 of 433

them an allowance off the original price
...
When a seller agrees to the sales
return or sales allowance, the seller sends the buyer a credit memorandum indicating a reduction
(crediting) of the buyer's account receivable
...
A credit memorandum becomes the basis for recording a sales return or a
sales allowance
...

However, because the amount of sales returns and sales allowances is useful information to
management, it should be shown separately
...
Thus, sellers
record sales returns and sales allowances in a separate Sales Returns and Allowances account
...
(Some
companies use separate accounts for sales returns and for sales allowances, but this text does not
...
If payment has not yet been

received, the required entry is:

Sales Returns and Allowances (-SE)
Accounts Receivable (-A)

300
300

To record a sales return from a customer
...
Now, the credit is to Cash rather than to Accounts Receivable
...
For example, if a customer returns goods that sold for USD
300, on which a 2 per cent discount was taken, the following entry would be made:

p
...


The debit to the Sales Returns and Allowances account is for the full selling price of the purchase
...

Next, we illustrate the recording of a sales allowance in the Sales Returns and Allowances account
...
If the customer has not yet paid the account, the required entry
would be:
Sales Returns and Allowances (-SE)

400

Accounts Receivable (-A)

400

To record a sales allowance granted for damaged
merchandise
...
If
the customer took a 2 per cent discount when paying the account, the company would refund only the
net amount (USD 392)
...
The entry would be:
Sales Returns and Allowances (-SE)

400

Cash (-A)

392

Sales Discount (+SE)

8

To record a sales allowance when a customer has paid and
taken a 2% discount
...

Exhibit 35: Partial income statement*

p
...
More often, the income statement in a company's annual report
begins with "Net sales" because sales details are not important to external financial statement users
...
A national
retailer of personal computers and related products and services, for example, should
include wording similar to that in the following paragraph in its Annual Report
describing seasonality
...

Excluding the effects of new store openings, net sales and earnings are generally
lower during the first and fourth fiscal quarters than in the second and third fiscal
quarters
...
They attempt to stock just the right amount of goods
to meet demand
...
The only way
they can unload these goods is to offer huge discounts during the following period
...
5 Cost of goods sold
The second main division of an income statement for a merchandising business is cost of goods
sold
...
For a merchandising
company, the cost of goods sold can be relatively large
...
Merchandise inventory (or
inventory) is the quantity of goods available for sale at any given time
...

Look at the cost of goods sold section of Hanlon Retail Food Store's income statement in Exhibit 36
...
The net cost of purchases for the year
p
...
Thus, Hanlon had USD 190,000 of merchandise available for sale during 2010
...
Subtracting the unsold inventory (the ending inventory), USD 31,000, from the amount
Hanlon had available for sale during the year, USD 190,000, gives the cost of goods sold for the year of
USD 159,000
...

Cost of goods sold:
Merchandise inventory, 2010 January 1
Purchases
Less: Purchase discounts
Purchase returns and allowances
Net Purchases
Add: Transportation-in

$167,00
0

$
24,000

$3,00
0
8,000 11,000

$156,00
0
10,000

Net cost of purchases

166,000

Cost of goods available for sale

$190,00
0
31,000

Less: Merchandise inventory, 2010
December 31
Cost of goods sold

$159,00
0

Exhibit 36: Determination of cost of goods sold for Hanlon Retail Food Store
To determine the cost of goods sold, accountants must have accurate merchandise inventory
figures
...
We mention perpetual inventory
procedure only briefly here
...

When discussing inventory, we need to clarify whether we are referring to the physical goods on
hand or the Merchandise Inventory account, which is the financial representation of the physical goods
on hand
...
Under
perpetual inventory procedure, the Merchandise Inventory account is continuously updated to
reflect items on hand
...
When
your box of Rice Krispies crosses the scanner, the Merchandise Inventory account shows that one less
box of Rice Krispies is on hand
...
313 of 433

Under periodic inventory procedure, the Merchandise Inventory account is updated
periodically after a physical count has been made
...

Perpetual inventory procedure Companies use perpetual inventory procedure in a variety of
business settings
...
Today, computerized
cash registers, scanners, and accounting software programs automatically keep track of inflows and
outflows of each inventory item
...

Under perpetual inventory procedure, the Merchandise Inventory account provides close control by
showing the cost of the goods that are supposed to be on hand at any particular time
...
Usually, firms also maintain detailed unit records showing
the quantities of each type of goods that should be on hand
...
Then they compare this physical count
with the records showing the units that should be on hand
...

Periodic inventory procedure Merchandising companies selling low unit value merchandise
(such as nuts and bolts, nails, Christmas cards, or pencils) that have not computerized their inventory
systems often find that the extra costs of record-keeping under perpetual inventory procedure more
than outweigh the benefits
...

Under periodic inventory procedure, companies do not use the Merchandise Inventory account to
record each purchase and sale of merchandise
...
Also, the company usually does not maintain other records showing the exact number of units
that should be on hand
...

Companies using periodic inventory procedure make no entries to the Merchandise Inventory
account nor do they maintain unit records during the accounting period
...

Also, these companies make no attempt to determine the cost of goods sold at the time of each sale
...
To determine the cost of goods sold, a company must know:
p
...

 Net cost of purchases during the period
...


The company would show this information as follows:
Beginning inventory
Add: Net cost of purchases during the period
Cost of goods available for sale during the period
Deduct: Ending inventory
Cost of goods sold during the period

$ 34,000
140,000
$174,000
20,000
$154,000

In this schedule, notice that the company began the accounting period with USD 34,000 of
merchandise and purchased an additional USD 140,000, making a total of USD 174,000 of goods that
could have been sold during the period
...
Of course, the
USD 154,000 is not necessarily the precise amount of goods sold because no actual record was made of
the dollar cost of the goods sold
...
This method disregards problems such as theft or breakage
because the Merchandise Inventory account contains no up-to-date balance at the end of the
accounting period against which to compare the physical count
...
The Purchases
account, which is increased by debits, appears with the income statement accounts in the chart of
accounts
...
Hanlon purchased USD 30,000 of
merchandise on credit (on account) on May 4, and on May 21 purchased USD 20,000 of merchandise
for cash
...

21 Purchases (+A)
Cash (-A)
To record purchase of merchandise for cash
...
315 of 433

The buyer deducts purchase discounts and purchase returns and allowances from purchases to
arrive at net purchases
...

Purchase discounts Often companies purchase merchandise under credit terms that permit
them to deduct a stated cash discount if they pay invoices within a specified time
...
If Hanlon pays for the merchandise by May 14, the
store may take a 2 per cent discount
...
The entry to record the payment of the invoice on May 14 is:
May

14 Accounts Payable (-L)

30,000

Cash (-A)

29,400

Purchase Discount (+SE)

600

To record payment on account within the
discount period
...
The Purchase Discounts account is a contra account to Purchases that
reduces the recorded invoice price of the goods purchased to the price actually paid
...

Companies base purchase discounts on the invoice price of goods
...
For example, in the previous transaction, the invoice price of goods purchased was USD
30,000
...

Interest rate implied in cash discounts To decide whether you should take advantage of
discounts by using your cash or borrowing, make this simple analysis
...
By advancing payment 20 days from the final due date, you can secure a discount of USD 200
...
33,
calculated as (USD 9,800 x
...
You would save USD 134
...
33) by
borrowing the money and paying the invoice within the discount period
...
The formula is:

p
...
Thus, a company could afford to pay up to 36 per cent [(360/20) X 2 per cent] on
borrowed funds to take advantage of discount terms of 2/10, n/ 30
...

Purchase returns and allowances A purchase return occurs when a buyer returns merchandise
to a seller
...
Then, the buyer commonly uses a debit memorandum to notify the seller that the account
payable with the seller is being reduced (Accounts Payable is debited)
...

Both returns and allowances reduce the buyer's debt to the seller and decrease the cost of the goods
purchased
...
For this reason, buyers record purchase returns and allowances in a separate Purchase
Returns and Allowances account
...
Only the explanation would
change
...
If the company took a discount at the time it paid the
account, only the net amount would be refunded
...
317 of 433

Cash (+A)

343

Purchase Discounts (-SE)

7

Purchase Returns and Allowances (+SE)

350

To record return of damaged merchandise to supplier and
record receipt of cash
...
When both purchase discounts and purchase
returns and allowances are deducted from purchases, the result is net purchases
...
To understand how to account for
transportation costs, you must know the meaning of the following terms:
 FOB shipping point means "free on board at shipping point"
...
Thus, the buyer is responsible for ultimately paying the freight charges
...
The seller ships the goods to their

destination without charge to the buyer
...

 Passage of title is a term that indicates the transfer of the legal ownership of goods
...
Thus, when goods are shipped FOB
shipping point, title usually passes to the buyer at the shipping point
...

 Freight prepaid means the seller must initially pay the freight at the time of shipment
...


To illustrate the use of these terms, assume that a company ships goods FOB shipping point, freight
collect
...
The buyer is responsible for paying the USD 100 freight costs
and does so
...


The Transportation-In account records the inward freight costs of acquiring merchandise
...
318 of 433

purchases
...
Recall that a
contra account is just the opposite of an adjunct account
...

When shipping goods FOB destination, freight prepaid, the seller is responsible for and pays the
freight bill
...
The seller, however, has undoubtedly considered the freight cost in setting
selling prices
...


When the terms are FOB destination, the seller records the freight costs as delivery expense; this
selling expense appears on the income statement with other selling expenses
...
Goods in transit then belong
to either the seller or the buyer, and one of these parties must include these goods in its ending
inventory
...
Goods shipped FOB shipping point belong to the buyer while in
transit, and the buyer records these goods as a purchase and includes them in its ending inventory
...
If terms are FOB destination, the seller includes the goods in its 2009 December
31, inventory, and neither seller nor buyer records the exchange transaction until 2010 January 5
...

Sometimes the seller prepays the freight as a convenience to the buyer, even though the buyer is
ultimately responsible for it
...
For example,
assume that Wood Company sold merchandise to Loud Company with terms of FOB shipping point,
freight prepaid
...
The following entries are necessary on the books of
the buyer and the seller:
Buyer—Loud Company
Transportation-In (-SE)
Acc57i5G:sxi5ien h²NhÐ$5u° n):$,0

Seller—Wood Company
ðvð 57à
ANGNm :$,7`ðe9•ans`cS?hÐñ:,

T
...
Therefore, Loud Company must reimburse Wood for the charges
...
g
...
The following entries are necessary on the books of the buyer and the seller:
Buyer—Loud Company

Accounts Payable (-L)

Seller—Wood Company

100
100

Delivery Expense (-SE)
Accounts Receivable (-A)

100
100

Cash (-A)

Purchase discounts may be taken only on the purchase price of goods
...
We summarize our discussion of freight terms and the
resulting journal entries to record the freight charges in Exhibit 37
...
To
determine the cost of goods sold in any accounting period, management needs inventory information
...
Since the ending inventory of the preceding period is the beginning inventory for
the current period, management already knows the cost of the beginning inventory
...
Therefore, management needs to determine only the cost of the ending inventory at the end of
the period in order to calculate cost of goods sold
...
Taking a physical inventory
consists of counting physical units of each type of merchandise on hand
...
Then, they combine the total
costs of the various kinds of merchandise to provide the total ending inventory cost
...

Shipping point: Detroit-

Destination: San Diego

Goods travel from shipping point to destination
If shipping terms are:
FOB shipping point—Buyer incurs

the freight

FOB destination—Seller incurs

the freight

p
...
The proper party (buyer) paid the freight
...

FOB destination, freight prepaid – Seller both incurs and initially pays the freight charges
...
The seller
debits Delivery Expense and credits Cash
...
Buyer must reimburse seller for
freight charges
...
The buyer debits Transportation-In and credits
Accounts Payable when informed of the freight charges
...
Buyer deducts freight charges from amount
owed to seller
...
The seller debits Delivery Expense and credits
Accounts Receivable when informed of the freight charges
...
Similarly, companies should not record consigned goods (goods delivered to another
party who attempts to sell them for a commission) as sold goods
...

Merchandise in transit is merchandise in the hands of a freight company on the date of a
physical inventory
...
In general, the goods belong to the party who ultimately bears the
transportation charges
...
To illustrate, assume
the following account balances for Hanlon Retail Food Store as of 2010 December 31:
Merchandise Inventory, 2010 January 1
Purchases
Purchase Discounts
Purchase Returns and Allowances
Transportation-In

$ 24,000
167,000
3,000
8,000
10,000

Dr
...

Cr
...

Dr
...
Hanlon then calculated its cost of goods sold as shown in Exhibit 38
...


p
...


Exhibit 38: Determination of cost of goods sold for Hanlon Retain Food Store*
In Exhibit 38, Hanlon's beginning inventory (USD 24,000) plus net cost of purchases (USD
166,000) is equal to cost of goods available for sale (USD 190,000)
...
Ending
inventory cost (merchandise inventory) is also a current asset in the end-of-period balance sheet
...

However, periodic inventory procedure provides little control over inventory
...
Thus, they
mistakenly assume items that have been stolen have been sold and include their cost in cost of goods
sold
...
These figures suggest that the cost of goods sold was USD 140,000
...
If such goods had not been
stolen, the ending inventory would have been USD 62,000 and the cost of goods sold only USD
138,000
...


An accounting perspective: Uses of technology
Many companies are building private networks to link their employees, customers,
and suppliers together
...
The Internet can be likened to the entire universe, while an
intranet can be likened to a solar system within the universe
...
For instance, these networks are designed to be
secure against "hackers" and other unauthorized persons
...


7
...
An
unclassified income statement has only two categories—revenues and expenses
...
The statement also separates operating expenses into selling and administrative expenses
...

In Exhibit 39, we present a classified income statement for Hanlon Retail Food Store
...
323 of 433

together with additional assumed data on operating expenses and other expenses and revenues
...

 Cost of goods sold
...

 Nonoperating revenues and expenses (other revenues and other expenses)
...
For example, by deducting cost of goods sold from operating revenues, you can
determine by what amount sales revenues exceed the cost of items being sold
...
The classified income statement subdivides operating expenses into selling and
administrative expenses
...
Statement users can also make comparisons
with other years' data for the same business and with other businesses
...


An accounting perspective: Business insight
Management chooses whether to use a classified or unclassified income statement to
present a company's financial data
...

HANLON RETAIL FOOD STORE
Income Statement
For the Year Ended 2010 December 31

Operating revenues:
Gross sales

$282,000

Less: Sales discounts

$ 5,000

Sales return and allowances

15,000

Net sales

20,000
$262,000

Cost of goods sold:
Merchandise inventory, 2010 January 1
Purchases
Less: Purchase discount
Purchase returns and allowances
Net purchases

$24,000
$167,00
0

$3,00
0
8,000 11,000

$156,00
0

p
...
The terms in
some of these headings are already familiar to you
...

 Operating revenues are the revenues generated by the major activities of the business—

usually the sale of products or services or both
...
325 of 433

 Cost of goods sold is the major expense in merchandising companies
...
This chapter has already discussed
the items used in calculating cost of goods sold
...
The
excess of net sales over cost of goods sold is the gross margin or gross profit
...
In Exhibit 39, the gross margin
rate is approximately 39
...
The gross margin rate indicates
that out of each sales dollar, approximately 39 cents is available to cover other expenses and
produce income
...
Also, a downward trend in the gross
margin rate may indicate a problem, such as theft of merchandise
...
, suffered significant gross margin deterioration from
increased shoplifting and employee theft
...
Usually, operating expenses
are either selling expenses or administrative expenses
...
Examples include salaries and commissions of
salespersons, expenses for salespersons' travel, delivery, advertising, rent (or depreciation, if
owned) and utilities on a sales building, sales supplies used, and depreciation on delivery trucks
used in sales
...
Examples include administrative salaries, rent (or depreciation, if
owned) and utilities on an administrative building, insurance expense, administrative supplies
used, and depreciation on office equipment
...
For example,
a company might incur rent, taxes, and insurance on a building for both sales and administrative
purposes
...
For instance, if USD 1,000 of
depreciation expense relates 60 per cent to selling and 40 per cent to administrative based on the
square footage or number of employees, the income statement would show USD 600 as a selling
expense and USD 400 as an administrative expense
...
An example of a nonoperating revenue is interest that a business earns on notes
p
...
An example of a nonoperating expense is interest incurred on money borrowed by the
company
...

 Net purchases = Purchases - (Purchase discounts + Purchase returns and allowances)
...

 Cost of goods sold = Beginning inventory + Net cost of purchases - Ending inventory
...

 Income from operations = Gross margin - Operating (selling and administrative) expenses
...


Each of these relationships is important because of the way it relates to an overall measure of
business profitability
...
However,
because of large sales commissions and delivery expenses, the owner may realize only a very small
percentage of the gross margin as profit
...


An ethical perspective: World auto parts corporation
John Bentley is the chief financial officer for World Auto Parts Corporation
...

Most of the suppliers have cash discount terms of 2/10, n/30
...
Whenever a supplier
complains, John instructs his purchasing agent to find another supplier who will go
along with this practice
...
These small suppliers are much better off to go
along and have our business than to not go along and lose it
...
Besides, if they are willing to sell to others at a 2 per cent
discount, why should they not be willing to sell to us at that same discount even
though we pay a little later? The benefit to our company is very significant
...
327 of 433

our profits were USD 100 million
...
Do you really want me to change this practice and give
up USD 10 million of our profits?

7
...

($ millions)
Revenues
Gross profit
Gross profit (margin)
percentage

2000

1999

1998

$ 1,238
...
4

$ 1,030
...
4

$ 805
...
4

$ 509
...
6 = 41
...
4/$1,030
...
69%

$331
...
2 = 41
...

You should now understand the distinction between accounting for a service company and a
merchandising company
...


7
...

 An invoice is a document, prepared by the seller of merchandise and sent to the buyer, that

contains the details of a sale, such as the number of units sold, unit price, total price, terms of sale,
and manner of shipment
...
When a sale is for cash, the debit is to Cash and the

credit is to Sales
...

 When companies offer trade discounts, the gross selling price (gross invoice price) at which the

sale is recorded is equal to the list price minus any trade discounts
...
328 of 433

 Two common deductions from gross sales are (1) sales discounts and (2) sales returns and

allowances
...
Both
the Sales Discounts account and the Sales Returns and Allowances account normally have debit
balances
...

 Sales discounts arise when the seller offers the buyer a cash discount of 1 per cent to 3 per cent to

induce early payment of an amount due
...
A sales allowance is a deduction from the
original invoiced sales price granted to a customer when the customer keeps the merchandise but
is dissatisfied
...


Net cost of purchases=Purchases−(Purchase discounts+Purchase returns)+Transportation−¿
 Two methods of accounting for inventory are perpetual inventory procedure and periodic

inventory procedure
...
Under periodic inventory procedure, the inventory account
is updated only periodically—after a physical count has been made
...

 Two common deductions from purchases are (1) purchase discounts and (2) purchase returns

and allowances
...
From
the buyer's side of the transactions, cash discounts are purchase discounts, and merchandise
returns and allowances are purchase returns and allowances
...

 FOB destination means free on board at destination—the seller incurs the freight
...

 Freight prepaid is when the seller must initially pay the freight at the time of shipment
...

 Expansion and application of the relationship introduced in Learning objective 2
...
Cost of goods available for
sale - Ending inventory = Cost of goods sold
...


p
...

 Cost of goods sold is the major expense in merchandising companies
...
Usually, operating expenses are
classified as either selling expenses or administrative expenses
...

Gross margin
 Gross margin percentage=
Net sales
 The gross margin rate indicates the amount of sales dollars available to cover expenses and

produce income
...

 Any revenue accounts and contra purchases accounts in the Adjusted Trial Balance credit

column of the work sheet are carried to the Income Statement credit column
...
Purchases, Transportation-In, and expense

accounts in the Adjusted Trial Balance debit column are carried to the Income Statement debit
column
...

 Closing entries may be prepared directly from the work sheet
...
The
second entry credits all items appearing in the Income Statement debit column and debits Income
Summary
...
The fourth entry debits the Retained Earnings account and
credits the Dividends account
...
9 Appendix: The work sheet for a merchandising company
Exhibit 40 shows a work sheet for a merchandising company
...
The illustration for Lyons Company focuses on merchandise-related accounts
...
Except for the merchandise-related
accounts, the work sheet for a merchandising company is the same as for a service company
...
330 of 433

that use of a work sheet assists in the preparation of the adjusting and closing entries
...

To further simplify this illustration, assume Lyons needs no adjusting entries at month-end
...
The USD 7,000 merchandise inventory
in the trial balance is the beginning inventory
...

Lyons carries any revenue accounts (Sales) and contra purchases accounts (Purchase Discounts,
Purchase Returns and Allowances) in the Adjusted Trial Balance credit columns of the work sheet to
the Income Statement credit column
...

Assume that ending inventory is USD 8,000
...
It also enters the ending inventory in the Balance
Sheet debit column to establish the proper balance in the Merchandise Inventory account
...
Net income of USD 5,843 for the period balances the
Income Statement columns
...
Retained earnings of USD 18,843 balances the Statement of Retained Earnings
columns
...

Lyons carries all other asset account balances (Cash, Accounts Receivable, and ending Merchandise
Inventory) to the Balance Sheet debit column
...
The balance sheet columns total to
USD 29,543
...
After entering
any adjusting and closing entries in the journal, the firm posts them to the ledger
...
Finally, it prepares a post-closing trial balance
...
The focus in this income statement is on determining the cost of goods sold
...
In

p
...


Acct
...


100
103
105
200
300
310
320
410
411
412
500
SOI
502
503
557
567

Account Titles

LYONS COMPANY
Worksheet
For the Month Ended 2010 December 31

Retained Earnings,
Decernl5er 1
Dividends
Sales
Sales Discounts
Sales Returns and
Allowances
Purchases
Purchases Discounts
Purchase Returns and
Allowances
Transportation-In
Miscellaneous Selling
Expenses
Miscellaneous
Administrative
Expenses

Adjustments

Adjusted Trial
Balance

Income
Statement

Debit
Cash
Accounts Receivable
Merchandise Inventory,
December 1
Accounts Payable
Capital Stock

Trial Balance

Debit

Debit

Debit

Credit

19,663
1,380
7,000

2,000
44
20
6,000

Credit

Credit

Credit

Statement of
Retained
Earnings
Debit
Credit

19,663
1,880
700
10,00
0
15,00
0
14,60
0

82
100

7,000

2,000
44
20
6,000

75
2,650

75
2,650

1,150
40,482 40,48
2

1,150
40,432

Net Income
Retained Earnings,
December 31

Balance
Sheet
Debit
19,653
1,880

700
10,00
0
15,00
0
14,60
0

82
100

7,000

8,000

8,000

15,000
14,600

2,000

44
20
6,000

32
100

75
2,650

1,150
40,48 16,939 22,782
2
5,843
5,343
22,732 22,782 2,000 20,343 29,543
18,S43
20,843 20,843 29,543

Exhibit 40: Work sheet for a merchandising company

p
...
333 of 433

LYONS COMPANY
Balance Sheet 2010 December 31
Assets

Cash
Accounts receivable
Merchandise inventory
Total assets

$19,663
1,880
8,000
$29,543

Liabilities and Stockholders' Equity

Liabilities:
Accounts payable

$ 700

Stockholders' equity:
Capital stock
Retained earnings
Total stockholders' equity Total liabilities and
stockholders' equity

$ 10,000
18,843

28,843
$29,543

Exhibit 43: Balance sheet for a merchandising company
Balance sheet The balance sheet, Exhibit 43, contains the assets, liabilities, and stockholders'
equity items taken from the work sheet
...
The
Retained Earnings account balance comes from the statement of retained earnings
...
The closing process closes revenue and expense
accounts by transferring their balances to a clearing account called Income Summary and then to
Retained Earnings
...

Lyons's accountant would prepare closing entries directly from the work sheet in Exhibit 40 using
the same procedure presented in Chapter 4
...

The first journal entry debits all items appearing in the Income Statement credit column of the work
sheet and credits Income Summary for the total of the column, USD 22,782
...

• 1st entry

31 Merchandise Inventory (ending)
Sales
Purchase Discounts
Purchase Returns and Allowances
Income Summary
To close accounts with a credit balance in the Income
Statement columns and to establish ending merchandise
inventory
...


p
...


• 2nd entry

31 Income Summary
Merchandise Inventory (beginning)
Sales Discounts
Sales Returns and Allowance
Purchases
Transportation-In
Miscellaneous Selling Expenses
Miscellaneous Administrative Expenses
To close accounts with a debit balance in the Income
Statement columns
...

2010
Dec
...


5,843

The fourth entry closes the Dividends account balance of $2,000 to the Retained Earnings account
by debiting Retained Earnings and crediting Dividends
...


2,000
31 Retained Earnings
Dividends
To close the Dividends account to the Retained Earnings
account
...
In the first closing journal entry, the credit to the Income Summary account
is equal to the total of the Income Statement credit column
...
The
difference between the totals of the two Income Statement columns (USD 5,843) represents net
income and is the amount of the third closing entry
...
9
...

11 Company D paid freight of USD 1,200
...
335 of 433

14 Company C received an allowance of USD 4,000 from the gross selling price because of damaged
goods
...

30 Company D received payment in full from Company C
...
Journalize the transactions for Company C
...
Journalize the transactions for Company D
...
9
...

General Journal

Date
2010
June

Account Titles and Explanation
1
0

Post
...


Debit

Credit

Company C

Purchases
Accounts Payable

8 0 0 0 0
8 0 0 0 0

Purchased merchandise from Company D; terms
2/10/EOM, n/60
1
4

Accounts Payable

4 0 0 0

Purchase Return and Allowances

4 0 0 0

Received an allowance from Company D for damaged
goods
...
02)
Cash ($68,000 - $1,360)

6 8 0 0 0
1 3 6 0
6 6 6 4 0

Paid the amount due to Company D
...


p
...

Ref
...

1
4

Sales Returns and Allowances

4 0 0 0

Accounts Receivable

4 0 0 0

Granted an allowance to Company C for damaged
goods
...

3
0

Cash ($68,000 - $1,360)
Sales Discounts ($68,000 x 0
...


7
...

Administrative expenses Expenses a company incurs in the overall management of a
business
...
To the seller, it is a sales discount; to the buyer, it is a purchase discount
...

Classified income statement Divides both revenues and expenses into operating and
nonoperating items
...
Also called the multiple-step income statement
...

Cost of goods available for sale Equal to beginning inventory plus net cost of purchases
...
337 of 433

Cost of goods sold Shows the cost to the seller of the goods sold to customers; under periodic
inventory procedure, cost of goods sold is computed as Beginning inventory + Net cost of
purchases - Ending inventory
...

FOB destination Means free on board at destination; goods are shipped to their destination
without charge to the buyer; the seller is responsible for paying the freight charges
...

Freight collect Terms that require the buyer to pay the freight bill on arrival of the goods
...

Gross margin or gross profit Net sales - Cost of goods sold; identifies the number of dollars
available to cover expenses other than cost of goods sold
...

Gross selling price (also called the invoice price) The list price less all trade discounts
...

Invoice A document prepared by the seller of merchandise and sent to the buyer
...
It is a purchase invoice from the buyer's point of view and a sales
invoice from the seller's point of view
...

Merchandise in transit Merchandise in the hands of a freight company on the date of a
physical inventory
...

Net cost of purchases Net purchases + Transportation-in
...

Net purchases Purchases - (Purchase discounts +Purchase returns and allowances)
...

Nonoperating expenses (other expenses) Expenses incurred by a business that are not
related to the acquisition and sale of the products or services regularly offered for sale
...

Operating expenses Those expenses other than cost of goods sold incurred in the normal
business functions of a company
...

Passage of title A legal term used to indicate transfer of legal ownership of goods
...

Perpetual inventory procedure A method of accounting for merchandise acquired for sale
to customers wherein the Merchandise Inventory account is continuously updated to reflect

p
...

Physical inventory Consists of counting physical units of each type of merchandise on hand
...

Purchase Discounts account A contra account to Purchases that reduces the recorded gross
invoice cost of the purchase to the price actually paid
...

Purchases account An account used under periodic inventory procedure to record the cost of
goods or merchandise bought for resale during the current accounting period
...

Sales allowance A deduction from original invoiced sales price granted to a customer when
the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including
inferior quality, damage, or deterioration in transit
...

Sales Discounts account A contra revenue account to Sales; it is shown as a deduction from
gross sales in the income statement
...

Sales Returns and Allowances account A contra revenue account to Sales used to record
the selling price of merchandise returned by buyers or reductions in selling prices granted
...

Trade discount A percentage deduction, or discount, from the specified list price or catalog
price of merchandise to arrive at the gross invoice price; granted to particular categories of
customers (e
...
retailers and wholesalers)
...

Transportation-In account An account used under periodic inventory procedure to record
inward freight costs incurred in the acquisition of merchandise; a part of cost of goods sold
...

Also called the single-step income statement
...


7
...
11
...

o

To compute net sales, sales discounts are added to, and sales returns and allowances are
deducted from, gross sales
...


p
...


o

In taking a physical inventory, consigned goods delivered to another party who attempts to
sell the goods are not included in the ending inventory of the company that sent the goods
...


7
...
2

Multiple-choice

Select the best answer for each of the following questions
...
The entry on the books of the seller is:
a
...
Accounts Receivable

4,000
4,000

Sales
c
...
Accounts Receivable
Sales

4,000
3,200
3,200

X Company began the accounting period with USD 60,000 of merchandise, and net cost of
purchases was USD 240,000
...
The cost of goods sold of Y Company for the period is:
a
...

b
...

c
...

d
...

e
...

A business purchased merchandise for USD 12,000 on account; terms are 2/10, n/30
...
USD 240
...
USD 200
...
340 of 433

c
...

d
...

e
...

A classified income statement consists of all of the following major sections except for:
a
...

b
...

c
...

d
...

e
...

(Appendix) Closing entries for merchandise-related accounts include all of the following except for:
a
...

b
...

c
...

d
...

e
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
11
...




Sales discounts and sales returns and allowances are deducted from sales on the income
statement to arrive at net sales
...
341 of 433



What do the letters FOB stand for? When terms are FOB destination, who incurs the
cost of freight?



What type of an expense is delivery expense? Where is this expense reported in the
income statement?



Periodic inventory procedure is said to afford little control over inventory
...




How does the accountant arrive at the total dollar amount of the inventory after taking a
physical inventory?



How is cost of goods sold determined under periodic inventory procedure?



If the cost of goods available for sale and the cost of the ending inventory are known,
what other amount appearing on the income statement can be calculated?



What are the major sections in a classified income statement for a merchandising
company, and in what order do these sections appear?



What is gross margin? Why might management be interested in the percentage of gross
margin to net sales?



(Appendix) After closing entries are posted to the ledger, which types of accounts have
balances? Why?



The Limited, Inc
...
Based on the financial statements of The Limited, Inc
...
11
...

Increased

Normal

by

Balance

(debit
Title of Account

Decreased

by

(debit

(debit

or credit)

or credit)

or credit)

Merchandise Inventory
Sales

p
...
Silver Company purchased USD 56,000 of merchandise from Milton Company on
account
...
Assuming use of periodic inventory procedure, prepare entries on both
companies' books to record both the purchase/sale and the return
...
Show how any of the required entries would change assuming that Milton Company granted an
allowance of USD 3,360 on the damaged goods instead of giving permission to return the merchandise
...

Exercise D You have purchased merchandise with a list price of USD 36,000
...
6 per cent
...
How much will you remit if you pay the invoice by the end of the month of purchase? How much
will discounts on payment you remit if you do not pay the invoice until the following month?
Exercise E Lasky Company sold merchandise with a list price of USD 60,000 on July 1
...

Trade Discount
Granted
a
...
40%, 10%
c
...
40%

Credit
Terms

Date
Paid

2/10, n/30
2/EOM, n/60
3/10/EOM, n/60
1/10, n/30

July 10
August 10
August 10
July 12

Exercise F Raiser Company purchased goods at a gross selling price of USD 2,400 on August 1
...
For each of the following independent situations,
p
...

Purchase
Transportation
Terms
a
...
FOB destination
c
...
FOB destination

Freight
Paid (by)

Allowance
Granted

$240 (buyer)
120 (seller)
180 (seller)
192 (buyer)

$480
240
720
120

Exercise G Stuart Company purchased goods for USD 84,000 on June 14, under the following
terms: 3/10, n/ 30; FOB shipping point, freight collect
...

a
...

b
...
Prepare the entry to record the payment made on
that date
...
Determine the cost of goods sold
for the company assuming purchases during the period were USD 40,000, transportation-in was USD
300, purchase returns and allowances were USD 1,000, beginning inventory was USD 25,000,
purchase discounts were USD 2,000, and ending inventory was USD 13,000
...
344 of 433

Exercise J In each of the following equations supply the missing term(s):
a
...

b
...

c
...

d
...

e
...

Exercise K Given the balances in this partial trial balance, indicate how the balances would be
treated in the work sheet
...
(The amounts are unusually small for ease
in rewriting the numbers
...
)
Accounts Titles

Trial Balance
Debit
Credit

Adjustments
Debit

Credit

Adjusted
Trial Balance
Debit
Credit

Income Statement
Debit
Credit

Balance Sheet
Debit
Credit

Merchandise
Inventory

120

Sales

S40

Sales Discounts

18

Sales Returns
and Allowances

45

Purchases

600

Purchase
Discounts

12

Purchase Returns
and Allowances
Transportation-In

24
36

Exercise L Using the data in the previous exercise prepare closing entries for the preceding
accounts
...


7
...
5

Problems

Problem A

a
...
1 Sold merchandise on account for USD 288,000; terms 2/10, n/30, FOB shipping point,
freight collect
...
Payment
for these goods had not yet been received
...
345 of 433

8 A sales allowance of USD 5,760 was granted on the merchandise sold on April 1 because the
merchandise was damaged in shipment
...

b
...

July 2 Purchased stereo merchandise on account at a cost of USD 43,200; terms 2/10, n/30,
FOB destination, freight prepaid
...

16 Paid freight costs on the merchandise sold, USD 2,160
...

31 Paid the amount due on the purchase of July 2
...

Problem B Mars Musical Instrument Company and Tiger Company engaged in the following
transactions with each other during July 2010:
July 2 Mars Musical Instrument Company purchased merchandise on account with a list price of
USD 48,000 from Tiger Company
...
Trade discounts of 15 per cent, 10 per cent, and 5 per cent were granted by Tiger Company
...

6 The buyer returned damaged merchandise with an invoice price of USD 2,790 to the seller and
received full credit
...

Prepare all the necessary journal entries for the buyer and the seller
...

4 Merchandise was purchased for cash, USD 432,000; FOB shipping point, freight collect
...

13 The company sold merchandise on account, USD 288,000; terms 2/10, n/ 30
...

p
...

20 Salaries for services received were paid as follows: to office employees, USD 31,680; to
salespersons, USD 83,520
...

24 The company purchased merchandise on account at a cost of USD 345,600; terms 2/10,
n/30, FOB shipping point, freight collect
...

27 A trucking company was paid USD 7,200 for delivery to Rusk Company of the goods
purchased June 24
...

30 Sold merchandise for cash, USD 172,800
...

30 Paid store rent for June, USD 43,200
...

The inventory on hand at the close of business June 30 was USD 672,000 at cost
...
Prepare journal entries for the transactions
...
Post the journal entries to the proper ledger accounts
...
Assume that all postings are from page 20 of
the general journal
...
Prepare a trial balance as of 2010 June 30
...
Prepare a classified income statement for the month ended 2010 June 30
...

Problem D The Western Wear Company, a wholesaler of western wear clothing, sells to retailers
...
The stockholders purchased
stock at par for the following assets in the business: USD 462,000 cash, USD 168,000 merchandise,
and USD 105,000 land
...

p
...
Freight terms were FOB shipping point, freight collect
...

14 The company sold merchandise on account, USD 315,000; terms 2/10, n/30
...

16 Of the merchandise sold May 14, USD 13,860 was returned for credit
...

24 The company collected the amount due on USD 126,000 of the accounts receivable arising
from the sale of May 14
...
Freight terms were FOB shipping point, freight collect
...

28 A trucking company was paid USD 2,100 for delivery to The Western Wear Company of the
goods purchased May 25
...

30 Cash sales were USD 74,088
...

31 Paid Bond Company for the merchandise purchased on May 25, taking into consideration the
merchandise returned on May 27
...

From the data given for The Western Wear Company:
a
...

b
...
Use the account numbers in the chart of
accounts shown in a separate file at the end of the text
...

(There were no adjusting journal entries
...
Prepare a trial balance
...
Prepare a classified income statement for the month ended 2010 May 31
...
Prepare a classified balance sheet as of 2010 May 31
...
348 of 433

Problem E The following data are for Leone Lumber Company:
LEONE LUMBER COMPANY
Trial Balance
2010 December 31
Acct
...


Account Title

Debits

100
103
105
107
108
112
170
171
200
300
310
410
412
418
500
502
503
505
508
509
510
511
536
540
567

Cash
Accounts Receivable
Merchandise Inventory, 2010 January 1
Supplies on Hand
Prepaid Insurance
Prepaid Rent
Equipment
Accumulated Depreciation—Equipment
Accounts Payable
Capital Stock
Retained Earnings, 2010 January 1
Sales
Sales Returns and Allowances
Interest Revenue
Purchases
Purchases Returns and Allowances
Transportation-In
Advertising Expense
Sales Salaries Expense
Office Salaries Expense
Officers' Salaries Expense
Utilities Expense
Legal and Accounting Expense
Interest Expense
Miscellaneous Administrative Expense

$ 70,640
159,520
285,200
5,360
4,800
57,600
88,000

5,160
$ 500,840
$7,840
78,000
138,400
80,800
160,000
4,800
10,000
600
9,880
$1,667,440

Credits

$ 17,600
102,800
200,000
219,640
1,122,360
$ 1,000
$4,040

$1,667,440

 A total of USD 3,400 of the prepaid insurance has expired
...

 Prepaid rent expired during the year is USD 50,600
...

 Accrued sales salaries are USD 4,000
...

 Merchandise inventory on hand is USD 350,000
...
A work sheet for the year ended 2010 December 31
...

b
...
The only selling expenses are sales salaries, advertising, supplies,
and depreciation expense—equipment
...
A statement of retained earnings
...
A classified balance sheet
...
349 of 433

e
...


7
...
6

Alternate problems

Alternate problem A
a
...
2 Sold merchandise on account for USD 300,000; terms 2/10, n/30, FOB shipping point,
freight collect
...

20 A total of USD 10,000 of the merchandise sold on August 2 was returned, and a full
refund was made because it was the wrong merchandise
...

b
...
4 Purchased merchandise on account at a cost of USD 140,000; terms 2/10, n/30, FOB
shipping point, freight collect
...

10 Sold goods for USD 100,000; terms 2/10, n/30
...

14 Paid the amount due on the purchase of August 4
...

Alternate problem B Edwardo Auto Parts Company and Spoon Company engaged in the
following transactions with each other during August 2010:
Aug
...
Trade discounts of 20 per cent and 10 per cent were allowed
...

16 The seller paid the freight charges, USD 2,400
...

20 The seller granted the allowance requested on August 17
...
Record all of the entries
required on the books of both the buyer and the seller
...
350 of 433

Alternate problem C Gardner Company engaged in the following transactions in June 2010, the
company's first month of operations:
June 1 Stockholders invested USD 384,000 cash and USD 144,000 of merchandise inventory in the
business in exchange for capital stock
...

4 Paid height on the June 3 purchase, USD 5,280
...

10 Sold merchandise on account, USD 230,400; terms 2/10, n/30, FOB shipping point, freight
collect
...

12 Paid the amount due on the purchase of June 3
...

14 Paid height on sale of June 13, USD 14,400
...

21 USD 48,000 of the goods sold on June 13 were returned for credit
...

25 Received the amount due on sale of June 10
...

30 Paid sales salaries of USD 57,600 for June
...

The inventory on hand on June 30 was USD 288,000
...
Prepare journal entries for the transactions
...
Post the journal entries to the proper ledger accounts
...
Assume that all postings are from page 10 of the
general journal
...
Prepare a trial balance as of 2010 June 30
...
Prepare a classified income statement for the month ended 2010 June 30
...

p
...

1 Purchased merchandise on account from String Company, USD 46,800; terms n/60, FOB
shipping point, freight collect
...

6 Paid transportation charges on May 1 purchase, USD 1,440 cash
...

10 Requested and received an allowance of USD 1,800 from String Company for improper quality of
certain items
...

16 Issued cash refund for return of merchandise relating to sale made on May 3, USD 180
...

18 Received a bill for freight charges of USD 900 from Ball Trucking Company on the purchase
from Tan Company
...

24 Returned USD 2,880 of defective merchandise to Tan Company
...

28 Texas Company remitted balance due on sale of May 14
...

31 Paid miscellaneous selling expenses of USD 7,200
...

The May 31st inventory is USD 57,600
...
Journalize the transactions
...

b
...
Use the account numbers appearing in the chart of
account shown in a separate file at the end of the text
...

(There were no adjusting journal entries
...
352 of 433

c
...

d
...

Alternate problem E
The following data are for Bayer Lamp Company:
Bayer Lamp Company
Trial Balance
2010 December 31
Acct
...


$ 132,000
222,400

2,206,000

1,600
1,251,600
10,400
5,600

$ 3,432,400

$ 3,432,400

Depreciation expense on the store building is USD 8,800
...

 Accrued sales salaries are USD 5,600
...

 Cost of merchandise inventory on hand 2010 December 31, is USD 222,000
...
353 of 433

Prepare the following:
a
...
Refer to the chart of accounts shown in a
separate file at the end of the text for any other account numbers you need
...
A classified income statement
...
The building depreciation is on the store building
...
A statement of retained earnings
...
A classified balance sheet
...
The required closing entries
...
11
...
, has an opportunity to purchase 40,000 shirts
with the logo of her favorite school in January 2009
...
Based on the following information and estimates, Candy needs to decide if
the business would be profitable:
 Cost of the 40,000 shirts, all of which must be purchased in January 2009, is USD 440,000
...
She estimates her sales at 25,000

shirts in 2009 and 15,000 shirts in 2010
...

 Candy can buy some counters on which to display the merchandise for USD 4,000
...

 Candy estimates the cost to decorate her kiosk would be USD 2,500
...

 Candy plans to sell the shirts for USD 17 each
...
Therefore, she

plans to borrow USD 400,000 from their family banker
...
Candy plans to repay USD 300,000 on 2010 January 2,
and the remaining USD 100,000 on 2010 July 1
 Candy needs to rent some storage space because all 40,000 shirts cannot be stored at the kiosk
...

a
...
Does it appear
that the business will be profitable?
p
...
Will Candy have the cash available to pay the bank loan as she planned?
Business decision case B In the Annual report appendix, refer to the consolidated statements of
earnings for The Limited's most recent three years
...

Annual report analysis C Refer to the consolidated statements of income of The Limited in the
Annual report appendix
...
Do the results present a favorable
trend? Comment on the results
...
Do you agree that the total impact of this practice could be as much as USD 10 million?
b
...
Is this practice ethical?
Group project E In teams of two or three students, go to the library (or find an annual report at
www
...
gov/edgar
...
Calculate the company's gross margin percentage for each of the most recent three years
...
The heading of the memorandum should contain the date, to whom it is written, from whom,
and the subject matter
...
Calculate the approximate annual rate of
interest implied in several of the more common discount terms
...

Present your findings in a written report to your instructor
...
sec
...
shtml
...
355 of 433

and identify differences in their formats
...


7
...
8

Using the Internet—A view of the real world

Visit the Fat Brains Toys website at:
http://fatbraintoys
...
What products do they sell? What journal
entries would they make to record sales of these products? Write a report to your instructor
summarizing your experience at this site
...
11
...
Sales discounts, as well as sales returns and allowances, are deducted from gross sales
...
Under perpetual inventory procedure, the Merchandise Inventory account is debited for each
purchase and credited for each sale
...
Purchase Discounts and Purchase Returns and Allowances are contra accounts to the
Purchases account
...

False
...

False
...

Multiple-choice
d
...
In other words, the
invoice price of sales (purchases) is recorded: USD4,000 X0
...
The cost of goods sold is computed as follows:
Beginning inventory
Net cost of purchases
Cost of goods available for sale
Ending inventory
Cost of goods sold

$60,000
240,000
$ 300,000
72,000
$228,000

b
...


p
...
All of the sections mentioned in (a-d) appear in a classified income statement
...

b
...


You may close debit balanced accounts (in the income statement) before credit balanced
accounts
...


p
...
1 Learning objectives
After studying this chapter, you should be able to:


Explain and calculate the effects of inventory errors on certain financial statement items
...




Calculate cost of ending inventory and cost of goods sold under the four major inventory

costing methods using periodic and perpetual inventory procedures
...




Record merchandise transactions under perpetual inventory procedure
...




Estimate cost of ending inventory using the gross margin and retail inventory methods
...


8
...
Similarly, one of the greatest benefits of obtaining
an accounting degree is the broad range of career choices available
...
For
example,

check

out

the

list

of

accounting

jobs

at:

http://www
...
edu/stuaff/career/Majors/accounting
...

One of the primary reasons many students go into accounting is successful job placement
...
Even the relative
demand for MIS majors has diminished recently, while the demand for accounting majors remains
strong
...
Another
important factor to keep in mind regarding job placement is where you would like to be three to five
years from now
...

Many students pursue an accounting degree because it does not restrict their career opportunities
as much as having a different business degree
...
358 of 433

apply for positions in management, marketing, and finance, as well as accounting
...
However, management, marketing, and finance students
cannot apply for accounting positions because they lack necessary accounting coursework
...

Have you ever taken advantage of a pre-inventory sale at your favorite retail store? Many stores
offer bargain prices to reduce the merchandise on hand and to minimize the time and expense of
taking the inventory
...
From Chapter 6 you know that companies use inventory
amounts to determine the cost of goods sold; this major expense affects a merchandising company's
net income
...

This chapter discusses merchandise inventory carried by merchandising retailers and wholesalers
...
Merchandising companies determine the quantity of inventory items by a physical count
...
This chapter discusses four accepted methods of costing the items: (1)
specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weightedaverage
...

This chapter stresses the importance of having accurate inventory figures and the serious
consequences of using inaccurate inventory figures
...


8
...
The
inventory of some companies, like car dealerships or jewelry stores, may cost several times more than
any other asset the company owns
...
As a factor in determining cost of goods sold, the
inventory figure has a direct impact on the profitability of the company's operations as reported in the
income statement
...

p
...
4 Importance of proper inventory valuation
A merchandising company can prepare accurate income statements, statements of retained
earnings, and balance sheets only if its inventory is correctly valued
...
Since the cost of goods sold figure affects the company's net income, it also affects the balance of
retained earnings on the statement of retained earnings
...
Inventories appear on the
balance sheet under the heading "Current Assets", which reports current assets in a descending order
of liquidity
...

Recall that under periodic inventory procedure we determine the cost of goods sold figure by adding
the beginning inventory to the net cost of purchases and deducting the ending inventory
...
Applied to inventory, matching involves determining (1) how much of the
cost of goods available for sale during the period should be deducted from current revenues and (2)
how much should be allocated to goods on hand and thus carried forward as an asset ( merchandise
inventory) in the balance sheet to be matched against future revenues
...
This relationship involves three items:
First, a merchandising company must be sure that it has properly valued its ending inventory
...
Also, overstatement of ending inventory causes current assets, total assets, and
retained earnings to be overstated
...

Second, when a company misstates its ending inventory in the current year, the company carries
forward that misstatement into the next year
...

Third, an error in one period's ending inventory automatically causes an error in net income in the
opposite direction in the next period
...


p
...
Allen Company's income statements and the statements of retained
earnings for years 2009 and 2010 show this relationship
...
As a result,
Allen has a gross margin of USD 135,000 and net income of USD 50,000
...
When the ending inventory is overstated by USD 5,000, as shown on the right in Exhibit 44,
the gross margin is USD 140,000, and net income is USD 55,000
...
361 of 433

then has an ending retained earnings of USD 175,000
...
The balance sheet would show both an overstated inventory and an overstated retained
earnings
...

Exhibit 45 is a continuation of Exhibit 44 and contains Allen's operating results for the year ended
2010 December 31
...
However, Allen's inventory at 2010 December 31, is now an accurate inventory of USD
45,000
...
In the income statement columns at the right, in which the beginning
inventory is overstated by USD 5,000, the gross margin is USD 140,000 and net income is USD
86,500, with the ending retained earnings also at USD 261,500
...
If the beginning inventory
is overstated, then cost of goods available for sale and cost of goods sold also are overstated
...
Note, however, that when net income in
the second year is closed to retained earnings, the retained earnings account is stated at its proper
amount
...
For the two years combined the net income is correct
...

Exhibit 46 summarizes the effects of errors of inventory valuation:
Ending Inventory

Beginning Inventory

Understated

Overstated

Understated

Overstated

Cost of good sold

Overstated

Understated

Understated

Overstated

Net income

Understated

Overstated

Overstated

Understated

Exhibit 46: Inventory errors

8
...
362 of 433

costs, it must answer the question: Which cost should be assigned to the items sold? In this section,
you learn how accountants answer these questions
...
To arrive at a current
inventory figure, companies must begin with an accurate physical count of inventory items
...
This section
discusses the taking of a physical inventory and the methods of costing the physical inventory under
both perpetual and periodic inventory procedures
...

As briefly described in Chapter 6, to take a physical inventory, a company must count, weigh,
measure, or estimate the physical quantities of the goods on hand
...
Throughout the taking of a physical inventory, the goal should be accuracy
...
Thus, the count
should be administered as quickly and as efficiently as possible
...
Proper forms
are required to record accurate counts and determine totals
...

Inventory Tag
JMA Corp
...
281

Date

Description
Location
Quantity Counted
Counted by
Checked by
Duplicate Inventory Tag
Inventory Tag No
...
363 of 433

Exhibit 47: Inventory tag
Taking a physical inventory often involves using inventory tags, such as that in Exhibit 47
...
A tag usually consists of a stub and a detachable
duplicate section
...
The format of the tags can
vary
...

The descriptive information and count may be entered on one copy of the tag by one team of
counters
...

Discrepancies between counts of the same items by different teams are reconciled by supervisors, and
the correct counts are assembled on intermediate inventory sheets
...
The tabulated result is the dollar amount of the physical
inventory
...

Usually, inventory cost includes all the necessary outlays to obtain the goods, get the goods ready to
sell, and have the goods in the desired location for sale to customers
...

 Cost of the buyer's insurance to cover the goods while in transit
...

 Handling costs, such as the cost of pressing clothes wrinkled during shipment
...
The 1986 Tax Reform Act requires companies to assign these costs to
inventory for tax purposes
...

Practical difficulties arise in allocating some of these costs to inventory items
...
Also,
assume that the company wants to include the freight cost as part of the inventory cost of the shirt
...

In practice, allocations of freight, insurance, and handling costs to the individual units of inventory
purchased are often not worth the additional cost
...
Instead, they have expensed these
costs as incurred
...
364 of 433

minimize the effect of expensing these costs on net income
...

Even if a company derives a cost for each unit in inventory, the inventory valuation problem is not
solved
...
, purchased two identical DVD players for resale
...
If one was sold during the period, should Hi-Fi Buys assign it a cost of USD
250, USD 200, or an average cost of USD 225?
 Does the fact that current replacement costs are less than the costs of some units in inventory

have any bearing on the amount at which inventory should be carried? Using the same
example, if Hi-Fi Buys can currently buy all DVD players for USD 200, is it reasonable to carry
some units in inventory at USD 250 rather than USD 200?
We answer these questions in the next section
...
However, this rule does not indicate how to assign costs to ending inventory and
to cost of goods sold when the goods have been purchased at different unit costs
...
One costs USD 20; another, USD 22; and a third, USD 24
...

Before explaining the inventory costing methods, we briefly introduce perpetual inventory procedure
and compare periodic and perpetual inventory procedures
...
Under periodic inventory
procedure, firms debit the Purchases account when goods are acquired; they use other accounts, such
as Purchase Discounts, Purchase Returns and Allowances, and Transportation-In, for purchase-related
transactions
...
They keep no records of the cost of items
as they are sold, and have no information on possible inventory shortages
...


p
...
inv
...
Under perpetual inventory procedure,
companies have no Purchases and purchase-related accounts
...
Thus,
they debit or credit Merchandise Inventory in place of debiting or crediting Purchases, Purchase
Discounts, Purchase Returns and Allowances, and Transportation-In
...
The second debits Cost of Goods Sold and credits Merchandise Inventory at cost
...
Comparison of this amount with the cost obtained by taking and pricing a physical inventory
may reveal inventory shortages
...

Perpetual inventory records Even though companies could apply perpetual inventory
procedure manually, tracking units and dollars in and out of inventory is much easier using a
computer
...
Look at
Exhibit 48, an inventory record for Entertainment World, a firm that sells many different brands of
television sets
...
Other information on the record includes (1) the maximum and
p
...
The number of units on hand and their cost are readily available also
...
This assumption is
the first-in, first-out (FIFO) method of inventory costing; we will discuss it later
...
Under a manual system, the cost of an up-to-date inventory
for stores with high turnover would outweigh the benefit
...
These bar codes not only provide accurate sales prices but also record the
merchandise sold so that the total cost of the store's inventory is up to date
...
We explain these differences by using data from Exhibit 48 and
making additional assumptions
...

These entries record the purchase on July 5 under each of the methods:
Periodic Procedure
Purchases (+A)
Accounts Payable (+L)

3,000
3,000

Perpetual Procedure
Merchandise Inventory (+A) 3,000
Accounts Payable (+L)
3,000

Assuming the merchandise sold on July 7 was priced at USD 4,800, these entries record the sale:
Periodic Procedure
Accounts Receivable (+A)
Sales (+SE)

4,800

4,800

Perpetual Procedure
Accounts Receivable (+A) 4,800
Sales (+SE)
4,800
Cost of Goods Sold (-SE)
3,600
Merchandise Inventory(-A)
3,600

Several other transactions not included in Exhibit 48 could occur:
 Assume that two of the units purchased on July 5 were returned to the supplier because they

were defective
...
367 of 433

Periodic Procedure
Accounts Payable
Purchase
Returns and
Allowances

600
600

Perpetual Procedure
Accounts Payable
Merchandise
Inventory

600
600

 Assume that the supplier instead granted an allowance of USD 600 to the company because

of the defective merchandise
...
The entries would be:
Periodic Procedure
Transportation-In (+A)
Cash (-A)

100
100

Perpetual Procedure
Merchandise Inventory
(+A)
Cash (-A)

100
100

In these entries, notice that under perpetual inventory procedure the Merchandise Inventory
account records purchases, purchase returns and allowances, purchase discounts, and transportationin
...

At the end of the accounting period, under perpetual inventory procedure, the only merchandiserelated expense account to be closed is Cost of Goods Sold
...


p
...
00

$ 80

March 10

10

$12
...
50

85

July 14

20

12
...
40

168

September 7

10

14
...
00

90

November 22

20

14
...
80

176

December 21

10

9
...


Exhibit 49: Beginning inventory, purchases and sales

An accounting perspective: Business insight
When you buy a box of breakfast cereal at the supermarket, the cashier scans the bar
code on the box
...
The information is also printed on the sales slip so that you can later compare
the items paid for with the items received
...
The
information is also fed to the store's computer to update the inventory records
...
At a certain point, the
company also uses the reduced inventory levels to order more merchandise from
suppliers, such as wholesalers that supply the region with breakfast cereals and other
goods
...


Using the data for purchases, sales, and beginning inventory in Exhibit 49, next we explain the four
inventory costing methods
...
Total goods available for sale consist of 80 units with a total cost of USD 690
...
Sales revenue for the

p
...
The questions to be answered are: What is the cost of the 20 units in
inventory? What is the cost of the 60 units sold?
Specific identification The specific identification method of inventory costing attaches the
actual cost to an identifiable unit of product
...
Under the specific identification method, the firm must
identify each unit in inventory, unless it is unique, with a serial number or identification tag
...
The company
computes the ending inventory as shown in Exhibit 50; it subtracts the USD 181 ending inventory cost
from the USD 690 cost of goods available for sale to obtain the USD 509 cost of goods sold
...
The
USD 509 cost of goods sold is an expense on the income statement, and the USD 181 ending inventory
is a current asset on the balance sheet
...
The
method does not involve any assumptions about the flow of the costs as in the other inventory costing
methods
...
Therefore, periodic and perpetual
inventory procedures produce the same results for the specific identification method
...
00
9
...
00

$ 80

10
20
20

8
...
40
8
...
370 of 433

to cost of goods sold when the company actually sells goods
...
In some companies, the first units in (bought) must be the first units
out (sold) to avoid large losses from spoilage
...
In these cases, an assumed first-in, first-out flow corresponds with the
actual physical flow of goods
...
When using periodic inventory
procedure, to determine the cost of the ending inventory at the end of the period under FIFO, you
would begin by listing the cost of the most recent purchase
...
You would list these units from the latest purchases until that
number agrees with the units in the ending inventory
...
The company assumes that the 20 units in inventory consist of 10 units
purchased December 21 and 10 units purchased October 12
...

We show the relationship between the cost of goods sold and the cost of ending inventory under
FIFO using periodic inventory procedure in Exhibit 52
...
Under FIFO, the ending
inventory of 20 units consists of the most recent purchases—10 units of the December 21 purchase and
10 units of the October 12 purchase—costing USD 179
...


p
...
10
8
...
00

$ 80

10
20
10
10

8
...
40
9
...
80

85
168
90
88
$511

Units

$690
179
$511

Exhibit 51: Determining FIFO cost of ending inventory under periodic inventory procedure

Exhibit 52: FIFO flow of costs
LIFO (last-in, first-out) under periodic inventory procedure The LIFO (last-in, firstout) method of inventory costing assumes that the costs of the most recent purchases are the first
costs charged to cost of goods sold when the company actually sells the goods
...
Since the company
charges the latest costs to cost of goods sold under periodic inventory procedure, the ending inventory
always consists of the oldest costs
...
372 of 433

inventory procedure, the company lists the oldest units and their costs
...
Thus, ending inventory in Exhibit 53 consists of the 10 units from beginning
inventory and the 10 units purchased on March 2
...
Exhibit 54 is a graphic representation of the
LIFO flow of costs under periodic inventory procedure
...
00
8
...
10
8
...
00
8
...
373 of 433

Weighted-average under periodic inventory procedure The weighted-average method
of inventory costing is a means of costing ending inventory using a weighted-average unit cost
...
Since
the units are alike, firms can assign the same unit cost to them
...
The ending inventory is carried at this per unit cost
...
Note that we compute weighted-average cost per unit by dividing the
cost of units available for sale, USD 690, by the total number of units available for sale, 80
...
625, meaning that each unit sold or remaining in inventory is
valued at USD 8
...


Beginning inventory
Purchases
March 2
May 28
August 12
October 12
December 21
Total
Weighted-average unit cost is
$690 / 80, or $8
...
625 x 20
Cost of goods sold:
$8
...
00

Total
Cost
$ 80
...
50
8
...
00
8
...
10

85
...
00
90
...
00
91
...
00
172
...
50

Exhibit 55: Determining ending inventory under weighted-average method using periodic inventory
procedure

p
...
40

(C)85

10
20

8
...
80 176

Nov
...
10 91

9
...
50

85

8
...
40

84

8
...
00

90

10

9
...
00

90

8
...
80

88

8
...
10

91

Sales are assumed to be
from the oldest units on
hand

(E)90

10
Dec 21

8
...
00 90

Sept
...
12

8
...
12

10

10

10

8
...
50

10(D)

$8
...
00

10

Mar
...
00

20(F)

Mar
...
50 $85

Beg
...


Cost

10

10

Units

Units

20(C)

Cost Cost

Total

10

Units

Unit

10

Date

Unit

8
...


$179

Exhibit 56: Determining FIFO cost of ending inventory under perpetual inventory procedure
FIFO under perpetual inventory procedure Under perpetual inventory procedure, the ending
balance in the Merchandise Inventory account reflects the most recent purchases as a result of making
the required entries during the period
...
Exhibit 56 shows how to determine the cost of ending inventory under
FIFO using perpetual inventory procedure
...
The company keeps a record of the balance in the inventory
account as it makes purchases and sells items from inventory
...
375 of 433

Purchased

Sold

Date
Beg
...


Units

Unit
Cost

Total
Cost

Mar
...
50

$85

Mar
...
40

9
...
80

20
10

9
...
80

91

176

80
85

10

8
...
00
8
...
00

80

8
...
00

80
90

10

8
...
00
8
...
00

80

10
10

90

176

Nov
...
21

9
...
00
8
...
7
Oct
...
40

Total
Cost
80

10
10

85

Unit
Cost
$8
...
50

Total
Cost

168

20
10

Unit
Cost

Units

10
10
10

July 14
Aug
...
00
9
...


$171

Exhibit 57: Determining LIFO cost of ending inventory under perpetual inventory procedure
Notice in Exhibit 56 that each time a sale occurs, the company assumes the items sold are the oldest
on hand
...
The balance after the December 21 purchase
represents the 20 units from the most recent purchases
...
During the accounting period, as
sales occurred the firm would have debited a total of USD 511 to Cost of Goods Sold
...

Under FIFO, using either perpetual or periodic inventory procedures results in the same total amounts
for ending inventory and for cost of goods sold
...
Under this procedure, the inventory composition and balance are
updated with each purchase and sale
...
Despite numerous purchases and sales during the

p
...
The
remainder of the ending inventory consists of the last purchase because no sale occurred after the
December 21 purchase
...
Exhibit 58 shows graphically the LIFO flow of costs under perpetual inventory
procedure
...
(Compare Exhibit 57 and Exhibit 53 to verify that ending inventory and
cost of goods sold are different under the two procedures
...
Complicated applications of LIFO perpetual inventory
procedures that require such adjustments are beyond the scope of this text
...
377 of 433

Purchased

Sold

Date
Beg
...


Units

Unit
Cost

Total
Cost

Mar
...
50

$85

Mar
...
40

9
...
80

8
...
758
10

9
...
75

176

Nov
...
00

91

175
...
25aA

165
...
25

82
...
35b

250
...
35

83
...
675c

173
...
675

86
...
35

90

Sept
...
12

$82
...
00

20

B

Unit
Cost
$8
...
25

Total
Cost

168
20

10

Unit
Cost

Units
10
20

10

July 14
Aug
...
758 c

262
...
758

87
...
929e

$178
...
00/2 = $8
...
b$250
...
35
...
50/20 = $8
...
d$262
...
758
...
929 * rounding difference
...
58/2
0
A

A new unit cost is calculated after each purchase
...
C Balance
of $178
...


Exhibit 59: Determining ending inventory under weighted-average method using perpetual
inventory procedure
Look at Exhibit 58 and Exhibit 54, the flow of inventory costs under LIFO using both the perpetual
and periodic inventory procedures
...

Weighted-average under perpetual inventory procedure Under perpetual inventory
procedure, firms compute a new weighted-average unit cost after each purchase by dividing total cost
of goods available for sale by total units available for sale
...
In Exhibit 59, you can see how to compute the moving
weighted-average using perpetual inventory procedure
...
The unit cost
of the 20 units in ending inventory is USD 8
...
58
...
58, or USD 511
...


p
...
Some accountants argue that this method provides the
most precise matching of costs and revenues and is, therefore, the most theoretically sound method
...
For these items, use of
any other method would seem illogical
...
For example, assume that a company bought three identical units of a given product at
different prices
...

The company sold one unit for USD 2,800
...
However, the gross margin on the sale could be either USD 800,
USD 700, or USD 600, depending on which unit the company ships
...
All the advantages of FIFO occur because when a company sells
goods, the first costs it removes from inventory are the oldest unit costs
...
Instead, the cost attached to the unit sold is always the oldest cost
...

The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden
if used for tax purposes in periods of inflation
...

Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the
fact that prices have risen almost constantly for decades
...
Inventory, or paper, profits
are equal to the current replacement cost of a unit of inventory at the time of sale minus the unit's
historical cost
...
The sales price of the unit normally rises
because the unit's replacement cost is rising
...
FIFO
gross margin would be USD 18 (USD 30 – USD 12), while LIFO would show a gross margin of USD 10
(USD 30 – USD 20)
...
379 of 433

represents inventory (paper) profit; it is merely the additional amount that the company must spend
over cost of goods sold to purchase another unit of inventory (USD 8 + USD 12 = USD 20)
...
The company cannot distribute the USD 8 to owners, but must
retain it to continue handling that particular product
...

During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods
because the newest costs charged to cost of goods sold are also the highest costs
...

Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the
other methods
...
The resulting gross margin is a better indicator of management's
ability to generate income than gross margin computed using FIFO, which may include substantial
inventory (paper) profits
...

The first criticism—that LIFO matches the cost of goods not sold against revenues—is an extension
of the debate over whether the assumed flow of costs should agree with the physical flow of goods
...

The second criticism—that LIFO grossly understates inventory—is valid
...
LIFO supporters contend that the increased usefulness of the income statement
more than offsets the negative effect of this undervaluation of inventory on the balance sheet
...
Income manipulation is
possible under LIFO
...
The company
could purchase an abnormal amount of goods at current high prices near the end of the current period,
with the purpose of selling the goods in the next period
...
To
obtain higher income, management could delay making the normal amount of purchases until the next
period and thus include some of the older, lower costs in cost of goods sold
...
The Internal Revenue Service allows companies to use LIFO for
tax purposes only if they use LIFO for financial reporting purposes
...
380 of 433

alternative inventory amount in the notes to their financial statements for comparison purposes
...

Advantages and disadvantages of weighted-average When a company uses the weightedaverage method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but
more than that obtained under FIFO
...
Weighted-average costing takes a middle-of-the-road approach
...
However, the averaging process reduces the effects of buying or not buying
...
In some instances, assumed cost flows
may correspond with the actual physical flow of goods
...
In contrast, firms use coal stacked in a pile in a
LIFO manner because the newest units purchased are unloaded on top of the pile and sold first
...
As the tank
is refilled, the new gasoline mixes with the old
...

Although physical flows are sometimes cited as support for an inventory method, accountants now
recognize that an inventory method's assumed cost flows need not necessarily correspond with the
actual physical flow of the goods
...

In Exhibit 60 and Exhibit 61, we use data from Exhibit 49 to show the cost of goods sold, inventory
cost, and gross margin for each of the four basic costing methods using perpetual and periodic
inventory procedures
...
No differences would occur if purchase prices were constant
...
Therefore, companies must disclose on their financial
statements which inventory costing methods were used
...
Different methods are attractive under different conditions
...
If a
company seeks to reduce its income taxes in a period of rising prices, it would also use LIFO
...
381 of 433

other hand, LIFO often charges against revenues the cost of goods not actually sold
...

The FIFO and specific identification methods result in a more precise matching of historical cost
with revenue
...
The weighted-average method also allows manipulation of income
...


An accounting perspective: Business insight
Management decides which inventory costing method or methods (LIFO, FIFO, etc
...
Also, management must determine which method is the most meaningful and
useful in representing economic results
...

The principal business of Kellwood Company is the marketing, merchandising, and
manufacturing of apparel, primarily for women
...
Inventories and revenue recognition
Inventories are stated at the lower of cost or market
...
Inventories of foreign subsidiaries are valued using the specific
identification method
...
”

Generally, companies use the inventory method that best fits their individual circumstances
...
Continuous switching of methods violates the
accounting principle of consistency, which requires using the same accounting methods from period to
period in preparing financial statements
...


p
...
00

Sales
Cost of goods sold:
Beginning inventory
$ 80
...
00
Cost of goods available for sale $690
...
00
Cost of goods sold
$509
...
00

FIFO
$780
...
00

WeightedAverage
$780
...
00
610
...
00
179
...
00
$269
...
00
610
...
00
171
...
00
$261
...
00
610
...
00
178
...
42
$268
...
00

Sales
Cost of goods sold:
Beginning inventory
$ 80
...
00
Cost of goods available for sale $690
...
00
Cost of goods sold
$509
...
00

FIFO
$780
...
00

WeightedAverage
$780
...
00
610
...
00
179
...
00
$269
...
00
610
...
00
165
...
00
$255
...
00
610
...
00
172
...
50
$262
...
383 of 433

An accounting perspective: Business insight
Sometimes, companies change inventory methods in spite of the principle of
consistency
...
A company that changes its inventory method must make a full
disclosure of the change
...
The footnote consists of a complete description of the change,
the reasons why the change was made, and, if possible, the effect of the change on net
income
...
M
...
, sells a diverse range of metals (aluminum, brass, copper,
steel, stainless steel, and nickel alloys) for severe corrosion conditions and hightemperature applications
...
M
...
Change in accounting method for inventory
The company changed its method of determining inventory cost from the lower of
average cost or market method to the last-in, first-out (LIFO) method for
substantially all inventory
...


Now we illustrate in more detail the journal entries made when using perpetual inventory
procedure
...

You would debit the Merchandise Inventory account to record the increases in the asset due to
purchase costs and transportation-in costs
...
The balance in the account is the cost of the inventory that should be on
hand at any date
...


2

Merchandise Inventory (+A)
Accounts Payable (+L)
To record purchases of 10 units at $8
...


85
85

p
...
Perpetual
inventory procedure requires two journal entries for each sale
...
The other entry is at cost—a debit to Cost of Goods
Sold and a credit to Merchandise Inventory
...


10 Accounts Receivable (+A)
Sales (+SE)
To record 10 units sold at $13 each on account
...


130
130
80
80

When a company sells merchandise to customers, it transfers the cost of the merchandise from an
asset account (Merchandise Inventory) to an expense account (Cost of Goods Sold)
...
Thus, the Cost of Goods Sold account accumulates the cost of all the
merchandise that the company sells during a period
...
Assume that a customer
returned merchandise that cost USD 20 and originally sold for USD 32
...


17 Sales Return and Allowances (-SE)
Accounts Receivable (-A)
To record the reduction in amount owed by a
customer upon return of goods
...


17 Merchandise Inventory (+A)
Cost of Goods Sold (+SE)
To record replacement of goods returned to
inventory
...
In contrast, sales allowances granted to customers affect only
revenues because the customers do not have to return goods
...

p
...
This fact is a major reason some companies choose to use perpetual inventory procedure
...
A physical inventory determines the
accuracy of the account balance
...
It thereby achieves greater control
over inventory
...
Assuming a USD 15
shortage (at cost) is discovered, the entry is:
Dec
...
There are no other purchase-related accounts to be closed
...


31 Income Summary
Cost of Goods Sold
To close Cost of Goods Sold account to Income
Summary at the end of the year
...
6 Departures from cost basis of inventory measurement
Generally, companies should use historical cost to value inventories and cost of goods sold
...
One of these circumstances is
when the utility or value of inventory items is less than their cost
...
This section explains how
accountants handle some of these departures from the cost basis of inventory measurement
...
Net
realizable value is the estimated selling price of an item less the estimated costs that the company
incurs in preparing the item for sale and selling it
...
However, goods do not have to be damaged, obsolete, or shopworn for this situation to occur
...


p
...
The dealer acquired the auto at a cost of USD 18,000
...
Since the dealer used the auto as a demonstrator and the new
models are coming in, the auto now has an estimated selling price of only USD 18,100
...
This work and the sales commission cost USD
300
...
For inventory purposes, the required journal entry is:
Loss Due to the Decline in Market Value of Inventory (-SE)
Merchandise Inventory (-A)
To write down inventory to net realizable value ($18,000 $17,800)

200
200

This entry treats the USD 200 inventory decline as a loss in the period in which the decline in utility
occurred
...
If net
realizable value declines but still exceeds cost, the dealer would continue to carry the item at cost
...
The term cost
refers to historical cost of inventory as determined under the specific identification, FIFO, LIFO, or
weighted-average inventory method
...
The basic assumption of the LCM method is that if the purchase
price of an item has fallen, its selling price also has fallen or will fall
...

Under LCM, inventory items are written down to market value when the market value is less than
the cost of the items
...
Then, the company would record a USD 400 loss because the inventory has lost
some of its revenue-generating ability
...
On the other hand, if ending inventory has a market value of USD 45,000 and a cost of USD
40,000, the company would not recognize this increase in value
...

LCM applied A company may apply LCM to each inventory item (such as Monopoly), each
inventory class (such as games), or total inventory
...


p
...
The company
would deduct the USD 5,000 ending inventory from cost of goods available for sale on the income
statement and report this inventory in the current assets section of the balance sheet
...

One class might be games; another might be toys
...
If LCM is applied on a total inventory basis, ending inventory would be USD
5,100, since total cost of USD 5,100 is lower than total market of USD 5,150
...
The report states that
"substantially all inventories are valued at cost as determined by the last-in, first-out (LIFO) method;
in the aggregate, such valuations are not in excess of market"
...


An accounting perspective: Business insight
Procter & Gamble markets a broad range of laundry, cleaning, paper, beauty care,
health care, food, and beverage products around the world
...

Inventories are valued at cost, which is not in excess of current market price
...
The
replacement cost of last-in, first-out inventories exceeds carrying value by
approximately USD 169 [million]
...
00
8
...
00

Total
Cost
$1,000
1,600
2,500
$5,100

Total
Market
$ 900
1 ,7 5 0
2,500
$5,150

LCM on
Item-by-Item
Basis
$ 900
1,600
2,500
$5,000

Exhibit 62: Application of lower-of-cost-or-market method

p
...
The effort of taking a physical inventory can be very expensive and
disrupts normal business operations; once a year is often enough
...

 To determine the amount recoverable from an insurance company when fire has destroyed

inventory or the inventory has been stolen
...

Gross margin method The steps in calculating ending inventory under the gross margin method
are:
 Estimate gross margin (based on net sales) using the same gross margin rate experienced in

prior accounting periods
...

 Determine estimated ending inventory by deducting estimated cost of goods sold from cost of

goods available for sale
...

The gross margin method assumes that a fairly stable relationship exists between gross margin and
net sales
...
If this percentage relationship has changed, the
gross margin method does not yield satisfactory results
...
389 of 433

To illustrate the gross margin method of computing inventory, assume that for several years Field
Company has maintained a 30 per cent gross margin on net sales
...
As shown in Exhibit 63, Field can estimate
the inventory for 2010 December 31, by deducting the estimated cost of goods sold from the actual cost
of goods available for sale
...
At
year-end, a physical inventory must be taken and valued by either the specific identification, FIFO,
LIFO, or weighted-average methods
...
Taking a physical inventory during an accounting
period (such as monthly or quarterly) is too time consuming and significantly interferes with business
operations
...
The advantage of this method is that
companies can estimate ending inventory (at cost) without taking a physical inventory
...
390 of 433

taking a physical inventory
...

 Divide the cost of goods available for sale by the retail price of the goods available for sale to

find the cost/retail price ratio
...

 Multiply the cost/retail price ratio or percentage by the ending inventory at retail prices to

reduce it to the ending inventory at cost
...
In the exhibit, the cost (USD 22,000) and retail
(USD 40,000) amounts for beginning inventory are available from the preceding period's computation
...
The amounts for purchase allowances and
transportation-in appear only in the cost column
...
The difference between what was available for
sale at retail prices and what was sold at retail prices (which is sales) equals what should be on hand
(March 31 inventory of USD 60,000) expressed in retail prices
...
We do this by multiplying
it times the cost/retail price ratio
...
To find the 2010 March
31, inventory at cost (USD 36,000), we multiplied the ending inventory at retail (USD 60,000) by 60
per cent
...
391 of 433

Once the March 31 inventory has been estimated at cost (USD 36,000), we deduct the cost of the
inventory from cost of goods available for sale (USD 204,000) to determine cost of goods sold (USD
168,000)
...

For the next quarterly period, the USD 36,000 and USD 60,000 amounts would appear on the
schedule as beginning inventory at cost and retail, respectively
...
From these amounts, we could compute a new cost/retail price
ratio for the second quarter
...
Since the
retail prices are on the individual items (while the cost is not), taking an inventory at retail prices is
more convenient than taking an inventory at cost
...

Both the gross margin and the retail inventory methods can help you detect inventory shortages
...
Assume that
use of the retail method for the fourth quarter showed that USD 66,000 of goods should be on hand,
thus indicating a USD 4,000 inventory shortage at retail
...
60) you would report this as a "Loss from inventory shortage" in the
income statement
...


p
...
The first year of operations resulted in a substantial
loss; in the second year, there was a small net income
...
The current
year of operations looked much better
...
To increase sales, however, Terry had to invest his remaining funds and the
proceeds of a USD 40,000 bank loan into doubling the size of his inventory and
purchasing some new display shelves and a new truck
...
Terry was delighted until he
learned that the federal income taxes on that income would be about USD 17,250
...

Terry asked the accountant for a copy of the income statement figures so he could see if
any items had been overlooked that might reduce his net income
...
Net sales of USD
720,000 and expenses of USD 160,000 could not be changed
...
The next day he told his accountant that he had made
an error in determining ending inventory and that its correct amount was USD
120,000
...
The resulting income taxes would
be about USD 6,000, which was just about what Terry had paid in estimated taxes
...


p
...
7 Analyzing and using financial results—inventory turnover
ratio
An important ratio for managers, investors, and creditors to consider when analyzing a company's
inventory is the inventory turnover ratio
...
To calculate the inventory turnover ratio:
Inventory turnover ratio=

Cost of goods sold
Average inventory

Inventory turnover measures the efficiency of the firm in managing and selling inventory: thus, it
gauges the liquidity of the firm's inventory
...
A relatively low turnover could be the result of a company carrying too much inventory or
stocking inventory that is obsolete, slow-moving, or inferior
...
When making
comparisons among firms, they check the cost-flow assumption used to value inventory and cost of
products sold
...

Beginning inventory
...


$728,229
75,262
120,997

Their inventory turnover is:
USD 728,229/[(USD 75,262 + USD 120,997)/2] = 7
...
In the next chapter, you will learn the general principles of internal control
and how to control cash
...


8
...

 If ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement

of gross margin, net income, and retained earnings
...
394 of 433

 When ending inventory is misstated in the current year, companies carry that misstatement

forward into the next year
...

 Inventory cost includes all necessary outlays to obtain the goods, get the goods ready to sell, and

have the goods in the desired location for sale to customers
...
Seller's gross selling price less purchase discount
...
Cost of insurance on the goods while in transit
...
Transportation charges when borne by the buyer
...
Handling costs, such as the cost of pressing clothes wrinkled during shipment
...
Specific identification creates precise matching in determining
net income
...
FIFO

assumes that the costs of the first goods purchased are those charged to cost of goods sold when
goods are sold
...

 LIFO (last-in, first-out): Ending inventory consists of the oldest costs
...
Net income is
usually lower under LIFO since the costs charged to cost of goods sold are higher due to inflation
...

 Weighted-average: Ending inventory is priced using a weighted-average unit cost
...
Under
periodic procedure, the average is determined at the end of the accounting period by dividing the
total number of units purchased plus those in beginning inventory into total cost of goods
available for sale
...

Under the weighted-average method, in a period of rising prices net income is usually higher than
income under LIFO and lower than income under FIFO
...
Disadvantage: Income manipulation is possible
...
395 of 433

 FIFO: Advantages: (1) FIFO is easy to apply, (2) the assumed flow of costs often corresponds

with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the
balance sheet amount for inventory is likely to approximate the current market value
...

 LIFO: Advantages: (1) LIFO reports both sales revenue and cost of goods sold in current dollars,

and (2) lower income taxes result if used for tax purposes when prices are rising
...

 Weighted-average: Advantages: Due to the averaging process, the effects of year-end buying

or not buying are lessened
...

 Perpetual inventory procedure requires an entry to Merchandise Inventory whenever goods are

purchased, returned, sold, or otherwise adjusted, so that inventory records reflect actual units on
hand at all times
...

 Companies should not carry goods in inventory at more than their net realizable value
...
Inventory items are written down to market value when
the market value is less than the cost of the items
...
LCM may be applied to each inventory item, each inventory class, or
total inventory
...
Estimate gross margin (based on net sales) using the same gross margin rate experienced
in prior accounting periods
...
Determine estimated cost of goods sold by deducting estimated gross margin from net
sales
...
Determine estimated ending inventory by deducting estimated cost of goods sold from cost
of goods available for sale
...
To find the cost/retail price ratio, divide the
cost of goods available for sale by the retail price of the goods available for sale
...
396 of 433

 Inventory turnover measures the efficiency of the firm in managing and selling inventory
...


8
...
1 Demonstration problem
Demonstration problem A Following are data related to Adler Company's beginning inventory,
purchases, and sales:
Beginning Inventory
and Purchases
Units
Beginning inventory 6,250
March 15 5,000
May 10 8,750
August 12 6,250
November 20 3,750
30,000

Sales
@
@
@
@
@

Unit
Cost
$3
...
12
3
...
48
3
...
Compute the ending inventory under each of the following methods:
Specific identification (assume ending inventory is taken equally from the August 12 and November
20 purchases)
...

(b) Assume use of periodic inventory procedure
...

(b) Assume use of periodic inventory procedure
...

(b) Assume use of periodic inventory procedure
...
)
b
...

Demonstration problem B a
...
USD 27,200
2008
...
USD 24,000
Analysis of the inventories shows that certain clerical errors were made with the following results:

p
...
The records of Little Corporation show the following account balances on the day a fire destroyed
the company's inventory:
Merchandise inventory, January 1 USD 40,000
Net cost of purchases (to date) USD 200,000
Sales (to date) USD 300,000
Average rate of gross margin for the past five years 30 per cent of net sales
...

c
...
$17,600 $25,000
Purchases
68,000 100,000
Transportation-in
1,900
Sales
101,000
Compute the estimated ending inventory at cost using the retail inventory method
...
8
...
The ending inventory is 5,000 units, calculated as
follows:
Units
6,250
23,750
30,000
25,000
5,000

Beginning inventory
Purchases
Goods available
Sales
Ending inventory

Ending inventory under specific identification:
Purchased

Units

November 20
August 12

2,500
2,500

Unit
Cost
$3
...
48

Total
Cost
$ 9,300
8,700
$ 18,000

p
...
Ending inventory under FIFO:
(a) Perpetual:
Date

Purchased
Unit Total
Units
Cost Cost

5,250

8,750

Aug
...
48

21,750

Oct
...
00
3
...
30 28,875

Sept
...
20

$3
...
12 $15,600

May 4
May 10

Sold
Unit
Cost

1,000
3,500

Beg
...

Feb
...
15 5,000

Units

3
...
12
3
...
30
3
...
48)

Total
Cost

Balance
Unit

Units

6,250
$15,750 1,000
1,000
5,000
3,000
1,500
10,920
1,500
8,750
1,500
8,750
6,250
4,680
2,250
21,450 6,250
7,425
1,250
17,400
1,250
3,750
+ (3,750 X $3
...
00
3
...
00
3
...
12

$18,750
3,000
3,000
15,600
4,680

3
...
30
3
...
30
3
...
30
3
...
48

4,680
28,875
4,680
28,875
21,750
7,425
21,750
4,350

3
...
72
$18,300

4,350
13,950

(b) Periodic:
Purchased

Units

November 20
August 12

3,750
1,250
5,000

*Note that the cost of ending
inventory is the same as under
perpetual
...
72
3
...
399 of 433

3
...
inv
...
3

5,250

Mar
...
00

4,500

3
...
16

6,250
1,750

3
...
30

21,750
5,775

Oct
...
30
3
...
12

Nov
...
30

28,875

6,250

3
...
00

$18,750

3
...
72) =

3
...
12
3
...
12
3
...
12
3
...
00
3
...
30
3
...
00
3
...
30
3
...
12
3
...
12
3
...
00

Cost
$ 15,000

$15,750 1,000

$3
...
72

13,950

(1,00
0

X $3
...
12) + (3,750
X

(b) Periodic:

Merchandise Inventory, January 1

Units
5,000

p
...
Ending inventory under weighted-average:
(a) Perpetual:
Date
Beg
...

Feb
...
15

Purchased
Unit Total
Units Cost Cost

Units

Sold
Unit
Cost

5,250

$3
...
10

Balance
Unit
Units
Cost
Total Cost
6,250 $3
...
0000 3,000
6,000
3
...
12 $15,600

May 4
May 10

8,750

3
...
1000
3
...
12

6,250

3
...
3500
c

55,275

8,500
1,250
5
...
3500
3
...
6274
d

28,475 *
4,187 *
18,137

Sept
...
9
Nov
...
35
3
...
72 13,950

Ending inventory = (5,000 X $3
...
100 b $33,525 = $3
...
3500 d $18,137 = $3
...

Unit

(b) Periodic
Purchased
M e r c h a n d i s e I n v e n t o r y, J a n u a r y
1
March 15

Units
6,250

Cost
$3
...
12

May 10

8 ,7 5 0

3
...
48

November 20

3 ,7 5 0

Total

3
...
2975
Ending inventory cost = $3
...
401 of 433

b
...


3

Mar
...


12

Sept
...


9

Nov
...
12 on
Account
...
12 on 4,500 units sold
...
30 on
account
...
48 on
account
Cost of Goods Sold (-SE)
Merchandise Inventory (-A)
To record costs of $3
...
30 on 6,250 units
at 1,750 units sold, respectively
...
30 and $3
...

Merchandise Inventory (+A)
Accounts Payable (+L)
To record purchase of 3,750 units at $3
...


15,750

15,750

15,600

15,600

14,040

14,040

28,875

28,875

21,750

21,750

27,525

27,525

23,880

23,880

13,950

13,950

Solution to demonstration problem B a
...
402 of 433

b
...
30)
Estimated cost of goods sold
Inventory at cost, estimated by
gross margin method
...
Computation of inventory:
Merchandise Inventory, January 1
Purchases
Transportation-in
Goods available for sale
$
Cost/retail price ratio:
$87,500/$125,000 = 70%
Sales
Ending inventory at retail price
Times cost/retail price ratio
Ending inventory at cost, December 31
...
8
...

Gross margin method A procedure for estimating inventory cost in which estimated cost of
goods sold (determined using an estimated gross margin) is deducted from the cost of goods
available for sale to determine estimated ending inventory
...

Inventory, or paper, profits Equal to the current replacement cost to purchase a unit of
inventory at time of sale minus the unit's historical cost
...

LIFO (last-in, first-out) A method of costing inventory that assumes the costs of the most
recent purchases are the first costs charged to cost of goods sold when the company actually sells
the goods
...

Merchandise inventory The quantity of goods held by a merchandising company for resale to
customers
...

Retail inventory method A procedure for estimating the cost of the ending inventory by
applying a cost/ retail price ratio to ending inventory stated at retail prices
...
403 of 433

Specific identification method An inventory costing method that attaches the actual cost to
an identifiable unit of product
...
Under perpetual inventory procedure, a new weighted-average is calculated after each
purchase
...
Units in the ending inventory are carried at this per unit cost
...
8
...
8
...
1 True-false
Indicate whether each of the following statements is true or false
...

(2) In a period of rising prices, FIFO results in the lowest cost of goods sold
...

(4) Under the gross margin method, an estimate must be made of gross margin to determine
estimated cost of goods sold and estimated ending inventory
...

(6) Under perpetual procedure, cost of goods sold is determined as a result of the closing entries
made at the end of the period
...
8
...
2 Multiple-choice
Select the best answer for each of the following questions
...
During
the period, the company purchased an additional 5,000 units at USD 36 each and sold 4,600 units
...

Cost of ending inventory using FIFO is:
a
...

b
...

c
...

p
...
USD 147,600
...
None of the above
...
USD 165,600
...
USD 150,000
...
USD 147,600
...
USD 122,400
...
None of the above
...
USD 104,400
...
USD 114,750
...
USD 156,000
...
USD 122,400
...
None of the above
...
USD 155,250
...
USD 114,000
...
USD 147,600
...
USD 165,600
...
None of the above
...
USD 114,750
...
USD 157,600
...
USD 122,400
...
USD 109,650
...
None of the above
...
405 of 433

Cost of goods sold using weighted-average is:
a
...

b
...

c
...

d
...

e
...

During a period of rising prices, which inventory method might be expected to give the highest net
income?
a
...

b
...

c
...

d
...

e
...

Now turn to “Answers to self-test” at the end of the chapter to check your answers
...
8
...
3 Questions


Why is proper inventory valuation so important?



Why does an understated ending inventory understate net income for the period by the
same amount?



Why does an error in ending inventory affect two accounting periods?



What is the meaning of taking a physical inventory?



What is the accountant's responsibility regarding taking a physical inventory?



Which cost elements are included in inventory? What practical problems arise by
including the costs of such elements?



Which accounts that are used under periodic inventory procedure are not used under
perpetual inventory procedure?



What entries are necessary under perpetual inventory procedure when goods are sold?



Why is there closer control over inventory under perpetual inventory procedure than
under periodic inventory procedure?



Why is perpetual inventory procedure being used increasingly in business?
p
...
Is the same
opportunity available under FIFO? Why or why not?



What are the main advantages of using FIFO and LIFO?



Which inventory method is the correct one? Can a company change inventory methods?



Why are ending inventory and cost of goods sold the same under FIFO perpetual and
FIFO periodic?



Would you agree with the following statement? Reducing the amount of taxes payable
currently is a valid objective of business management and, since LIFO results in such a
reduction, all businesses should use LIFO
...
8
...
4 Exercises
Exercise A Crocker Company reported annual net income as follows:
2008
2009
2010

$484,480
487,680
409,984

p
...

Exercise B Slate Truck Company manufactures trucks and identifies each truck with a unique
serial plate
...
Ten of these trucks cost USD 20,000 each, and the other 10 cost USD 25,000
each
...
00

Total
Cost
$114,000

900
2,400
1,800
1,800
600

39
...
00
40
...
60
41
...
Miami Discount Company uses perpetual inventory
procedure
...

Exercise D Using the data in the previous exercise for Miami Discount Company, present a
schedule showing the measurement of the ending inventory using LIFO perpetual inventory procedure
...
408 of 433

Exercise E London Company had a beginning inventory of 160 units at USD 24 (total = USD
3,840) and the following inventory transactions during the year:
January 8, sold 40 units
...
00
...
00
...

Using the preceding information, price the ending inventory at its weighted-average cost, assuming
perpetual inventory procedure
...
40
7
...
60
8
...
Kettle uses periodic inventory procedure
...
Compute the cost of the ending inventory using each of the following methods: (1) FIFO, (2)
LIFO, and (3) weighted-average
...
Which method would yield the highest amount of gross margin? Explain why it does
...

Sold 6 units on account for USD 576 per unit on 2010 September 20
...

Prepare journal entries for these transactions using FIFO perpetual inventory procedure
...

Exercise H Following are selected transactions of Gamble Company:
Purchased 100 units of merchandise at USD 240 each; terms 2/10, n/30
...

Sold 80 units at USD 384 each for cash
...


p
...

Sold 60 units at USD 552 each for cash
...
Assume Gamble uses FIFO perpetual inventory
procedure
...

Sold 108 units at USD 90 on account
...

Sold 122 units at USD 95 on account
...

The beginning inventory consisted of 67 units purchased at a cost of USD 55
...
Do not
record the entries for sales
...
80
...

February sales totaled 120 units
...
24
...

September 1, purchased 40 units at USD 33
...

September through December sales were 180 units
...
00 and 2,000 units at USD
13
...
It sold all of these units at USD 18
...
80
...

Exercise L Clayton Company's inventory was 12,000 units with a cost of USD 160 each on 2010
January 1
...
Also during 2010, the purchase
price of this product fell steadily until at year-end it was USD 120
...
410 of 433

18,000 units
...

Exercise M Levi Motor Company owns a luxury automobile that it has used as a demonstrator for
eight months
...
At the end
of the fiscal year, the auto is on hand and has an expected selling price of USD 80,000
...

Compute the amount at which the auto should be carried in inventory
...
It cost USD 3,600 and
had an original selling price of USD 4,800
...
The sound system had an estimated selling price of USD 2,880, but when
the company performed USD 480 in repairs, it could be sold for USD 3,840
...

Exercise O Your assistant has compiled the following data:

Item
A
B
C
D

Quantity
(units)
300
300
900
500

Unit
Cost
$ 57
...
80
21
...
00

Unit
Market
$ 55
...
60
21
...
20

Total
Cost
$17,280
8,640
19,440
6,000

Total
Market
$16,560
10,080
19,440
6,600

Calculate the dollar amount of the ending inventory using the LCM method, applied on an item-byitem basis, and the amount of the decline from cost to lower-of-cost-or-market
...

Exercise Q Tilley-Mill Company takes a physical inventory at the end of each calendar-year
accounting period to establish the ending inventory amount for financial statement purposes
...

On July 18, a fire destroyed the entire store building and its contents
...
Through July 17, these records show:

p
...

Exercise R Ryan Company takes a physical inventory at the end of each calendar-year accounting
period
...

On June 12, a fire destroyed the entire store building and the inventory
...
Through June 11, these records show:
Merchandise inventory, January 1
Merchandise purchases
Purchase returns
Transportation -in
Sales

$120,000
$3,000,000
$36,000
$204,000
$3,720,000

The company was fully covered by insurance and asks you to determine the amount of its claim for
loss of merchandise
...
, records show the following account balances for the year
ending 2010 December 31:
Cost

Retail

Beginning inventory

USD 42,000

USD 57,500

Purchases

25000

37500

Transportation-in

500

Sales

52500

Using these data, compute the estimated cost of ending inventory using the retail method of
inventory valuation
...
412 of 433

8
...
4
...
Recently, Kelley corrected the inventory amounts for those dates
...

Incorrect

Correct

2009 December 31

USD 72,600

USD 86,200

2010 December 31

84000

70200

Prepare a schedule that shows: (a) the reported net income for each year, (b) the amount of
correction needed for each year, and (c) the correct net income for each year
...

2006 December 31, inventory was overstated USD 200,000
...

2081 December 31, inventory was understated USD 220,000
...

The reported net income for each year was:
2006
2007
2008
2009

$384,000
544,000
670,000
846,000

a
...

b
...

c
...

Problem C Brett Company sells personal computers and uses the specific identification method to
account for its inventory
...
413 of 433

Units
10
@
20
@
16
@

July 3
September 10
November 29

Unit cost
$10,080
$ 9,600
$10,700

Brett sold 36 Orange III computers at USD 12,720 each in December
...

a
...

b
...

c
...

3 Sold 5 units at USD 94 per unit
...

12 Sold 8 units at USD 96 per unit
...

25 Purchased 16 units at USD 50 per unit
...

Assume all purchases and sales are made on credit
...

Problem E The following purchases and sales for Ripple Company are for April 2010
...

Purchases
April
April
April
April

3
10
22
28

Units
3,200
1,600
2,000
1,800

Sales
@
@
@
@

Unit
Cost
$33
...
00
35
...
00

April 6
April 12
April 25

Units
1,500
1,400
2,300

p
...
Compute the ending inventory as of 2010 April 30, using perpetual inventory procedure, under
each of the following methods: (1) FIFO, (2) LIFO, and (3) weighted-average (carry unit cost to four
decimal places and round total cost to nearest dollar)
...
Repeat a using periodic inventory procedure
...
Using LIFO perpetual inventory procedure, prepare the journal entries for the purchases and
sales (Cost of Goods Sold entry only)
...
Repeat (a) using LIFO periodic inventory procedure, including closing entries
...
)
Problem G The following data relate to the beginning inventory, purchases, and sales of Braxton
Company for the year 2010:
Merchandise Inventory, January 1
Purchases:
February 2
April 5
June 15
September 30
November 28
Sales:
March 10
May 15
July 6
August 23
December 22

Units
1,400

Unit
Cost
@ $5
...
80
3
...
00
2
...
20

900
1,800
800
600
2,500

a
...

b
...

Problem H Welch Company accounts for a product it sells using LIFO periodic inventory
procedure
...
Merchandise
inventory on January 1 was 3,000 units at USD 14
...


p
...
00
21
...
00
28
...
80
32
...
00
39
...
Compute the gross margin earned on sales of this product for 2009
...
Repeat part (a) assuming that the December 26 purchase was made in January 2010
...
Recompute the gross margin assuming that 10,000 rather than 6,000 units were purchased on
December 26 at the same cost per unit
...
Solve parts (a), (b), and (c) using the FIFO method
...
20
6
...
80
4
...
20
5
...
56
4
...
State whether this approach is an acceptable method of inventory measurement and show the
calculations used to determine the amounts
...
Compute the amount of the ending inventory using the LCM method on an item-by-item basis
...
State the effect on net income in 2009 if the method in (b) was used rather than the method
referred to in (a)
...
The company uses periodic inventory procedure
and marks its merchandise to sell at a price yielding a gross margin of 30 per cent
...
416 of 433

The cost of the physical inventory taken 2008 December 31, was USD 30,400
...
Indicate how income statements can be prepared without taking a physical inventory at the end
of each of the first two quarters of 2009
...
Prepare income statements for the first quarter, the second quarter, and the first six months of
2009
...


8
...
4
...
Harris used the correct 2011 December 31,
inventory amount in calculating 2011 net income
...

Alternate problem B An examination of the financial records of Jersey Company on 2009
December 31, disclosed the following with regard to merchandise inventory for 2009 and prior years:
2008 December 31, inventory was correct
...

2010 December 31, inventory was overstated USD 35,000
...

2012 December 31, inventory was correct
...
417 of 433

2009
2010
2011
2012

$292,500
$355,000
$382,500
$350,000

a
...

b
...

c
...

Alternate problem C High Surf Company sells the Ultra-Light model wind surfer and uses the
specific identification method to account for its inventory
...
On 2009 August 1, the company had three Ultra-Lights that cost USD
14,000 each in its inventory
...

a
...

b
...

c
...
1 Beginning inventory consists of 12 units costing USD 48 per unit
...
92 per unit
...

12 Sold 7 units @ USD108 per unit
...
16 per unit
...


p
...
40 per unit
...

a
...

b
...

c
...
Is there a difference
between the amount computed using the two different procedures?
Alternate problem E Following are data for Dandy Company for the year 2010:
Units

M e r c h a n d i s e I n v e n t o r y,
January 1
Purchases:
Fe b r u a r y 2

700

@

500

April 5
June 1 5
September 30
November 28

1,000
600
700
900
4,400

@
@

Sales:
March 5
July 18
August 12
October 15

@
@
@

Unit
Cost
$20
...
00
24
...
00
30
...
20

400
1,200
800
900
3,300

a
...

b
...

Alternate problem F Refer to the data in alternate problem E
a
...

b
...
(Note: You may
want to refer to the Appendix in Chapter 6 for this part
...
419 of 433

Units
2,100
1,500
3,000
1,800
2,100
2,700

Merchandise Inventory, January 1
Purchases:
March 10
May 24
July 15
September 20
December 1
Sales:
April 5
June 13
October 9
November 21

Unit
Cost
@ $12
...
00
11
...
50
9
...
00

1,400
2,900
2,300
1,700

a
...

b
...

Alternate problem H Star Company accounts for its inventory using the LIFO method under
periodic inventory procedure
...

a
...

b
...

c
...

d
...


p
...
20
2
...
80
3
...
60
3
...
12
3
...
88
3
...
68
2
...
Compute the ending inventory applying the LCM method to the total inventory
...
Determine the ending inventory by applying the LCM method on an item-by-item basis
...
However,
the company does not wish to take a complete physical inventory as of 2009 July 31
...
Indicate how financial statements can be prepared without taking a complete physical inventory
...
From the data given, compute the estimated inventory as of 2009 July 31
...
421 of 433

8
...
5 Beyond the numbers—Critical thinking
Business decision case A Susan Green and Carol Lewis, were interested in starting part-time
business activities to supplement their family incomes
...
Green's sales territory is
Cobb County, and Lewis's sales territory is Gwinnett County
...

To induce Green and Lewis to become distributors, the manufacturer made price concessions on the
first 1,000 units purchased
...
After that, Green and Lewis had to pay USD 20
per unit
...
Green had USD 2,600 of selling expenses; Lewis incurred USD 1,700 of selling expenses
...
The brochures stressed that people
would want to take off the extra pounds gained during the holiday season; also, these exercisers were
inexpensive and could be used at home
...
Green received a B in the
accounting course she took at State University
...
Lewis knows nothing about inventory costing methods
...
He will help her compute the
cost of the ending inventory and the cost of goods using LIFO
...
Prepare income statements for Green and Lewis
...
Which business has performed better? Explain why
...
Determine the inventory turnovers for Green and Lewis
...
422 of 433

Business decision case B Connie Dalton owns and operates a sporting goods store
...
Dalton uses periodic
inventory procedure and has the following information in her accounting records, which were
undamaged:
Merchandise Inventory, January 1
Purchases:
January 8
January 20
January 30
Net Sales:
During January
February 1 and 2

$ 80,000
32,000
48,000
64,000
240,000
16,000

Dalton's gross margin rate on net sales has been 40 per cent for the past three years
...
She has asked you, her CPA, to help her in determining her loss
...
Describe how inventory values are determined (see Footnote 1)
...

Ethics case – Writing experience D Respond in writing to the following questions based on the
ethics case concerning Terry Dorsey:
a
...
What would you do if you were Terry's accountant?
c
...

Group project E In teams of two or three students, interview the manager of a merchandising
company
...
As a team, write a memorandum to your
instructor summarizing the results of the interview
...


p
...
Investigate how the
system works by interviewing a knowledgeable person in the company
...

Group project G With a small group of students, identify and visit a retail store that uses periodic
inventory procedure and uses the retail inventory method for preparing interim (monthly or quarterly)
financial reports
...
Write a report to your instructor summarizing your findings
...
8
...
nasba
...
Also check out some of the
information provided at websites of other state boards by clicking on any sites that appear at the end of
a listing for a particular state
...

Visit the Lexis-Nexis website at:
http://www
...
com
Determine the kinds of information that can be obtained at this site
...


8
...
7 Answers to self-test
8
...
7
...
Overstated ending inventory results in an understatement of cost of goods sold and an
overstatement of gross margin and net income
...
The cost of goods sold consists of the earliest purchases at the lowest costs in a period of
rising prices
...
Under LCM, inventory is adjusted to market value only when the market (replacement)
value is less than the cost
...
The first step in the gross margin method is to estimate gross margin using the gross margin
rate experienced in the past
...
424 of 433

True
...

False
...


8
...
7
...
The cost of ending inventory using FIFO consists of the most recent purchase:
Cost of ending inventory=3,400× USD36= USD122,400
c
...
The cost of ending inventory using LIFO is:
(3,000× USD30)+(400× USD36)=USD 104,400
d
...
The cost of ending inventory using weighted-average cost is computed:
Unit cost=USD 270,000−8,000=USD 33
...
75=USD114,750
c
...
During a period of rising prices, FIFO results in the lowest cost of goods sold, thus the
highest net income
...
425 of 433

Alphabetical Index
academic accountants
...
31, 77, 86, 87, 123, 124, 126, 167, 190, 191, 214, 215, 229, 232, 234
Accounting Education Change Commission
...
30, 39-48, 53, 54, 56, 58, 60, 62-64, 66, 70, 75, 78, 81, 82, 86, 191
Accounting period
...
24
Accounting Review
...
24
accounting system
...
224, 254, 255, 270, 279, 283, 284, 295, 298, 299
Accounting year
...
37, 38, 42-44, 47, 48, 51, 54, 56-58, 61, 65, 66, 68-72, 75, 76, 79, 92, 99-101, 108-110,
112, 116, 118-122, 125, 129, 131-134, 136, 138, 139, 150, 162-164, 169, 170, 172, 186, 195, 200, 201, 210212, 216, 219, 220, 223, 226, 227, 229, 232, 234, 235, 237, 239-242, 244-248, 252, 253, 259, 261, 299, 306,
307, 310-312, 320-322, 329, 332, 333, 335, 338, 341, 344, 348-350, 354, 367, 368, 386
accrual basis
...
123
accrued assets and liabilities
...
170
Accumulated amortization
...
158-160, 168, 170, 171, 182, 183, 186, 188, 195, 211, 218, 221, 227-229, 235, 238248, 252, 259, 284, 299, 300, 320, 350, 354
Accumulated Depreciation account
...
319, 320, 338
adjusting entries
...
266, 294, 296, 297, 324-327, 331, 332, 336, 338, 353, 355, 417
AECC
...
17, 23, 24, 28, 147, 210, 261, 262, 266, 301
Allowances account
...
15, 23-25, 261
assets
...
7, 16, 30, 34-39, 41, 44, 45, 47, 48, 51, 54-56, 58-62, 65, 67-73, 76, 78, 90, 93, 118, 124, 140,
141, 145, 147, 150, 151, 153, 155, 156, 158, 159, 161-166, 168, 170, 171, 178, 188, 190-192, 196-200, 208,
215-223, 225, 227, 229-235, 240, 244, 245, 248, 250-253, 256, 258-260, 273, 275, 293, 324, 331-333, 335,
346, 349, 350, 355, 358, 360, 361, 363, 371, 377, 380, 381, 389, 397, 414, 419

p
...
260, 275, 276, 284, 285, 295
bonds payable
...
158-160, 170, 261, 267, 284, 285, 299, 300
Buildings
...
6
business entity concept
...
123
calendar year
...
36, 38, 42, 44, 46-48, 51, 54-58, 62-72, 82, 84, 85, 89, 91-93, 105-108, 111, 112, 118, 119, 121,
122, 124, 125, 127-136, 138, 139, 143, 150, 181, 186, 192, 195, 197, 200, 202, 209, 211, 226, 227, 234, 235,
237, 239-248, 252, 332, 333, 335, 347, 350, 352-355
cash basis of accounting
...
309, 310, 317, 318, 328, 330, 338, 340, 344, 345
cash equivalents
...
3
Certified Internal Auditor
...
20
Certified Public Accountant
...
308, 338, 340
Chart of accounts
...
20
classified balance sheet
...
303, 304, 324-327, 330, 338, 341-343, 348-350, 352, 354, 355, 357, 358
closing process
...
276, 277, 283, 284, 292, 295, 297
completed-contract method
...
123
Conservatism
...
322, 338, 341, 357
consistency
...
218, 221, 229
continuity
...
151, 159, 170, 188, 221
Copyright
...
24, 33, 35, 38-40, 42, 45, 52, 53, 55, 58, 60, 63, 71, 76, 82, 91, 140, 212, 214, 222, 224, 230, 235,
238, 256, 289, 293, 328, 348, 356, 399
cost
...
314, 316, 323, 324, 326, 330, 332, 334, 338, 343, 345, 357, 361-363, 366, 371375, 377, 379, 384, 389-394, 396, 397, 404, 405, 426
cost of goods sold
...
261, 284, 285, 296
Cost-benefit consideration
...
17-20, 22-25, 28, 32, 50, 77, 78, 142, 147, 210, 233, 261, 262, 266, 268, 298, 301, 424

p
...
123
Creditors and lenders
...
123
current assets
...
217-219, 222-226, 229, 232, 238
current ratio
...
5
customers
...
123
deferred items
...
320-322, 326, 338, 339, 343, 354
Depreciable amount
...
157, 170
depreciation accounting
...
150, 157, 158, 160, 169, 170, 188, 193, 195, 198, 201, 204, 206, 226-228, 237, 239, 240,
243-245, 248, 252, 253, 257, 267, 269, 275, 326, 327, 350, 354
depreciation formula
...
35, 49, 58, 59, 63, 64, 73, 79, 83, 84, 86, 91, 104, 120, 123-125, 131, 134, 135, 139, 202
Dividends payable
...
123
Earning principle
...
2
Employees and their unions
...
9, 26
entity
...
30
equities
...
30, 52, 54, 59, 74
estimated useful life
...
25, 26
ethics
...
41, 59, 61, 62, 261, 270, 283, 285, 288, 290, 294, 296
exchange-price (or cost) principle
...
4, 23, 35-37, 45, 46, 49, 51, 52, 54, 56, 57, 59, 61, 63, 66, 68-70, 72, 73, 81-83, 85, 90-92, 113, 117,
120, 123, 126, 129, 140, 141, 145-151, 153, 157, 164, 167-170, 173-175, 187, 192, 194, 196-198, 202-204,
206, 218-220, 222, 229, 230, 241, 249, 253, 257-261, 263, 264, 266-268, 270, 278, 285, 291, 293, 294, 296,
297, 301, 305, 320, 324-328, 330-334, 336, 338-343, 346, 350, 353, 355, 356, 361, 362, 386, 394, 417, 423
Exposure Drafts
...
24, 25, 255, 261, 269, 271, 273, 277, 279, 283, 297
feedback value
...
23-25, 254, 255, 261, 269, 273, 277, 300
Financial Analysts Federation
...
23, 25, 261
financial reporting objectives
...
428 of 433

114, 115, 117, 123, 127, 130, 145, 147-151, 155, 156, 159, 160, 166, 170-174, 176, 177, 181, 191, 199-201,
213-216, 224, 225, 229, 231-233, 256-260, 262, 266, 268, 270, 271, 275-277, 279, 280, 283-285, 288-291,
295, 296, 298-301, 315, 320, 332, 335, 338, 343, 366, 382, 383, 385, 389-392, 408, 412, 413, 422, 424
fiscal year
...
263, 299, 306, 319-322, 330, 336, 338, 339, 343, 345, 347, 351, 352
FOB shipping point
...
322
freight prepaid
...
261, 268, 276, 284, 285, 289
GAAP
...
261, 267, 285
Gains
...
24
general public
...
4, 22, 23, 33, 187, 260-262, 270, 277, 279, 288, 293, 298
Global Text Project
...
41, 58, 59, 61, 62, 256, 285, 288, 293
goodwill
...
23, 24
Governmental units
...
4, 264-266, 285, 287, 291, 293, 294, 296, 303-305, 325-329, 331, 334, 339, 343, 345, 346, 356,
359, 361-363, 380-382, 384, 390, 391, 393, 395, 397, 399, 404, 405, 408, 410-413, 415, 417, 419, 421, 424,
425
gross margin percentage
...
264, 327, 329, 339, 356
gross selling price
...
2
historical cost
...
123
IASB
...
28
IFRS
...
326, 328, 339, 346
income statement16, 30, 34-39, 41, 45, 48, 51, 54, 56, 57, 59-61, 65, 67-69, 71, 72, 76, 78, 83, 84, 90, 145, 147,
148, 153, 155, 156, 158, 161, 163-165, 171, 184, 187, 188, 190, 192, 195-199, 202-204, 225, 227, 231-234,
236, 237, 240, 244, 245, 248, 250, 251, 253, 258-260, 275, 298, 303-306, 310, 312-314, 316, 317, 319, 320,
322, 324-328, 330-336, 338, 340-343, 346, 348-350, 352, 354, 355, 357, 358, 360-363, 371, 381, 389, 391,
393, 394
Income Summary account
...
218, 222, 230
installment basis
...
20
Institute of Chartered Accountants of India
...
20, 23, 25
intangible assets
...
166, 174, 222, 230, 240, 245
Interest Receivable
...
20

p
...
28
International Financial Reporting Standards
...
135, 267, 299, 306-310, 317, 328, 329, 338-340, 344, 345, 347, 357, 365, 410, 411
invoice price
...
123
Journal of Accountancy
...
218, 221, 230
Leaseholds
...
123
liabilities
...
256, 285, 293
long-term assets
...
220, 221, 230
Long-term liabilities
...
19, 32, 52, 197, 267, 270, 275, 278, 281, 282, 285, 372, 382
Maher
...
19
Manufacturers
...
33, 34, 54, 59, 267
marketable securities
...
147, 148, 158, 170, 175, 261, 267, 270, 285, 286, 294, 296
Materiality
...
2
Merchandise in transit
...
33, 34, 53, 59, 282, 304, 305, 307, 310, 313, 315, 327, 329, 331, 360
Modifying conventions
...
41, 59, 62, 76, 256, 257, 260, 283, 285, 287
Net cost of purchases
...
35-38, 46-48, 52, 55, 57, 59, 60, 62, 63, 65, 69, 73, 148, 165-168, 177, 178, 180, 184, 195-199, 202,
206, 207, 221, 225, 227, 229, 232-237, 250, 252, 258-260, 263, 266, 269, 270, 274, 284, 290, 291, 293, 294,
296, 297, 299, 300, 305, 326-328, 331-334, 336, 339, 346, 358, 360-363, 366, 380-383, 385, 394-396, 398,
399, 403, 405, 407-409, 412, 414, 417-419, 425, 426
net purchases
...
166, 306, 312, 313, 322, 325, 327, 328, 330, 334, 339, 340, 342, 343, 345, 346, 356, 390, 391, 394,
397, 399, 404, 412, 413, 424
neutrality
...
123
Nonoperating expenses
...
325-328, 330, 331, 339, 342
Note38, 41, 42, 44, 47, 48, 56, 59, 63-66, 70, 79, 82, 86, 92, 106, 109, 113, 114, 123, 129-132, 135, 136, 138,

p
...
36-38, 42-44, 46-48, 51, 54, 56, 57, 59, 61, 65, 66, 70, 79, 82, 106, 107, 118, 119, 121, 122, 131,
132, 136, 138, 183, 222, 223, 226, 227, 230, 238-240, 242, 245, 247, 248
Objectives and overall approach of the eighth edition
...
36-38, 42-44, 51, 64, 132, 134-136, 186, 220, 230, 242-245, 248, 326, 327
office furniture
...
219, 222, 229, 230, 361
Operating expenses
...
306, 312, 325, 326, 330, 331, 334, 339, 342
Owners and prospective owners
...
14, 79, 142
Paid-in Capital
...
32, 53-55, 59, 60, 63, 214
Passage of title
...
221, 230
Pedagogy
...
265, 266, 283, 285, 291, 294, 296, 297
Period costs
...
314-316, 321, 324, 330, 339, 340, 342-345, 361, 366, 370-375, 378, 384, 390,
398, 405, 407, 410, 416, 417, 420, 421, 424, 425
Periodicity
...
124
perpetual inventory procedure
...
4
physical inventory
...
87, 118, 190, 208, 209, 224, 225, 229-231, 233, 237, 240, 246, 251-253, 332
Predictive value
...
151, 153, 155-157, 165, 170
prepaid expenses
...
24, 28, 300
Product costs
...
34, 39, 40, 52-54, 59, 60, 86, 148, 191, 256, 305, 325, 328, 360, 363
Property, plant, and equipment
...
309, 317, 325, 334, 338, 340, 341, 356, 365, 396
Purchase Discounts account
...
314, 317-319, 321-323, 325, 328, 330, 332-335, 337, 339-341, 344-346, 357, 366, 367, 369,
385, 392, 393, 413, 417, 418, 422
Purchases account
...
271, 273, 274, 277, 283, 286, 288, 289, 297, 298
Retained Earnings
...
124
Realization principle
...
215, 273, 275, 276, 283, 286, 292, 295, 298, 302
reliability
...
275, 286, 292, 298

p
...
281, 304, 307, 308, 313, 340, 348, 360
retained earnings
...
261, 263, 267, 286, 287, 296
revenues
...
222, 231
Salaries Payable
...
311, 312, 330, 340, 347, 386
sales discount
...
309, 310, 312, 330, 340
Sales Return
...
306, 309-313, 328, 330, 332, 333, 336, 338-340, 342, 344-346, 350, 354, 357, 386, 413, 417, 422
scrap value
...
24, 28, 261, 300
Securities and Exchange Act of 1934
...
19, 23-25, 28, 261
selling expenses
...
33, 34, 53, 59, 282, 304
service potential
...
33, 60
Simple journal entry
...
32, 53, 55, 59, 60, 63
solvency
...
257, 286, 294, 295
statement of cash flows
...
16, 30, 34-37, 39, 54, 56, 57, 60, 61, 65, 67, 68, 72, 76, 78, 145, 190, 192, 195200, 225, 227, 231-235, 240, 244, 245, 248, 251, 253, 259, 275, 332-335, 346, 350, 355, 360-362
stockholders 16, 21, 23, 27, 33-40, 42-49, 51-55, 57-62, 64, 65, 68, 69, 71, 72, 74-76, 78-82, 85, 86, 89-93, 104,
106-109, 113, 117, 118, 120, 123-125, 127, 140, 143, 147, 167, 178, 186, 191, 192, 197, 200, 202, 216-219,
222, 223, 226, 229, 231, 232, 238, 252, 259, 261-263, 275, 276, 281, 335, 347, 348, 352, 353, 363
stockholders' equity
...
37-40, 42, 44-49, 52-55, 58-62, 64, 74-76, 147
straight-line
...
14
summary of transactions
...
124
Tax services
...
222, 231, 238
Temporary accounts
...
2, 3
time periods
...
274, 286, 292, 295, 297
Trade Discount
...
432 of 433

transaction
...
319, 340
unclassified balance sheet
...
324, 325, 340, 357
unearned revenue
...
222, 231
verifiability
...
304, 308, 339, 340, 360, 370
work sheet 87, 117, 190-193, 195-197, 199, 200, 202-204, 224-227, 229, 231-237, 241, 243, 244, 246-248, 251,
253, 303, 304, 331-333, 335, 336, 346, 350, 355
work sheet
...

Purchase bound textbooks and download free PDFs
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opencollegetextbooks
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