1

INTRODUCTION TO
ACCOUNTING AND BUSINESS
objectives
After studying this chapter, you
should be able to:

1 Describe the nature of a business.

2 Describe the role of accounting in

business.

3 Describe the importance of business

ethics and the basic principles of
proper ethical conduct.

4 Describe the profession of account-

ing.

5 Summarize the development of ac-

counting principles and relate them
to practice.

6 State the accounting equation and

define each element of the equation.

7 Explain how business transactions

can be stated in terms of the result-
ing changes in the basic elements of
the accounting equation.

8 Describe the financial statements of a

proprietorship and explain how they
interrelate.

9 Use the ratio of liabilities to owner’s

equity to analyze the ability of a
business to withstand poor business
PHOTO: © DON CARSTENS/BRAND X PICTURES

conditions.
 D o you use accounting? Yes, we all use accounting information in one form or an-
other. For example, when you think about buying a car, you use accounting-type in-
formation to determine whether you can afford it and whether to lease or buy.
Similarly, when you decided to attend college, you considered the costs (the tuition,
textbooks, and so on). Most likely, you also considered the benefits (the ability to ob-
tain a higher-paying job or a more desirable job).
Is accounting important to you? Yes, accounting is important in your personal life
as well as your career, even though you may not become an accountant. For exam-
ple, assume that you are the owner/manager of a small Mexican restaurant and are
considering opening another restaurant in a neighboring town. Accounting informa-
tion about the restaurant will be a major factor in your deciding whether to open the
new restaurant and the bank’s deciding whether to finance the expansion.
Our primary objective in this text is to illustrate basic accounting concepts that will
help you to make good personal and business decisions. We begin by discussing what
a business is, how it operates, and the role that accounting plays.

Nature of a Business You can probably list some examples of companies with which you have recently
objective 1 done business. Your examples might be large companies, such as Coca-Cola, Dell
Describe the nature of a Computer, or Amazon.com. They might be local companies, such as gas stations
business. or grocery stores, or perhaps employers. They might be restaurants, law firms, or
medical offices. What do all these examples have in common that identify them as
businesses?
In general, a business is an organization in which basic resources (inputs), such
as materials and labor, are assembled and processed to provide goods or services
(outputs) to customers.1 Businesses come in all sizes, from a local coffee house to
a DaimlerChrysler, which sells several billion dollars worth of cars and trucks each
year. A business’s customers are individuals or other businesses who purchase goods
or services in exchange for money or other items of value. In contrast, a church is
not a business because those who receive its services are not obligated to pay for
them.
The objective of most businesses is to maximize profits. Profit is the difference
between the amounts received from customers for goods or services provided and
the amounts paid for the inputs used to provide the goods or services. Some busi-
nesses operate with an objective other than to maximize profits. The objective of
such nonprofit businesses is to provide some benefit to society, such as medical re-
search or conservation of natural resources. In other cases, governmental units such
as cities operate water works or sewage treatment plants on a nonprofit basis. We
will focus in this text on businesses operating to earn a profit. Keep in mind, though,
that many of the same concepts and principles apply to nonprofit businesses as well.

Types of Businesses
There are three different types of businesses that are operated for profit: manufac-
turing, merchandising, and service businesses. Each type of business has unique
characteristics.
Manufacturing businesses change basic inputs into products that are sold to
individual customers. Examples of manufacturing businesses and some of their prod-
ucts are as follows.

1A complete glossary of terms appears at the end of the text.

 Chapter 1 • Introduction to Accounting and Business 3
Manufacturing Business Product

General Motors Cars, trucks, vans

Intel Computer chips
Boeing Jet aircraft
Nike Athletic shoes and apparel
Coca-Cola Beverages
Sony Stereos and televisions

Merchandising businesses also sell products to customers. However, rather than

making the products, they purchase them from other businesses (such as manufac-
turers). In this sense, merchandisers bring products and customers together. Examples
of merchandising businesses and some of the products they sell are shown below.

Merchandising Business Product

Wal-Mart General merchandise

Toys “R” Us Toys
Circuit City Consumer electronics
Lands’ End Apparel
Amazon.com Internet books, music, video retailer

Service businesses provide services rather than products to customers. Exam-

ples of service businesses and the types of services they offer are shown below.

Service Business Service

Disney Entertainment
Delta Air Lines Transportation
Roughly eight out of every ten Marriott Hotels Hospitality and lodging
workers in the United States are Merrill Lynch Financial advice
service providers. Sprint Telecommunications

Types of Business Organizations

The common forms of business organization are proprietorship, partnership, cor-
poration, or limited liability corporation. In the following paragraphs, we briefly de-
scribe each form and discuss its advantages and disadvantages.
A proprietorship is owned by one individual. More than 70% of the businesses
in the United States are organized as proprietorships. The popularity of this form is
due to the ease and the low cost of organizing. The primary disadvantage of propri-
etorships is that the financial resources available to the business are limited to the in-
dividual owner’s resources. Small local businesses such as hardware stores, repair
shops, laundries, restaurants, and maid services are often organized as proprietorships.
As a business grows and more financial and managerial resources are needed, it
may become a partnership. A partnership is owned by two or more individuals.
Like proprietorships, small local businesses such as automotive repair shops, music
stores, beauty salons, and clothing stores may be organized as partnerships. Currently,
about 10% of the businesses in the United States are organized as partnerships.
A corporation is organized under state or federal statutes as a separate legal
taxable entity. The ownership of a corporation is divided into shares of stock. A
corporation issues the stock to individuals or other businesses, who then become
owners or stockholders of the corporation.
A primary advantage of the corporate form is the ability to obtain large amounts
of resources by issuing stock. For this reason, most companies that require large in-
vestments in equipment and facilities are organized as corporations. For example,
Toys “R” Us has raised over $400 million by issuing shares of common stock to fi-
nance its operations. Other examples of corporations include General Motors, Ford,
International Business Machines (IBM), Coca-Cola, and General Electric.
 4 Chapter 1 • Introduction to Accounting and Business

About 20% of the businesses in the United States are organized as corporations.
Given that most large companies are organized as corporations, over 90% of the
total dollars of business receipts are received by corporations. Thus, cor-
porations have a major influence on the economy.
Manufacturing, merchandising, A limited liability corporation combines attributes of a partnership
and a corporation in that it is organized as a corporation, but it can elect
and service businesses are to be taxed as a partnership. Thus, its owners’ (or members’) liability is
commonly organized as either limited to their investment in the business, and its income is taxed when
the owners report it on their individual tax returns.
proprietorships, partnerships, The three types of businesses we discussed earlier—manufacturing,
corporations, or limited liability merchandising, and service—may be either proprietorships, partnerships,
corporations, or limited liability corporations. However, because of the
corporations. large amount of resources required to operate a manufacturing business,
most manufacturing businesses are corporations. Likewise, most large re-
tailers such as Wal-Mart, Sears, and JCPenney are corporations.

Business Strategies
How does a business decide which products or services to offer its customers? For
example, should Best Buy offer warranty and repair services to its customers? Many
factors influence this decision, but ultimately the decision is made on the basis of
whether it is consistent with the overall business strategy of the company.
A business strategy is an integrated set of plans and actions designed to en-
able the business to gain an advantage over its competitors, and in doing so, to
maximize its profits. The two basic strategies a business may use are a low-cost
strategy or a differentiation strategy.
Under a low-cost strategy, a business designs and produces products or services
of acceptable quality at a cost lower than that of its competitors. Wal-Mart and
Southwest Airlines are examples of businesses with a low-cost strategy. Such busi-
nesses often sell no-frills, standardized products to the most typical customer in the
industry. Following this strategy, businesses must continually focus on lowering costs.
Businesses may try to achieve lower costs in a variety of ways. For example, a
business may employ strict budgetary controls, use sophisticated training programs,
implement simple manufacturing technologies, or enter into cost-saving supplier re-
lationships. Such supplier relationships may involve linking the supplier’s produc-
tion process directly to the client’s production processes to minimize inventory costs,
variations in raw materials, and record keeping costs.
A primary concern of a business using a low-cost strategy is that a competitor
may achieve even lower costs by replicating the low costs or developing techno-
logical advances. Another concern is that competitors may differentiate their prod-
ucts in such a way that customers no longer desire a standardized, no-frills product.
For example, local pharmacies most often try to compete with Wal-Mart on the ba-
sis of personalized service rather than cost.
Under a differentiation strategy, a business designs and produces products or
services that possess unique attributes or characteristics for which customers are will-
ing to pay a premium price. For the differentiation strategy to be successful, a prod-
uct or service must be truly unique or perceived as unique in quality, reliability, image,
or design. To illustrate, Maytag attempts to differentiate its appliances on the basis
of reliability, while Tommy Hilfiger differentiates its clothing on the basis of image.
Businesses using a differentiation strategy often use information systems to cap-
ture and analyze customer buying habits and preferences. For example, many gro-
cery stores such as Kroger and Safeway issue magnetic cards to preferred customers
that allow the consumer to receive special discounts on purchases. In addition to
establishing brand loyalty, the cards allow the stores to track consumer preferences
and buying habits for use in purchasing and advertising campaigns.
Companies may enhance differentiation by investing in manufacturing and ser-
vice technologies, such as flexible manufacturing methods that allow timely prod-
uct design and delivery. Some companies use marketing and sales efforts to promote
 Chapter 1 • Introduction to Accounting and Business 5

product differences. Other companies use unique credit-granting arrangements, em-

phasize personal relationships with customers, or offer extensive training and after-
sales service programs for customers.
A business using a differentiation strategy wants customers to pay a premium
price for the differentiated features of its products. However, a business may pro-
vide features that exceed the customers’ needs. In this case, competitors may be
able to offer customers less differentiated products at lower costs. Also, customers’
perceptions of the differentiated features may change. As a result, customers may
not be willing to continue to pay a premium price for the products. For example,
as Tommy Hilfiger clothing becomes more commonplace, customers may be un-
willing to pay a premium price for Hilfiger clothing. Over time, customers may also
I have 30,000 restau- become better educated about the products and the value of the differentiated fea-
rants in 121 coun- tures. For example, IBM personal computers were once viewed as being differenti-
tries, with about ated on quality. However, as consumers have become better educated and more
13,000 in the United
experienced with personal computers, Dell computers have also become perceived
States. I serve more than 45 mil-
lion people each day and employ as being of high quality.
1.5 million. Moscow’s Pushkin A business may attempt to implement a combination strategy that includes
Square sports one of my busiest elements of both the low-cost and differentiation strategies. That is, a business
stores. Fortune Magazine named may attempt to develop a differentiated product at competitive, low-cost prices.
me No. 1 for social responsibility.
For example, Andersen Windows allows customers to design their own windows
I’m busy cutting fat from my offer-
ings. I use more than three million through the use of its proprietary manufacturing software. By using flexible man-
pounds of potatoes per day. My ufacturing, Andersen Windows can produce a variety of windows in small quan-
New Tastes Menu is Made for You. tities with a low or moderate cost. Thus, Andersen windows sell at a higher price
My spokesman’s shoes are size than standard low-cost windows but at a lower price than fully customized win-
14 1/2 and he helps sick kids. More
dows built on site.
than 37 percent of my American
owner/operators are women and Exhibit 1 summarizes the characteristics of the low-cost, differentiation, and com-
minorities. Who am I? (Go to page bination strategies. In addition, some common examples of businesses that employ
28 for answer.) each strategy are also listed.

•Exhibit 1 Business Strategies and Industries

Industry
Business Financial
Strategy Airline Freight Automotive Retail Services Hotel
Low cost Southwest Union Saturn Sam’s Schwab Super 8
Pacific Clubs
Differentiated Virgin Federal BMW Talbot’s Morgan Four
Atlantic Express Stanley Seasons
Combination Delta United Ford Target Merrill Marriott
Postal Lynch
Service

As you might expect, a danger of a business using a combination strategy is that

its products might not adequately satisfy either end of the market. That is, because
its products are differentiated, it cannot establish itself as the low-cost leader, and
at the same time, its products may not be differentiated enough that customers are
willing to pay a premium price. In other words, the business may become “stuck
in the middle.” For example, J.C.Penney has difficulty competing as a low-cost
leader against Wal-Mart, Kmart, Goody’s Family Clothing, Fashion USA, and
T.J. Maxx. At the same time, J.C.Penney cannot adequately differentiate its stores
and merchandise from such competitors as The Gap, Old Navy, Eddie Bauer, and
Talbot’s so that it can charge higher prices.
6 Chapter 1 • Introduction to Accounting and Business

A business may also attempt to implement different strategies for different mar-
kets. For example, Toyota segments the market for automobiles by offering the
Lexus to image- and quality-conscious buyers. To reinforce this image, Toyota devel-
oped a separate dealer network. At the same time, Toyota offers a low-cost auto-
mobile, the Echo, to price-sensitive buyers.

Value Chain of a Business

Once a business has chosen a strategy, it must implement the strategy in its value
chain. A value chain is the way a business adds value for its customers by pro-
cessing inputs into a product or service, as shown in Exhibit 2.

•Exhibit 2 The Value Chain

Inputs Business Processes Products or Services Customer Value

To illustrate, Delta Air Lines’ value chain consists of taking inputs, such as peo-
ple, aircraft, and equipment, and processing these inputs into a service of trans-
porting goods and passengers throughout the world. The extent to which customers
value Delta’s passenger service is reflected by the air fares Delta is able to charge
as well as passenger load factors (percentage of seats occupied). For example, the
extent to which Delta can, on average, charge higher fares than discount airlines,
such as AirTran, implies that passengers value Delta’s services more than AirTran’s.
These services may include newer, more comfortable aircraft, the ability to earn fre-
quent flyer miles, more convenient passenger schedules, passenger lounges for fre-
quent flyers, and international connections.
A business’s value chain can be divided into primary and supporting processes.
Primary processes are those that are directly involved in creating value for customers.
Examples of primary processes include manufacturing, selling, and customer service.
Supporting processes are those that facilitate the primary processes. Examples of
support processes include purchasing and personnel.2 For Delta Air Lines, primary
processes would include aircraft maintenance, baggage handling, ticketing, and flight
operations. Secondary processes for Delta Air Lines would include the accounting
and finance functions, contracting for fuel deliveries, and investor relations.

Business Stakeholders
A business stakeholder is a person or entity having an interest in the economic
performance of the business. These stakeholders normally include the owners, man-
agers, employees, customers, creditors, and the government.
The owners who have invested resources in the business clearly have an inter-
est in how well the business performs. Most owners want to get the most economic
value for their investments. To the extent that the business is profitable, owners will
expect to share in the business profits. Since owners may eventually decide to sell
their business, they also have an interest in the total economic worth of the busi-
ness. This economic worth may reflect results of past profits as well as prospects
for future profits.
The managers are those individuals who the owners have authorized to oper-
ate the business. Managers are primarily evaluated on the economic performance of
the business. The managers of poor-performing businesses are often fired by the
owners. Thus, managers have an incentive to maximize the economic value of the

2The value chain is described and illustrated in most management textbooks.

 Chapter 1 • Introduction to Accounting and Business 7

business. Owners may offer managers salary contracts that are tied directly to how
well the business performs. For example, a manager might receive a percent of the
profits or a percent of the increase in profits. Such contracts are often referred to
as profit-sharing plans.
The employees provide services to the business in exchange for a paycheck.
The employees have an interest in the economic performance of the business be-
cause their jobs depend upon it. During business downturns, it is not unusual for
a business to lay off workers for extended periods of time. Whenever a business
fails, the employees lose their jobs permanently. Employee labor unions often use
the good economic performance of a business to argue for wage increases. In con-
trast, businesses often cite poor economic performance as a reason for decreasing
wages or denying raises.
The customers may also have an interest in the continued success of a business.
For example, if Apple Computer were to fail, customers might not be able to get
hardware and software for their computers. Likewise, customers who purchase ad-
vance tickets on Southwest Airlines have an interest in whether Southwest will
continue in business. Frequent flyers on Eastern Airlines lost their accumulated
frequent-flyer points when Eastern went out of business.
Like the owners, the creditors invest resources in the business by extending
credit, such as a loan. They, too, have an interest in how well the business per-
forms. In order for the creditors to recover their investment, the business must gen-
erate enough cash to pay them back. In addition, creditors view the business as
their customer and thus have a stake in the continued success of the business.
Various governments have an interest in the economic performance of busi-
nesses. City, county, state, and federal governments collect taxes from businesses
within their jurisdictions. The better a business does, the more taxes the government
can collect. In addition, workers are taxed on their wages. In contrast, workers who
The state of Alabama offered
DaimlerChrysler millions of are laid off and are unemployed can file claims for unemployment compensation,
dollars in incentives to locate a which results in a financial burden for the government. City and state governments
Mercedes plant in Alabama. often provide incentives for businesses to locate in their jurisdictions.

SUCCESSFUL ENTREPRENEURS

What are the characteristics of entrepreneurs who suc- Examples of some well-known entrepreneurs and their
cessfully start and manage a new business? companies are listed below.
It goes without saying that an entrepreneur must have
a thorough technical knowledge of the business. For ex- Entrepreneur Company
ample, a successful computer consultant must have a thor-
Jeffrey Yang Yahoo!
ough knowledge of computers. Entrepreneurs must also
Henry Ford Ford Motor Company
have basic management skills, such as the ability to or-
George Eastman Kodak
ganize and interact with others. Terms that are often used
King C. Gillette Gillette Company
to describe entrepreneurs are listed below.
Steven Jobs Apple Computer
Bill Gates Microsoft
Terms
Frederick Smith Federal Express
Vision Spirit of adventure Sam Walton Wal-Mart
Perseverance Need for achievement
Independent Self-starter Examples of entrepreneurs also include the owners of
Self-confident Sense of commitment many small businesses in your community, from local
Risk taker Willingness to make restaurants to video rental stores.
High energy level personal sacrifices
Motivated Communication skills
Personal drive
 8 Chapter 1 • Introduction to Accounting and Business

The Role of Accounting in Business

What is the role of accounting in business? The simplest answer to this question is
objective 2 that accounting provides information for managers to use in operating the business.
Describe the role of account- In addition, accounting provides information to other stakeholders to use in assess-
ing in business. ing the economic performance and condition of the business.
In a general sense, accounting can be defined as an information system that
provides reports to stakeholders about the economic activities and condition of a
business. As we indicated earlier in this chapter, we will focus our discussions on
accounting and its role in business. However, many of the concepts in this text apply
also to individuals, governments, and other types of organizations. For example, in-
dividuals must account for activities such as hours worked, checks written, and bills
due. Stakeholders for individuals include creditors, dependents, and the government.
A main interest of the government is making sure that individuals pay the proper
taxes.
You may think of accounting as the “language of business.” This is be-
cause accounting is the means by which business information is communi-
Accounting is an information cated to the stakeholders. For example, accounting reports summarizing the
profitability of a new product help Coca-Cola’s management decide whether
system that provides reports to continue selling the product. Likewise, financial analysts use accounting
to stakeholders about the reports in deciding whether to recommend the purchase of Coca-Cola’s stock.
Banks use accounting reports in determining the amount of credit to extend
economic activities and to Coca-Cola. Suppliers use accounting reports in deciding whether to offer
condition of a business. credit for Coca-Cola’s purchases of supplies and raw materials. State and fed-
eral governments use accounting reports as a basis for assessing taxes on
Coca-Cola.
The process by which accounting provides information to business stakeholders
is illustrated in Exhibit 3. A business must first identify its stakeholders. It must then
assess the various informational needs of those stakeholders and design its accounting
system to meet those needs. Finally, the accounting system records the economic
data about business activities and events, which the business reports to the stake-
holders according to their informational needs.
Stakeholders use accounting reports as a primary source of information on which
they base their decisions. They use other information as well. For example, in de-
ciding whether to extend credit to an appliance store, a banker might use economic
forecasts to assess the future demand for the store’s products. During periods of
economic downturn, the demand for consumer appliances normally declines. The
banker might inquire about the ability and reputation of the managers of the busi-
ness. For small corporations, bankers may require major stockholders to personally
guarantee the loans of the business. Finally, bankers might consult industry publi-
cations that rank similar businesses as to their quality of products, customer satis-
faction, and future prospects for growth.

Business Ethics Individuals may have different views about what is “right” and “wrong” in a given
objective 3 situation. For example, you may believe it is wrong to copy another student’s home-
Describe the importance of work and hand it in as your own. Other students may feel that it is acceptable to
business ethics and the basic copy homework if the instructor has no stated rule against it. Unfortunately, busi-
principles of proper ethical ness managers sometimes find themselves in situations where they feel pressure to
conduct. violate personal ethics. For example, managers of Sears automotive service depart-
ments were accused of recommending unnecessary repairs and overcharging cus-
tomers for actual repairs in order to meet company goals and earn bonuses.
 Chapter 1 • Introduction to Accounting and Business 9

•Exhibit 3 Accounting Information and the Stakeholders of a Business

P R O V I D I N G I N F O R M AT I O N TO USERS

Stakeholders

1
Identify
Internal:
Owners,
managers,
External:
Customers,
creditors,
2
Assess stakeholders'
stakeholders employees government informational needs

SHAR
RT
R E P OT O
EHOL
DERS
5
Prepare accounting
reports for stakeholders

4
Record economic
ACCOUNTING
3
Design the accounting
INFORMATION
data about SYSTEM information system
business activities to meet stakeholders'
and events needs

The moral principles that guide the conduct of individuals are called ethics. Re-
gardless of differences among individuals, proper ethical conduct implies a behav-
ior that considers the impact of one’s actions on society and others. In other words,
proper ethical conduct implies that you not only consider what’s in your best in-
Most colleges and universities pub- terest, but also what’s in the best interests of others.
lish a Student Code of Conduct Ethical conduct is good business. For example, an automobile manufacturer that
that sets forth the ethical conduct fails to correct a safety defect to save costs may later lose sales due to lack of con-
expected of students. sumer confidence. Likewise, a business that pollutes the environment may find it-
self the target of lawsuits and customer boycotts.
Businesspeople should work within an ethical framework.3 Although an ethical
framework is based on individual experiences and training, there are a number of
sound principles that form the foundation for ethical behavior:
1. Avoid small ethical lapses. Small ethical lapses may appear harmless in and of
themselves. Unfortunately, such lapses can compromise your work. Small ethical
Stanley James Cardiges, the former lapses can build up and lead to larger consequences later.
top U.S. sales representative for 2. Focus on your long-term reputation. One characteristic of an ethical dilemma is
American Honda, admitted to that it places you under severe short-term pressure. The ethical dilemma is cre-
receiving $2 million to $5 million ated by the stated or unstated threat that failure to “go along” may result in un-
in illegal kickbacks from dealers.
desirable consequences. You should respond to ethical dilemmas by minimizing
After being sentenced to five years
in prison, he admitted to falling the short-term pressures and focusing on long-term reputation instead. Your rep-
into a pattern of unethical behav- utation is very valuable. You will lose your effectiveness if your reputation be-
ior early in his career. comes tarnished.
3. You may suffer adverse personal consequences for holding to an ethical position.
In some unethical organizations, managers have endured career setbacks for not
budging from their ethical positions. Some managers have resigned because they
were unable to support management in what they perceived as unethical be-
havior. Thus, in the short term, ethical behavior can sometimes adversely affect
your career.

3“Integrity in Business” items and end-of-chapter ethics discussion cases are provided throughout this text to focus at-

tention on the importance of proper ethical conduct in business.

10 Chapter 1 • Introduction to Accounting and Business

INTEGRITY IN BUSINESS

DOING THE RIGHT THING

Time Magazine named three women as “Persons of the countant, informed WorldCom’s Board of Directors of
Year 2002.” Each of these not-so-ordinary women had phony accounting that allowed WorldCom to cover up
the courage, determination, and integrity to do the right over $3 billion in losses and forced WorldCom into bank-
thing. Each risked their personal careers to expose short- ruptcy. Coleen Rowley, an FBI staff attornery, wrote a
comings in their organizations. Sherron Watkins, an Enron memo to FBI Director Robert Mueller, exposing how the
vice-president, wrote a letter to Enron’s chairman, Kenneth Bureau brushed off her pleas to investigate Zacarias
Lay, warning him of improper accounting that eventually Moussaoui, who was indicted as a co-conspirator in the
led to Enron’s collapse. Cynthia Cooper, an internal ac- September 11 terrorist attacks.

Profession of Accounting Accountants engage in either private accounting or public accounting. Accountants
objective 4 employed by a business firm or a not-for-profit organization are said to be engaged
Describe the profession of in private accounting. Accountants and their staff who provide services on a fee
accounting. basis are said to be employed in public accounting.
Because all functions within a business use accounting information, experience
in private or public accounting provides a solid foundation for a career. Many po-
sitions in industry and in government agencies are held by individuals with ac-
counting backgrounds. For example, in a Special Bonus Issue on “The Corporate
Elite,” Business Week reported the career paths for the chief executives of the 1,000
largest public corporations. These career paths are shown in Exhibit 4.

•Exhibit 4

C A R E E R P AT H S OF C O R P O R AT E E X E C U T I V E S

Finance– Merchandising– Engineering–

Accounting Marketing Technical

31% 27% 22%

 Chapter 1 • Introduction to Accounting and Business 11

Private Accounting
The scope of activities and duties of private accountants varies widely. Private ac-
countants are frequently called management accountants. If they are employed by a
manufacturer, they may be referred to as industrial or cost accountants. The chief ac-
countant in a business may be called the controller. Various state and federal agen-
A career in accounting can be
cies and other not-for-profit agencies also employ accountants.
financially rewarding. Warren The Institute of Certified Management Accountants, an affiliate of the Institute of
Jensen, a Certified Public Accoun- Management Accountants (IMA), sponsors the Certified Management Accountant
tant, accepted a position with (CMA) program. The CMA certificate is evidence of competence in management ac-
Amazon.com as its Chief Financial counting. Becoming a CMA requires a college degree, two years of experience, and
Officer (CFO). Mr. Jensen, the
former CFO of Delta Air Lines, re-
successful completion of a two-day examination. Continuing professional education is
ceived stock options in Amazon required for renewal of the CMA certificate. In addition, members of the IMA must
.com that are potentially worth adhere to standards of ethical conduct.
over $100 million. The Institute of Internal Auditors sponsors a similar program for internal auditors.
Internal auditors are accountants who review the accounting and operating proce-
dures prescribed by their firms. Accountants who specialize in internal auditing may
be granted the Certified Internal Auditor (CIA) certificate.

Public Accounting
In public accounting, an accountant may practice as an individual or as a member
of a public accounting firm. Public accountants who have met a state’s education,
experience, and examination requirements may become Certified Public Accoun-
tants (CPAs).
The requirements for obtaining a CPA certificate differ among the various states.
All states require a college education in accounting, and most states require 150 se-
mester hours of college credit. In addition, a candidate must pass an examination
prepared by the American Institute of Certified Public Accountants (AICPA).
Most states do not permit individuals to practice as CPAs until they have had from
one to three years’ experience in public accounting. Some states, however, accept
similar employment in private accounting as equivalent experience. All states require
continuing professional education and adherence to standards of ethical conduct.4

INTEGRITY IN BUSINESS

ACCOUNTING REFORM
The financial accounting and reporting failures of Enron, Accounting Oversight Board to regulate the portion of
WorldCom, Tyco, Xerox, and others shocked the invest- the accounting profession that has public companies as
ing public. The disclosure that some of the nation’s largest clients. In addition, the Act prohibits auditors (CPAs) from
and best-known corporations had overstated profits and providing certain types of nonaudit services, such as in-
misled investors raised the question: Where were the CPAs? vestment banking or legal services, to their clients, pro-
In response, Congress passed the Investor Protection, hibits employment of auditors by clients for one year after
Auditor Reform, and Transparency Act of 2002, called the they last audited the client, and increases penalties for the
Sarbanes-Oxley Act. The Act establishes a Public Company reporting of misleading financial statements.

Specialized Accounting Fields

You may think that all accounting is the same. However, you will find several spe-
cialized fields of accounting in practice. The two most common are financial account-
ing and managerial accounting. Other fields include cost accounting, environmental

4The text of the Code of Professional Conduct of the American Institute of Certified Public Accountants is reproduced

in Appendix B.
12 Chapter 1 • Introduction to Accounting and Business

accounting, tax accounting, accounting systems, international accounting, not-for-profit

accounting, and social accounting.
Financial accounting is primarily concerned with the recording and reporting
of economic data and activities for a business. Although such reports provide use-
ful information for managers, they are the primary reports for owners, creditors,
governmental agencies, and the public. For example, if you wanted to buy some
stock in PepsiCo, American Airlines, or McDonald’s, how would you know in
which company to invest? One way is to review financial reports and compare the
financial performance and condition of each company. The purpose of financial
accounting is to provide such reports.
Managerial accounting, or management accounting, uses both financial ac-
counting and estimated data to aid management in running day-to-day operations
and in planning future operations. Management accountants gather and report in-
formation that is relevant and timely to the decision-making needs of management.
For example, management might need information on alternative ways to finance
the construction of a new building. Alternatively, management might need infor-
mation on whether to expand its operations into a new product line. Thus, reports
to management can differ widely in form and content.

Generally Accepted Accounting Principles

If the management of a company could record and report financial data as it saw
objective 5 fit, comparisons among companies would be difficult, if not impossible. Thus, fi-
Summarize the development nancial accountants follow generally accepted accounting principles (GAAP) in
of accounting principles and preparing reports. These reports allow investors and other stakeholders to compare
relate them to practice. one company to another.
To illustrate the importance of generally accepted accounting principles, assume
that each sports conference in college football used different rules for counting touch-
downs. For example, assume that the Pacific Athletic Conference (PAC 10) counted
a touchdown as six points and the Atlantic Coast Conference (ACC) counted a touch-
down as two points. It would be difficult to evaluate the teams under such differ-
ent scoring systems. A standard set of rules and a standard scoring system help fans
compare teams across conferences. Likewise, a standard set of generally accepted
accounting principles allows for the comparison of financial performance and con-
dition across companies.
The FASB is also developing a Accounting principles and concepts develop from research, accepted accounting
broad conceptual framework for practices, and pronouncements of authoritative bodies. Currently, the Financial
financial accounting. Seven State-
ments of Financial Accounting
Accounting Standards Board (FASB) is the authoritative body having the primary
Concepts have been published to responsibility for developing accounting principles. The FASB publishes Statements
date. of Financial Accounting Standards and Interpretations to these Standards.
Because generally accepted accounting principles impact how companies report
and what they report, all stakeholders are interested in the setting of these princi-
ples. For example, the setting of accounting standards for stock-based compensa-
tion or stock options has been especially controversial. Even the United States Senate
has been involved in the debate. Many managers opposed an initial proposal by the
FASB that would record the value of such options as a reduction of profits because
doing so would negatively impact their financial results. The FASB issued a revised
proposal, but investors, analysts, and other stakeholders criticized manager stock op-
tions in light of the poor financial performances of many companies and the finan-
cial failures of Enron, Tyco, and WorldCom. As the debate continues, some
companies are voluntarily treating stock options as a reduction of profits.
In this chapter and throughout this text, we emphasize accounting principles and
concepts. It is through this emphasis on the “why” of accounting as well as the
“how” that you will gain an understanding of the full significance of accounting.
In the following paragraphs, we discuss the business entity concept and the cost
concept.
 Chapter 1 • Introduction to Accounting and Business 13

Business Entity Concept

The individual business unit is the business entity for which economic data
Under the business are needed. This entity could be an automobile dealer, a department store,
or a grocery store. The business entity must be identified, so that the ac-
entity concept, the countant can determine which economic data should be analyzed, recorded,
activities of a business and summarized in reports.
The business entity concept is important because it limits the economic
are recorded separately data in the accounting system to data related directly to the activities of the
from the activities of business. In other words, the business is viewed as an entity separate from
its owners, creditors, or other stakeholders. For example, the accountant for
the stakeholders. a business with one owner (a proprietorship) would record the activities of
the business only, not the personal activities, property, or debts of the owner.

The Cost Concept

If a building is bought for $150,000, that amount should be entered into the buyer’s
accounting records. The seller may have been asking $170,000 for the building up
to the time of the sale. The buyer may have initially offered $130,000 for the build-
ing. The building may have been assessed at $125,000 for property tax purposes.
The buyer may have received an offer of $175,000 for the building the day after it
was acquired. These latter amounts have no effect on the accounting records be-
cause they did not result in an exchange of the building from the seller to the buyer.
The cost concept is the basis for entering the exchange price, or cost, of $150,000
into the accounting records for the building.
Continuing the illustration, the $175,000 offer received by the buyer the day af-
ter the building was acquired indicates that it was a bargain purchase at $150,000.
To use $175,000 in the accounting records, however, would record an illusory or
unrealized profit. If, after buying the building, the buyer accepts the offer and sells
the building for $175,000, a profit of $25,000 is then realized and recorded. The new
owner would record $175,000 as the cost of the building.
Using the cost concept involves two other important accounting concepts—
objectivity and the unit of measure. The objectivity concept requires that the
accounting records and reports be based upon objective evidence. In exchanges
between a buyer and a seller, both try to get the best price. Only the final agreed-
upon amount is objective enough for accounting purposes. If the amounts at which
properties were recorded were constantly being revised upward and downward
based on offers, appraisals, and opinions, accounting reports could soon become
unstable and unreliable.
The unit of measure concept requires that economic data be recorded in dol-
lars. Money is a common unit of measurement for reporting uniform financial data
and reports.

A ssets, Liabilities, and Owner’s Equity

The resources owned by a business are its assets. Examples of assets include
objective 6 cash, land, buildings, and equipment. The rights or claims to the properties are
State the accounting equation normally divided into two principal types: (1) the rights of creditors and (2) the
and define each element of rights of owners. The rights of creditors represent debts of the business and are
the equation. called liabilities. The rights of the owners are called owner’s equity. The rela-
tionship between the two may be stated in the form of an equation, as follows:

Assets
Liabilities  Owner’s Equity

This equation is known as the accounting equation. It is usual to place liabil-

ities before owner’s equity in the accounting equation because creditors have first
14 Chapter 1 • Introduction to Accounting and Business

If a company’s assets increase by rights to the assets. The claim of the owners is sometimes given greater
$20,000 and its liabilities decrease emphasis by transposing liabilities to the other side of the equation,
by $5,000, how much did the
owner’s equity increase or decrease?
which yields:

Change Change Change Assets  Liabilities
Owner’s Equity

in  in  in Owner’s
Assets Liabilities Equity To illustrate, if the assets owned by a business amount to $100,000
and the liabilities amount to $30,000, the owner’s equity is equal to
$20,000
$5,000  X
$25,000
X
$70,000, as shown below.

Assets
Liabilities  Owner’s Equity

$100,000  $30,000
$70,000

FINANCIAL REPORTING AND DISCLOSURE

THE ACCOUNTING EQUATION

T he accounting equation provides a basic framework for such as a local convenience store, to the largest businesses.
recording the effects of transactions on companies of all Some examples taken from recent financial reports of well-
sizes and types. This basic framework serves as the foun- known companies are shown below.
dation for accounting systems from the smallest business,

Company Assets*  Liabilities  Owners’ Equity

Coca-Cola $22,417
$11,051  $11,366

Circuit City 3,815
1,436  2,379
Dell Computer 13,435
7,813  5,622
eBay 1,182
168  1,014
Hilton Hotels 9,140
7,498  1,642
McDonald’s 22,535
13,047  9,488
Microsoft 59,257
11,968  47,289
Southwest Airlines 8,997
4,983  4,014
Wal-Mart 78,130
46,787  31,343
*Amounts are shown in millions of dollars.

Business Transactions and the

Accounting Equation
Paying a monthly telephone bill of $168 affects a business’s financial condition be-
objective 7 cause it now has less cash on hand. Such an economic event or condition that di-
Explain how business transac- rectly changes an entity’s financial condition or directly affects its results of operations
tions can be stated in terms is a business transaction. For example, purchasing land for $50,000 is a business
of the resulting changes in transaction. In contrast, a change in a business’s credit rating does not directly af-
the basic elements of the ac- fect cash or any other element of its financial condition.
counting equation. All business transactions can be stated in terms of changes in the elements of the
accounting equation. You will see how business transactions affect the accounting
equation by studying some typical transactions. As a basis for illustration, we will
use a business organized by Chris Clark.
Assume that on November 1, 2005, Chris Clark begins a business that will be
known as NetSolutions. The first phase of Chris’s business plan is to operate Net-
 Chapter 1 • Introduction to Accounting and Business 15

Solutions as a service business that provides assistance to individuals and

small businesses in developing Web pages and in configuring and installing
All business transactions application software. Chris expects this initial phase of the business to last
can be stated in terms of one to two years. During this period, Chris will gather information on the
software and hardware needs of customers. During the second phase of
changes in the elements the business plan, Chris plans to expand NetSolutions into a personalized
of the accounting retailer of software and hardware for individuals and small businesses.
Each transaction or group of similar transactions during NetSolutions’ first
equation. month of operations is described in the following paragraphs. The effect
of each transaction on the accounting equation is then shown.

Transaction a Chris Clark deposits $25,000 in a bank account in the name of Net-
Solutions. The effect of this transaction is to increase the asset cash (on the left side
of the equation) by $25,000. To balance the equation, the owner’s equity (on the
right side of the equation) is increased by the same amount. The equity of the owner
is referred to by using the owner’s name and “Capital,” such as “Chris Clark, Capital.”
The effect of this transaction on NetSolutions’ accounting equation is shown below.

Assets    Owner’s Equity

 
Cash 
 Chris Clark, Capital
a. 25,000 
  25,000 Investment by Chris Clark
Note that since Chris Clark is the sole owner, NetSolutions is a proprietorship. Note,
too, that the accounting equation shown above relates only to the business, NetSolu-
tions. Under the business entity concept, Chris Clark’s personal assets, such as a home
or personal bank account, and personal liabilities are excluded from the equation.

Transaction b If you purchased this textbook by paying cash, you entered into
a transaction in which you exchanged one asset for another. That is, you exchanged
cash for the textbook. Businesses often enter into similar transactions. Net-
If NetSolutions had purchased a Solutions, for example, exchanged $20,000 cash for land. The land is lo-
van for $28,000, paying $8,000 cated in a new business park with convenient access to transportation
cash and signing a loan agree-
facilities. Chris Clark plans to rent office space and equipment during the
ment (note payable) for $20,000,
how would the transaction be recorded using first phase of the business plan. During the second phase, Chris plans to
the accounting equation? build an office and warehouse on the land.
The purchase of the land changes the makeup of the assets but does
Cash  Van  Notes Payable
not change the total assets. The items in the equation prior to this trans-
8,000  28,000 20,000 action and the effect of the transaction are shown next, as well as the new
amounts, or balances, of the items.

Assets    Owner’s Equity

 
Cash  Land   Chris Clark, Capital
Bal. 25,000 
 25,000
20,000 20,000  
b.
Bal. 5,000
 
20,000   25,000

Transaction c You have probably used a credit card at one time or another to buy
clothing or other merchandise. In this type of transaction, you received clothing for a
promise to pay your credit card bill in the future. That is, you received an asset and
incurred a liability to pay a future bill. During the month, NetSolutions entered into
a similar transaction, buying supplies for $1,350 and agreeing to pay the supplier in
Other examples of common pre-
the near future. This type of transaction is called a purchase on account. The liabil-
paid expenses include insurance
and rent. Businesses usually report ity created is called an account payable. Items such as supplies that will be used in
these assets together as a single the business in the future are called prepaid expenses, which are assets. The effect
item, prepaid expenses. of this transaction is to increase assets and liabilities by $1,350, as follows:
16 Chapter 1 • Introduction to Accounting and Business

Assets    Liabilities  Owner’s Equity

 
 
  Accounts Chris Clark,
Cash  Supplies  Land 

 Payable Capital
Bal.
c.
5,000
1,350
20,000
 
  1,350
25,000

Bal. 5,000 1,350 20,000  

  1,350 25,000
Transaction d You may have earned money by painting houses. If so, you re-
ceived money for rendering services to a customer. Likewise, a business earns money
by selling goods or services to its customers. This amount is called revenue.
During its first month of operations, NetSolutions provided services to customers,
earning fees of $7,500 and receiving the amount in cash. The receipt of cash increases
NetSolutions’ assets and also increases Chris Clark’s equity in the business. Thus, this
transaction increased cash and the owner’s equity by $7,500, as shown here.

Assets    Liabilities  Owner’s Equity

 
 
  Accounts Chris Clark,
Cash  Supplies  Land Payable  Capital
  1,350


Bal. 5,000
7,500
1,350 20,000
 
 
25,000
 7,500 Fees earned
 
d.
Bal. 12,500 1,350 20,000   1,350 32,500

Special terms may be used to describe certain kinds of revenue, such as sales
for the sale of merchandise. Revenue from providing services is called fees earned.
For example, a physician would record fees earned for services to patients. Other
examples include rent revenue (money received for rent) and interest revenue
(money received for interest).
Instead of requiring the payment of cash at the time services are provided or
goods are sold, a business may accept payment at a later date. Such revenues are
called fees on account or sales on account. In such cases, the firm has an account
receivable, which is a claim against the customer. An account receivable is an as-
set, and the revenue is earned as if cash had been received. When customers pay
their accounts, there is an exchange of one asset for another. Cash increases, while
accounts receivable decreases.

Transaction e If you painted houses to earn money, you probably used your own
ladders and brushes. NetSolutions also spent cash or used up other assets in earn-
ing revenue. The amounts used in this process of earning revenue are called ex-
penses. Expenses include supplies used, wages of employees, and other assets and
services used in operating the business.
For NetSolutions, the expenses paid during the month were as follows: wages,
$2,125; rent, $800; utilities, $450; and miscellaneous, $275. Miscellaneous expenses
include small amounts paid for such items as postage, coffee, and magazine sub-
scriptions. The effect of this group of transactions is the opposite of the effect of
revenues. These transactions reduce cash and owner’s equity, as shown here.

Assets    Liabilities  Owner’s Equity

 
  Accounts Chris Clark,
Cash  Supplies  Land   Payable  Capital
Bal. 12,500 1,350
 
20,000   1,350 32,500
e. 3,650 
 2,125 Wages expense

    800 Rent expense
   450 Utilities expense
   275 Misc. expense
8,850 1,350
 
20,000   1,350 28,850
 Chapter 1 • Introduction to Accounting and Business 17

Businesses usually record each revenue and expense transaction separately as it

occurs. However, to simplify this illustration, we have summarized NetSolutions’ rev-
enues and expenses for the month in transactions (d) and (e).

Transaction f When you pay your monthly credit card bill, you decrease the cash
in your checking account and also decrease the amount you owe to the credit card
company. Likewise, when NetSolutions pays $950 to creditors during the month, it
reduces both assets and liabilities, as shown below.

Assets    Liabilities  Owner’s Equity

 
 
  Accounts Chris Clark,
Cash  Supplies  Land
  1,350

Payable  Capital
Bal. 8,850 1,350 20,000
 
  950
28,850
950
f.
Bal. 7,900 1,350
  400
20,000   28,850

You should note that paying an amount on account is different from paying an
amount for an expense. The payment of an expense reduces owner’s equity, as il-
lustrated in transaction (e). Paying an amount on account reduces the amount owed
If supplies of $2,500 were pur-
on a liability.
chased during the month and sup-
plies of $350 are on hand at the
end of the month, how much is Transaction g At the end of the month, the cost of the supplies on hand (not
supplies expense for the month?
yet used) is $550. The remainder of the supplies ($1,350  $550) was used in the
$2,150 ($2,500 supplies pur- operations of the business and is treated as an expense. This decrease of $800 in
chased  $350 on hand) supplies and owner’s equity is shown as follows:

Assets    Liabilities  Owner’s Equity

 
 
  Accounts Chris Clark,
Cash  Supplies  Land Payable  Capital
  400


Bal.
g.
7,900 1,350
800
20,000
 
 
28,850
 800 Supplies expense
Bal. 7,900 550 20,000  
  400 28,050

Transaction h At the end of the month, Chris Clark withdraws $2,000 in cash
from the business for personal use. This transaction is the exact opposite of an in-
vestment in the business by the owner. Cash and owner’s equity are decreased. The
cash payment is not a business expense but a withdrawal of a part of the owner’s
equity. The effect of the $2,000 withdrawal is shown as follows:

Assets    Liabilities  Owner’s Equity

 
 
  Accounts Chris Clark,
Cash  Supplies  Land Payable  Capital
  400


Bal.
h.
7,900
2,000
550 20,000
 
 
28,050
2,000 Withdrawal
Bal. 5,900 550 20,000  
  400 26,050

You should be careful not to confuse withdrawals by the owner with expenses.
Withdrawals do not represent assets or services used in the process of earning rev-
enues. The owner’s equity decrease from the withdrawals is listed in the equation
under Capital. This is because withdrawals are considered a distribution of capital
to the owner.

Summary The transactions of NetSolutions are summarized as follows. They are

identified by letter, and the balance of each item is shown after each transaction.
18 Chapter 1 • Introduction to Accounting and Business

Assets  Liabilities  Owner’s Equity

Accounts Chris Clark,

Cash  Supplies  Land
Payable  Capital
a. 25,000 25,000 Investment by
Chris Clark
b. 20,000 20,000
Bal. 5,000 20,000 25,000
c. 1,350 1,350
Bal. 5,000 1,350 20,000 1,350 25,000
d.  7,500  7,500 Fees earned
Bal. 12,500 1,350 20,000 1,350 32,500
e.  3,650  2,125 Wages expense
 800 Rent expense
 450 Utilities expense
 275 Misc. expense
Bal. 8,850 1,350 20,000 1,350 28,850
f.  950  950
Bal. 7,900 1,350 20,000 400 28,850
g.  800  800 Supplies expense
Bal. 7,900 550 20,000 400 28,050
h.  2,000  2,000 Withdrawal
Bal. 5,900 550 20,000 400 26,050

In reviewing the preceding summary, you should note the following, which ap-
ply to all types of businesses:
1. The effect of every transaction is an increase or a decrease in one or more of the
accounting equation elements.
2. The two sides of the accounting equation are always equal.
3. The owner’s equity is increased by amounts invested by the owner and is de-
creased by withdrawals by the owner. In addition, the owner’s equity is increased
by revenues and is decreased by expenses. The effects of these four types of trans-
actions on owner’s equity are illustrated in Exhibit 5.

•Exhibit 5 Effects of Transactions on Owner’s Equity

O WNER'S E QUITY
 Chapter 1 • Introduction to Accounting and Business 19

Financial Statements After transactions have been recorded and summarized, reports are prepared for
objective 8 users. The accounting reports that provide this information are called financial
Describe the financial state- statements. The principal financial statements of a proprietorship are the income
ments of a proprietorship and statement, the statement of owner’s equity, the balance sheet, and the statement of
explain how they interrelate. cash flows. The order in which the statements are normally prepared and the na-
ture of the data presented in each statement are as follows:
• Income statement—A summary of the revenue and expenses for a specific pe-
riod of time, such as a month or a year.
• Statement of owner’s equity—A summary of the changes in the owner’s equity
that have occurred during a specific period of time, such as a month or a year.
• Balance sheet—A list of the assets, liabilities, and owner’s equity as of a specific
date, usually at the close of the last day of a month or a year.
• Statement of cash flows—A summary of the cash receipts and cash payments
for a specific period of time, such as a month or a year.
The basic features of the four statements and their interrelationships are illustrated
in Exhibit 6. The data for the statements were taken from the summary of transac-
tions of NetSolutions.
All financial statements should be identified by the name of the business, the title
of the statement, and the date or period of time. The data presented in the income
statement, the statement of owner’s equity, and the statement of cash flows are for a
period of time. The data presented in the balance sheet are for a specific date.
You should note the use of indents, captions, dollar signs, and rulings in the fi-
nancial statements. They aid the reader by emphasizing the sections of the statements.

Income Statement
The income statement reports the revenues and expenses for a period of time, based
on the matching concept. This concept is applied by matching the expenses with
the revenue generated during a period by those expenses. The income statement
also reports the excess of the revenue over the expenses incurred. This excess of
the revenue over the expenses is called net income or net profit. If the expenses
When you buy something at a
store, you may match the cash exceed the revenue, the excess is a net loss.
register total with the amount The effects of revenue earned and expenses incurred during the month for Net-
you paid the cashier and with the Solutions were shown in the equation as increases and decreases in owner’s equity
amount of change, if any, you (capital). Net income for a period has the effect of increasing owner’s equity (cap-
received.
ital) for the period, whereas a net loss has the effect of decreasing owner’s equity
(capital) for the period.
The revenue, expenses, and the net income of $3,050 for NetSolutions are re-
ported in the income statement in Exhibit 6. The order in which the expenses are
Net income—the listed in the income statement varies among businesses. One method is to list them
excess of revenue in order of size, beginning with the larger items. Miscellaneous expense is usually
shown as the last item, regardless of the amount.
over expenses—
increases owner’s Statement of Owner’s Equity
equity. The statement of owner’s equity reports the changes in the owner’s equity for a
period of time. It is prepared after the income statement because the net income
or net loss for the period must be reported in this statement. Similarly, it is pre-
pared before the balance sheet, since the amount of owner’s equity at the end of
the period must be reported on the balance sheet. Because of this, the statement of
owner’s equity is often viewed as the connecting link between the income state-
ment and balance sheet.
20 Chapter 1 • Introduction to Accounting and Business

•Exhibit 6
NetSolutions
Financial Statements Income Statement
For the Month Ended November 30, 2005
Fees earned $7 5 0 0 00
Operating expenses:
Wages expense $2 1 2 5 00
Rent expense 8 0 0 00
Supplies expense 8 0 0 00
Utilities expense 4 5 0 00
Miscellaneous expense 2 7 5 00
Total operating expenses 4 4 5 0 00
Net income $3 0 5 0 00

NetSolutions
Statement of Owner's Equity
For the Month Ended November 30, 2005
Chris Clark, capital, November 1, 2005 $ 0
Investment on November 1, 2005 $25 0 0 0 00
Net income for November 3 0 5 0 00
$28 0 5 0 00
Less withdrawals 2 0 0 0 00
Increase in owner's equity 26 0 5 0 00
Chris Clark, capital, November 30, 2005 $26 0 5 0 00

NetSolutions
Balance Sheet
November 30, 2005
Assets Liabilities
Cash $ 5 9 0 0 00 Accounts payable $ 4 0 0 00
Supplies 5 5 0 00 Owner's Equity
Land 20 0 0 0 00 Chris Clark, capital 26 0 5 0 00
Total liabilities and
Total assets $26 4 5 0 00 owner's equity $26 4 5 0 00

NetSolutions
Statement of Cash Flows
For the Month Ended November 30, 2005
Cash flows from operating activities:
Cash received from customers $ 7 5 0 0 00
Deduct cash payments for expenses and
payments to creditors 4 6 0 0 00
Net cash flow from operating activities $ 2 9 0 0 00
Cash flows from investing activities:
Cash payments for acquisition of land
Cash flows from financing activities: (20 0 0 0 00)
Cash received as owner's investment $25 0 0 0 00
Deduct cash withdrawal by owner 2 0 0 0 00
Net cash flow from financing activities 23 0 0 0 00
Net cash flow and November 30, 2005 cash balance $ 5 9 0 0 00
 Chapter 1 • Introduction to Accounting and Business 21

Three types of transactions affected owner’s equity for NetSolutions during No-
vember: (1) the original investment of $25,000, (2) the revenue and expenses that
resulted in net income of $3,050 for the month, and (3) a withdrawal of $2,000 by
the owner. This information is summarized in the statement of owner’s equity in
Exhibit 6.

Financial statements are used to

evaluate the current financial con- Balance Sheet
dition of a business and to predict The balance sheet in Exhibit 6 reports the amounts of NetSolutions’ assets, liabili-
its future operating results and
cash flows. For example, bank loan
ties, and owner’s equity at the end of November. These amounts are taken from the
officers use a business’s financial last line of the summary of transactions presented earlier. The form of balance sheet
statements in deciding whether to shown in Exhibit 6 is called the account form because it resembles the basic for-
grant a loan to the business. Once mat of the accounting equation, with assets on the left side and the liabilities and
the loan is granted, the borrower owner’s equity sections on the right side. We illustrate an alternative form of bal-
may be required to maintain a
certain level of assets in excess of
ance sheet called the report form in a later chapter. It presents the liabilities and
liabilities. The business’s financial owner’s equity sections below the assets section.
statements are used to monitor The assets section of the balance sheet normally presents assets in the order
this level. that they will be converted into cash or used in operations. Cash is presented
first, followed by receivables, supplies, prepaid insurance, and other assets. The
assets of a more permanent nature are shown next, such as land, buildings, and
equipment.
In the liabilities section of the balance sheet in Exhibit 6, accounts payable is the
only liability. When there are two or more categories of liabilities, each should be
listed and the total amount of liabilities presented as follows.

Liabilities
Accounts payable $12,900
Wages payable 2,570
Total liabilities $15,470

Statement of Cash Flows

The statement of cash flows consists of three sections, as we see in Exhibit 6: (1)
operating activities, (2) investing activities, and (3) financing activities. Each of these
sections is briefly described below.

Cash Flows from Operating Activities

This section reports a summary of cash receipts and cash payments from operations.
The net cash flow from operating activities ($2,900 in Exhibit 6) will normally dif-
fer from the amount of net income for the period ($3,050 in Exhibit 6). This differ-
ence occurs because revenues and expenses may not be recorded at the same time
that cash is received from customers or paid to creditors.

Cash Flows from Investing Activities

This section reports the cash transactions for the acquisition and sale of relatively
permanent assets.

Cash Flows from Financing Activities

This section reports the cash transactions related to cash investments by the owner,
borrowings, and cash withdrawals by the owner.
Preparing the statement of cash flows requires an understanding of concepts that
we have not discussed in this chapter. Therefore, we will illustrate the preparation
of the statement of cash flows in a later chapter.
22 Chapter 1 • Introduction to Accounting and Business

Financial Analysis and Interpretation

As we discussed earlier in this chapter, financial statements are useful to bankers,
objective 9 creditors, owners, and other stakeholders in analyzing and interpreting the finan-
Use the ratio of liabilities to cial performance and condition of a business. Throughout this text, we will discuss
owner’s equity to analyze the various tools that are often used in practice to analyze and interpret the financial
ability of a business to with- performance and condition of a business. The first such tool we will introduce is
stand poor business conditions. especially useful in analyzing the ability of a business to pay its creditors.
The relationship between liabilities and owner’s equity, expressed as a ratio, is
calculated as follows:

Ratio of liabilities Total liabilities


to owner’s equity Total owner’s equity (or Total stockholders’ equity)

To illustrate, NetSolutions’ ratio of liabilities to owner’s equity at the end of No-

vember is 0.015, as calculated below.

$400
Ratio of liabilities to owner’s equity

0.015
$26,050

Corporations normally refer to total owner’s equity as total stockholders’ equity.

Thus, you should substitute total stockholders’ equity for total owner’s equity when
computing this ratio for a corporation.
The rights of creditors to a business’s assets take precedence over the rights of
the owners or stockholders. Thus, the lower the ratio of liabilities to owner’s eq-
uity, the better able the business is to withstand poor business conditions and still
fully meet its obligations to creditors.
To illustrate, a ratio of 1 indicates that the liabilities and owner’s equity are equal.
In other words, if the business suffers a loss equal to the total liabilities, the amount
of total assets available to creditors will not drop below their claims on the assets.
If this were to happen, the creditors could collect their claims and the owner would
be left with nothing.

SPOTLIGHT ON STRATEGY

IT’S ALL IN THE NAME

Intel develops and produces microprocessors for use in share. In responding, Intel named its next microprocessor
electronic equipment, including personal computers and the “Pentium,” rather than the 586, and registered “Pen-
organizers. Beginning with the 8086 processor and con- tium” as a trademark. By doing so, Intel prevented its com-
tinuing with the 286, 386, and 486 processors, Intel’s petitors from selling their products as “Pentiums.” Thus,
processors were widely used in personal computers dur- Intel developed a “differentiated” brand name that its
ing the 1980s and 1990s. Intel’s competitors, however, competitors were unable to duplicate. Intel’s newest
also developed and sold 386 and 486 processors. In do- processor is called the “Pentium M.”
ing so, its competitors were able to erode Intel’s market
 Chapter 1 • Introduction to Accounting and Business 23

Key Points
1 Describe the nature of a
business.
A business is an organization in
fields of accounting are financial ac-
counting and managerial accounting.
Other fields include cost accounting,
7 Explain how business transac-
tions can be stated in terms of
the resulting changes in the
which basic resources (inputs), such environmental accounting, tax ac- basic elements of the account-
as materials and labor, are assem- counting, accounting systems, inter- ing equation.
bled and processed to provide national accounting, not-for-profit All business transactions can be
goods or services (outputs) to cus- accounting, and social accounting. stated in terms of the change in one
tomers. The objective of most busi- or more of the three elements of
nesses is to maximize profits.
There are three different types of
5 Summarize the development
of accounting principles and
relate them to practice.
the accounting equation. That is,
the effect of every transaction can
businesses that are operated for be stated in terms of increases or
Financial accountants follow gener- decreases in one or more of these
profit: manufacturing, merchandis- ally accepted accounting principles
ing, and service businesses. A busi- elements, while maintaining the
(GAAP) in preparing reports so that equality between the two sides of
ness is normally organized in one stakeholders can compare one com-
of the following forms: proprietor- the equation.
pany to another. Accounting prin-
ship, partnership, corporation, or
limited liability corporation. A busi-
ness stakeholder is a person or en-
ciples and concepts develop from
research, accepted accounting prac- 8 Describe the financial state-
ments of a proprietorship and
explain how they interrelate.
tices, and pronouncements of au-
tity (such as an owner, manager, thoritative bodies. Currently, the The principal financial statements of
employee, customer, creditor, or the Financial Accounting Standards a proprietorship are the income
government) who has an interest in Board (FASB) is the authoritative statement, the statement of owner’s
the economic performance of the body having the primary responsi- equity, the balance sheet, and the
business. bility for developing accounting statement of cash flows. The income
statement reports a period’s net in-
2 Describe the role of accounting
in business.
Accounting is an information system
principles.
The business entity concept
views the business as an entity sep-
come or net loss, which also appears
on the statement of owner’s equity.
that provides reports to stakeholders arate from its owners, creditors, or The ending owner’s capital reported
about the economic activities and other stakeholders. The business en- on the statement of owner’s equity
condition of a business. Accounting tity limits the economic data in the is also reported on the balance
is the “language of business.” accounting system to that related di- sheet. The ending cash balance is
rectly to the activities of the busi- reported on the balance sheet and

3 Describe the importance of

business ethics and the basic
ness. The cost concept requires that the statement of cash flows.

principles of proper ethical

conduct.
Ethics are moral principles that guide
properties and services bought by a
business be recorded in terms of ac-
tual cost. The objectivity concept re-
9 Use the ratio of liabilities to
owner’s equity to analyze the
ability of a business to with-
the conduct of individuals. Proper quires that the accounting records stand poor business conditions.
ethical conduct implies a behavior and reports be based upon objec- The ratio of liabilities to owner’s eq-
that considers the impact of one’s ac- tive evidence. The unit of measure uity is useful in analyzing the abil-
tions on society and others. Sound concept requires that economic data ity of a business to pay its creditors.
ethical principles include (1) avoid- be recorded in dollars. The lower the ratio, the better able
ing small ethical lapses, (2) focusing the business is to withstand poor
on your long-term reputation, and
(3) being willing to suffer adverse
6 State the accounting equation
and define each element of
the equation.
business conditions and still fully
meet its obligations to creditors.
personal consequences for holding The resources owned by a business
to an ethical position. and the rights or claims to these re-
sources may be stated in the form
4 Describe the profession of
accounting.
Accountants are engaged in either pri-
of an equation, as follows:

vate accounting or public accounting. Assets
Liabilities  Owner’s Equity

The two most common specialized
24 Chapter 1 • Introduction to Accounting and Business

Key Terms
account form (21) differentiation strategy (4) merchandising business (3)
account payable (15) ethics (9) net income (19)
account receivable (16) expenses (16) net loss (19)
accounting (8) financial accounting (12) owner’s equity (13)
accounting equation (13) Financial Accounting Standards partnership (3)
assets (13) Board (FASB) (12) prepaid expenses (15)
balance sheet (19) financial statements (19) private accounting (10)
business (2) generally accepted accounting proprietorship (3)
business entity concept (13) principles (GAAP) (12) public accounting (10)
business stakeholder (6) income statement (19) report form (21)
business strategy (4) liabilities (13) revenue (16)
business transaction (14) limited liability corporation (4) service business (3)
Certified Public Accountant (CPA) low-cost strategy (4) statement of cash flows (19)
(11) managerial accounting (12) statement of owner’s equity (19)
combination strategy (5) manufacturing business (2) unit of measure concept (13)
corporation (3) matching concept (19) value chain (6)

Illustrative Problem
Cecil Jameson, Attorney-at-Law, is a proprietorship owned and operated by Cecil
Jameson. On July 1, 2005, Cecil Jameson, Attorney-at-Law, has the following assets
and liabilities: cash, $1,000; accounts receivable, $3,200; supplies, $850; land, $10,000;
accounts payable, $1,530. Office space and office equipment are currently being
rented, pending the construction of an office complex on land purchased last year.
Business transactions during July are summarized as follows:
a. Received cash from clients for services, $3,928.
b. Paid creditors on account, $1,055.
c. Received cash from Cecil Jameson as an additional investment, $3,700.
d. Paid office rent for the month, $1,200.
e. Charged clients for legal services on account, $2,025.
f. Purchased office supplies on account, $245.
g. Received cash from clients on account, $3,000.
h. Received invoice for paralegal services from Legal Aid Inc. for July (to be paid
on August 10), $1,635.
i. Paid the following: wages expense, $850; answering service expense, $250; util-
ities expense, $325; and miscellaneous expense, $75.
j. Determined that the cost of office supplies on hand was $980; therefore, the cost
of supplies used during the month was $115.
k. Jameson withdrew $1,000 in cash from the business for personal use.
Instructions
1. Determine the amount of owner’s equity (Cecil Jameson’s capital) as of July 1,
2005.
2. State the assets, liabilities, and owner’s equity as of July 1 in equation form sim-
ilar to that shown in this chapter. In tabular form below the equation, indicate
the increases and decreases resulting from each transaction and the new balances
after each transaction. Explain the nature of each increase and decrease in owner’s
equity by an appropriate notation at the right of the amount.
 Chapter 1 • Introduction to Accounting and Business 25

3. Prepare an income statement for July, a statement of owner’s equity for July, and
a balance sheet as of July 31, 2005.
Solution
1. Assets  Liabilities
Owner’s Equity (Cecil Jameson, capital)
$15,050  $1,530
Owner’s Equity (Cecil Jameson, capital)
$13,520
Owner’s Equity (Cecil Jameson, capital)

2. Assets  Liabilities  Owner’s Equity

Accounts Accounts
Cash  Receivable  Supplies  Land
Payable  Cecil Jameson, Capital
Bal. 1,000 3,200 850 10,000 1,530 13,520
a. 3,928  3,928 Fees earned
Bal. 4,928 3,200 850 10,000 1,530 17,448
b. 1,055 1,055
Bal. 3,873 3,200 850 10,000 475 17,448
c. 3,700  3,700 Investment
Bal. 7,573 3,200 850 10,000 475 21,148
d. 1,200  1,200 Rent expense
Bal. 6,373 3,200 850 10,000 475 19,948
e. 2,025  2,025 Fees earned
Bal. 6,373 5,225 850 10,000 475 21,973
f.  245  245
Bal. 6,373 5,225 1,095 10,000 720 21,973
g. 3,000 3,000
Bal. 9,373 2,225 1,095 10,000 720 21,973
h. 1,635  1,635 Paralegal exp.
Bal. 9,373 2,225 1,095 10,000 2,355 20,338
i. 1,500  850 Wages exp.
 250 Answ. svc. exp.
 325 Utilities exp.
 75 Misc. exp.
Bal. 7,873 2,225 1,095 10,000 2,355 18,838
j.  115  115 Supplies exp.
Bal. 7,873 2,225 980 10,000 2,355 18,723
k. 1,000  1,000 Withdrawal
6,873 2,225 980 10,000 2,355 17,723

3.

Cecil Jameson, Attorney-at-Law

Income Statement
For the Month Ended July 31, 2005
Fees earned $5 9 5 3 00
Operating expenses:
Paralegal expense $1 6 3 5 00
Rent expense 1 2 0 0 00
Wages expense 8 5 0 00
Utilities expense 3 2 5 00
Answering service expense 2 5 0 00
Supplies expense 1 1 5 00
Miscellaneous expense 7 5 00
Total operating expenses 4 4 5 0 00
Net income $1 5 0 3 00

(continued)
26 Chapter 1 • Introduction to Accounting and Business

Cecil Jameson, Attorney-at-Law

Statement of Owner's Equity
For the Month Ended July 31, 2005
Cecil Jameson, capital, July 1, 2005 $13 5 2 0 00
Additional investment by owner $3 7 0 0 00
Net income for the month 1 5 0 3 00
$5 2 0 3 00
Less withdrawals 1 0 0 0 00
Increase in owner's equity 4 2 0 3 00
Cecil Jameson, capital, July 31, 2005 $17 7 2 3 00

Cecil Jameson, Attorney-at-Law

Balance Sheet
July 31, 2005
Assets Liabilities
Cash $ 6 8 7 3 00 Accounts payable $ 2 3 5 5 00
Accounts receivable 2 2 2 5 00 Owner's Equity
Supplies 9 8 0 00 Cecil Jameson, capital 17 7 2 3 00
Land 10 0 0 0 00 Total liabilities and
Total assets $20 0 7 8 00 owner's equity $20 0 7 8 00

Self-Examination Questions (Answers at End of Chapter)

1. A profit-making business operating as a separate C. a statement of owner’s equity.

legal entity and in which ownership is divided into D. a statement of cash flows.
shares of stock is known as a:
4. If total assets increased $20,000 during a period
A. proprietorship. C. partnership.
and total liabilities increased $12,000 during the
B. service business. D. corporation.
same period, the amount and direction (increase or
2. The resources owned by a business are called: decrease) of the change in owner’s equity for that
A. assets. period is:
B. liabilities. A. a $32,000 increase. C. an $8,000 increase.
C. the accounting equation. B. a $32,000 decrease. D. an $8,000 decrease.
D. owner’s equity.
5. If revenue was $45,000, expenses were $37,500, and
3. A listing of a business entity’s assets, liabilities, and the owner’s withdrawals were $10,000, the amount
owner’s equity as of a specific date is: of net income or net loss would be:
A. a balance sheet. A. $45,000 net income. C. $37,500 net loss.
B. an income statement. B. $7,500 net income. D. $2,500 net loss.
 Chapter 1 • Introduction to Accounting and Business 27

C lass Discussion Questions

1. What is the objective of most businesses?
2. What is the difference between a manufacturing business and a service business?
Is a restaurant a manufacturing business, a service business, or both?
3. Why are most large companies like Microsoft, Pepsi, Caterpillar, and AutoZone
organized as corporations?
4. Both KIA and Porche produce and sell automobiles. Describe and contrast the
business strategies of KIA and Porche.
5. Assume that a friend of yours operates a family-owned pharmacy. A Super
Wal-Mart is scheduled to open in the next several months that will also offer
pharmacy services. What business strategy would your friend use to compete
with the Super Wal-Mart pharmacy?
6. How does eBay offer value to its customers?
7. Who are normally included as the stakeholders of a business?
8. What is the role of accounting in business?
9. Deana Moran is the owner of First Delivery Service. Recently, Deana paid inter-
est of $3,600 on a personal loan of $60,000 that she used to begin the business.
Should First Delivery Service record the interest payment? Explain.
10. On July 10, Elrod Repair Service extended an offer of $100,000 for land that had
been priced for sale at $120,000. On July 25, Elrod Repair Service accepted the
seller’s counteroffer of $112,000. Describe how Elrod Repair Service should record
the land.
11. a. Land with an assessed value of $300,000 for property tax purposes is acquired
by a business for $500,000. Seven years later, the plot of land has an assessed
value of $400,000 and the business receives an offer of $600,000 for it. Should
the monetary amount assigned to the land in the business records now be
increased?
b. Assuming that the land acquired in (a) was sold for $600,000, how would the
various elements of the accounting equation be affected?
12. Describe the difference between an account receivable and an account payable.
13. A business had revenues of $280,000 and operating expenses of $315,000. Did
the business (a) incur a net loss or (b) realize net income?
14. A business had revenues of $750,000 and operating expenses of $670,000. Did
the business (a) incur a net loss or (b) realize net income?
15. What particular item of financial or operating data appears on both the income
statement and the statement of owner’s equity? What item appears on both the
balance sheet and the statement of owner’s equity? What item appears on both
the balance sheet and statement of cash flows?
28 Chapter 1 • Introduction to Accounting and Business

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 Chapter 1 • Introduction to Accounting and Business 29

E xercises
EXERCISE 1-1 Indicate whether each of the following companies is primarily a service, merchan-
Types of businesses dise, or manufacturing business. If you are unfamiliar with the company, you may
Objective 1 use the Internet to locate the company’s home page or use the finance Web site of
Yahoo.com.
1. Ford Motor 9. CVS
2. Citigroup 10. Caterpillar
3. Sears Roebuck 11. FedEx
4. AT&T 12. Dow Chemical
5. H&R Block Inc. 13. Gap
6. Boeing 14. Hilton Hotels
7. First Union Corporation 15. Procter & Gamble
8. Alcoa

EXERCISE 1-2 Identify the primary business strategy of each of the following companies as (a) a
Business strategy low-cost strategy, (b) a differentiation strategy, or (c) a combination strategy. If you
Objective 1 are unfamiliar with the company, you may use the Internet to locate the company’s
home page or use the finance Web site of Yahoo.com.
1. Southwest Airlines 9. Circuit City Stores
2. Home Depot 10. Maytag
3. BMW 11. Office Depot
4. Coca-Cola 12. Nike
5. Target 13. Charles Schwab
6. Goldman Sachs Group 14. Dollar General
7. Sara Lee 15. General Motors
8. Delta Air Lines

EXERCISE 1-3 A fertilizer manufacturing company wants to relocate to Collier County. A 13-year-
Professional ethics old report from a fired researcher at the company says the company’s product is re-
Objective 3 leasing toxic by-products. The company has suppressed that report. A second report
commissioned by the company shows there is no problem with the fertilizer.
Should the company’s chief executive officer reveal the context of the un-
favorable report in discussions with Collier County representatives? Discuss.

EXERCISE 1-4 Bechler Sports sells hunting and fishing equipment and provides guided hunting and
Business entity concept fishing trips. Bechler Sports is owned and operated by Lefty Wisman, a well-known
Objective 5 sports enthusiast and hunter. Lefty’s wife, Betsy, owns and operates Eagle Boutique,
a women’s clothing store. Lefty and Betsy have established a trust fund to finance
their children’s college education. The trust fund is maintained by First Montana
Bank in the name of the children, Jeff and Steph.
For each of the following transactions, identify which of the entities listed should
record the transaction in its records.

Entities

B Bechler Sports
F First Montana Bank
E Eagle Boutique
X None of the above

1. Lefty paid a local doctor for his annual physical, which was required by the
workmen’s compensation insurance policy carried by Bechler Sports.
(continued)
30 Chapter 1 • Introduction to Accounting and Business

2. Lefty received a cash advance from customers for a guided hunting trip.
3. Betsy purchased two dozen spring dresses from a Billings (MT) designer for a
special spring sale.
4. Betsy deposited a $2,000 personal check in the trust fund at First Montana Bank.
5. Lefty paid for an advertisement in a hunters’ magazine.
6. Betsy purchased mutual fund shares as an investment for the children’s trust.
7. Lefty paid for dinner and a movie to celebrate their twentieth wedding an-
niversary.
8. Betsy donated several dresses from inventory for a local charity auction for the
benefit of a women’s abuse shelter.
9. Betsy paid her dues to the YWCA.
10. Lefty paid a breeder’s fee for an English springer spaniel to be used as a hunt-
ing guide dog.

EXERCISE 1-5 The total assets and total liabilities of Coca-Cola and PepsiCo are shown below.
Accounting equation
Objective 6 Coca-Cola PepsiCo
(in millions) (in millions)

Assets $24,501 $23,474

Liabilities 12,701 14,183

Determine the owners’ equity of each company.

!Coca-Cola, $11,800

EXERCISE 1-6 The total assets and total liabilities of Toys “R” Us Inc. and Estée Lauder Compa-
Accounting equation nies Inc. are shown below.
Objective 6
Toys ”R” Us Estée Lauder Companies
!Toys “R” Us, $4,030 (in millions) (in millions)

Assets $9,397 $3,417

Liabilities 5,367 1,955

Determine the owners’ equity of each company.

EXERCISE 1-7 Determine the missing amount for each of the following:
Accounting equation
Objective 6 Assets  Liabilities  Owner’s Equity

!a. $96,500 a. X
$25,000  $71,500

b. $82,750
X  15,000
c. 37,000
17,500  X

EXERCISE 1-8 Chris Lund is the owner and operator of Saluki, a motivational consulting business.
Accounting equation At the end of its accounting period, December 31, 2005, Saluki has assets of $475,000
Objectives 6, 8 and liabilities of $200,000. Using the accounting equation and considering each case
!b. $310,000 independently, determine the following amounts:
a. Chris Lund, capital, as of December 31, 2005.
b. Chris Lund, capital, as of December 31, 2006, assuming that assets increased by
$75,000 and liabilities increased by $40,000 during 2006.
c. Chris Lund, capital, as of December 31, 2006, assuming that assets decreased by
$15,000 and liabilities increased by $27,000 during 2006.
d. Chris Lund, capital, as of December 31, 2006, assuming that assets increased by
$125,000 and liabilities decreased by $65,000 during 2006.
e. Net income (or net loss) during 2006, assuming that as of December 31, 2006,
assets were $425,000, liabilities were $105,000, and there were no additional in-
vestments or withdrawals.
 Chapter 1 • Introduction to Accounting and Business 31

EXERCISE 1-9 Indicate whether each of the following is identified with (1) an asset, (2) a liability,
Asset, liability, owner’s or (3) owner’s equity:
equity items
Objective 7 a. wages expense d. land
b. accounts payable e. fees earned
c. cash f. supplies

EXERCISE 1-10 Describe how the following business transactions affect the three elements of the
Effect of transactions on accounting equation.
accounting equation
Objective 7 a. Received cash for services performed.
b. Invested cash in business.
c. Paid for utilities used in the business.
d. Purchased supplies on account.
e. Purchased supplies for cash.

EXERCISE 1-11 a. A vacant lot acquired for $50,000 is sold for $130,000 in cash. What is the effect
Effect of transactions on of the sale on the total amount of the seller’s (1) assets, (2) liabilities, and (3)
accounting equation owner’s equity?
Objective 7 b. Assume that the seller owes $30,000 on a loan for the land. After receiving the
!(a)(1) increase $80,000 $130,000 cash in (a), the seller pays the $30,000 owed. What is the effect of the
payment on the total amount of the seller’s (1) assets, (2) liabilities, and (3) owner’s
equity?

EXERCISE 1-12 Indicate whether each of the following types of transactions will (a) increase owner’s
Effect of transactions on equity or (b) decrease owner’s equity:
owner’s equity
Objective 7 1. revenues 3. owner’s investments
2. expenses 4. owner’s withdrawals

EXERCISE 1-13 The following selected transactions were completed by Salvo Delivery Service dur-
Transactions ing February:
Objective 7
1. Received cash from owner as additional investment, $35,000.
2. Received cash for providing delivery services, $15,000.
3. Paid creditors on account, $1,800.
4. Billed customers for delivery services on account, $11,250.
5. Paid advertising expense, $750.
6. Purchased supplies for cash, $800.
7. Paid rent for February, $2,000.
8. Received cash from customers on account, $6,740.
9. Determined that the cost of supplies on hand was $135; therefore, $665 of sup-
plies had been used during the month.
10. Paid cash to owner for personal use, $1,000.
Indicate the effect of each transaction on the accounting equation by listing the
numbers identifying the transactions, (1) through (10), in a vertical column, and in-
serting at the right of each number the appropriate letter from the following list:
a. Increase in an asset, decrease in another asset.
b. Increase in an asset, increase in a liability.
c. Increase in an asset, increase in owner’s equity.
d. Decrease in an asset, decrease in a liability.
e. Decrease in an asset, decrease in owner’s equity.

EXERCISE 1-14 Mike Renner operates his own catering service. Summary financial data for March
Nature of transactions are presented in equation form as follows. Each line designated by a number indi-
Objective 7 cates the effect of a transaction on the equation. Each increase and decrease in
!d. $7,600 owner’s equity, except transaction (5), affects net income.
32 Chapter 1 • Introduction to Accounting and Business

Cash  Supplies  Land  Liabilities  Owner’s Equity

Bal. 18,000 1,500 54,000 15,000 58,500

1. 25,000 25,000
2. 10,000 10,000
3. 16,000 16,000
4.  800  800
5.  2,000  2,000
6. 10,600 10,600
7. 1,400  1,400
Bal. 4,400 900 64,000 5,200 64,100

a. Describe each transaction.

b. What is the amount of net decrease in cash during the month?
c. What is the amount of net increase in owner’s equity during the month?
d. What is the amount of the net income for the month?
e. How much of the net income for the month was retained in the business?

EXERCISE 1-15 The income statement of a proprietorship for the month of October indicates a net
Net income and owner’s income of $158,250. During the same period, the owner withdrew $180,000 in cash
withdrawals from the business for personal use.
Objective 8 Would it be correct to say that the business incurred a net loss of $21,750 dur-
ing the month? Discuss.

EXERCISE 1-16 Four different proprietorships, M, N, O, and P, show the same balance sheet data
Net income and owner’s at the beginning and end of a year. These data, exclusive of the amount of owner’s
equity for four businesses equity, are summarized as follows:
Objective 8
Total Total
!Company O: Net loss,
Assets Liabilities
($50,000)
Beginning of the year $750,000 $300,000
End of the year $1,200,000 $650,000

On the basis of the above data and the following additional information for the
year, determine the net income (or loss) of each company for the year. (Hint: First
determine the amount of increase or decrease in owner’s equity during the year.)
Company M: The owner had made no additional investments in the business and
had made no withdrawals from the business.
Company N: The owner had made no additional investments in the business but
had withdrawn $60,000.
Company O: The owner had made an additional investment of $150,000 but had
made no withdrawals.
Company P: The owner had made an additional investment of $150,000 and had
withdrawn $60,000.

EXERCISE 1-17 From the following list of selected items taken from the records of Ishmael Appli-
Balance sheet items ance Service as of a specific date, identify those that would appear on the balance
Objective 8 sheet:
1. Supplies 6. Fees Earned
2. Wages Expense 7. Supplies Expense
3. Cash 8. Accounts Payable
4. Land 9. Melinda Elder, Capital
5. Utilities Expense 10. Wages Payable

EXERCISE 1-18 Based on the data presented in Exercise 1-17, identify those items that would ap-
Income statement items pear on the income statement.
Objective 8
 Chapter 1 • Introduction to Accounting and Business 33

EXERCISE 1-19 Financial information related to Madras Company, a proprietorship, for the month
Statement of owner’s ended April 30, 2006, is as follows:
equity
Objective 8 Net income for April $ 73,000
Leo Perkins’s withdrawals during April 12,000
Leo Perkins, capital, April 1, 2006 297,200

Prepare a statement of owner’s equity for the month ended April 30, 2006.

!Leo Perkins, capital April

30, 2006: $358,200

EXERCISE 1-20 Hercules Services was organized on November 1, 2006. A summary of the revenue
Income statement and expense transactions for November follows:
Objective 8
Fees earned $232,120
Wages expense 100,100
Miscellaneous expense 3,150
Rent expense 35,000
Supplies expense 4,550

!Net income: $89,320 Prepare an income statement for the month ended November 30.

EXERCISE 1-21 One item is omitted in each of the following summaries of balance sheet and in-
Missing amounts from come statement data for four different proprietorships, A, B, C, and D.
balance sheet and income
statement data A B C D
Objective 8 Beginning of the year:
!(a) $156,300 Assets $720,000 $125,000 $160,000 (d)
Liabilities 432,000 65,000 121,600 $150,000
End of the year:
Assets 894,000 175,000 144,000 310,000
Liabilities 390,000 55,000 128,000 170,000
During the year:
Additional investment in
the business (a) 25,000 16,000 50,000
Withdrawals from the
business 48,000 8,000 (c) 75,000
Revenue 237,300 (b) 184,000 140,000
Expenses 129,600 32,000 196,000 160,000

Determine the missing amounts, identifying them by letter. (Hint: First determine
the amount of increase or decrease in owner’s equity during the year.)

EXERCISE 1-22 Financial information related to the proprietorship of Derby Interiors for October
Balance sheets, net income and November 2006 is as follows:
Objective 8
October 31, 2006 November 30, 2006

Accounts payable $12,320 $13,280

Accounts receivable 27,200 31,300
Mary Lou Reily, capital ? ?
Cash 48,000 81,600
!b. $36,340 Supplies 2,400 2,000

a. Prepare balance sheets for Derby Interiors as of October 31 and as of November

30, 2006.
b. Determine the amount of net income for November, assuming that the owner
made no additional investments or withdrawals during the month.
c. Determine the amount of net income for November, assuming that the owner
made no additional investments but withdrew $10,000 during the month.
34 Chapter 1 • Introduction to Accounting and Business

EXERCISE 1-23 Each of the following items is shown in the financial statements of Exxon Mobil
Financial statements Corporation. Identify the financial statement (balance sheet or income statement)
Objective 8 in which each item would appear.
a. Operating expenses i. Cash equivalents
b. Crude oil inventory j. Long-term debt
c. Income taxes payable k. Selling expenses
d. Sales l. Notes receivable
e. Investments m. Equipment
f. Marketable securities n. Accounts payable
g. Exploration expenses o. Prepaid taxes
h. Notes and loans payable

EXERCISE 1-24 Indicate whether each of the following activities would be reported on the state-
Statement of cash flows ment of cash flows as (a) an operating activity, (b) an investing activity, or (c) a fi-
Objective 8 nancing activity:
1. Cash paid for land
2. Cash received from fees earned
3. Cash received as owner’s investment
4. Cash paid for expenses

EXERCISE 1-25 Caddis Realty, organized June 1, 2006, is owned and operated by Jerry Maris. How
Financial statements many errors can you find in the following financial statements for Caddis Realty,
Objective 8 prepared after its second month of operations?

Caddis Realty
Income Statement
July 31, 2006

Sales commissions . . . . . . . . . ................................ $51,900

Operating expenses:
!Correct Amount of Total Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,400
Assets is $19,600 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Automobile expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,000
Net income $14,900

Jerry Maris
Statement of Owner’s Equity
July 31, 2005

Jerry Maris, capital, July 1, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,400

Less withdrawals during July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
$ 8,400
Additional investment during July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
$10,900
Net income for the month . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,900
Jerry Maris, capital, July 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,800

Balance Sheet
For the Month Ended July 31, 2006

Assets Liabilities
Cash . . . . . . . . . . . . . . . . $3,300 Accounts receivable . . . . . . . . . . . ....... $14,300
Accounts payable . . . . . . . 3,800 Supplies . . . . . . . . . . . . . . . . . . . . ....... 2,000
Owner’s Equity
Jerry Maris, capital . . . . . . . . . . . . ....... 25,800
Total assets . . . . . . . . . . . $7,100 Total liabilities and owner’s equity ....... $42,100
 Chapter 1 • Introduction to Accounting and Business 35

EXERCISE 1-26 The Home Depot, Inc., is the world’s largest home improvement retailer and one
Ratio of liabilities to of the largest retailers in the United States based on net sales volume. The Home
stockholders’ equity Depot operates over 1,100 Home Depot® stores that sell a wide assortment of build-
Objective 9 ing materials and home improvement and lawn and garden products. The Home
Depot also operates over 25 EXPO Design Center stores that offer interior design
products, such as kitchen and bathroom cabinetry, tiles, flooring, and lighting fix-
tures, and installation services.
For the years ending February 2, 2003, and February 3, 2002, The Home Depot
reported the following balance sheet data (in millions):

2003 2002

Total assets $30,011 $26,394

Total stockholders’ equity 19,802 18,082

a. Determine the total liabilities as of February 2, 2003, and February 3, 2002.

b. Determine the ratio of liabilities to stockholders’ equity for 2003 and 2002. Round
to two decimal places.
c. What conclusions regarding the margin of protection to the creditors can you
draw from (b)?

EXERCISE 1-27 Lowe’s, a major competitor of The Home Depot in the home improvement busi-
Ratio of liabilities to ness, operates over 700 stores. For the years ending January 31, 2003, and Febru-
stockholders’ equity ary 1, 2002, Lowe’s reported the following balance sheet data (in millions):
Objective 9
2003 2002

Total assets $16,109 $13,736

Total liabilities 8,302 7,062

a. Determine the total stockholders’ equity as of January 31, 2003, and February 1,
2002.
b. Determine the ratio of liabilities to stockholders’ equity for 2003 and 2002. Round
to two decimal places.
c. What conclusions regarding the margin of protection to the creditors can you
draw from (b)?
d. How does the ratio of liabilities to stockholders’ equity of Lowe’s compare to that
of The Home Depot?

Problems Series A
PROBLEM 1-1A Duane Mays established an insurance agency on July 1 of the current year and com-
Transactions pleted the following transactions during July:
Objective 7 a. Opened a business bank account with a deposit of $18,000 from personal funds.
!Cash bal. at end of July: b. Purchased supplies on account, $950.
$16,000 c. Paid creditors on account, $575.
d. Received cash from fees earned on insurance commissions, $4,250.
e. Paid rent on office and equipment for the month, $1,200.
f. Paid automobile expenses for month, $600, and miscellaneous expenses, $375.
g. Paid office salaries, $1,500.
h. Determined that the cost of supplies on hand was $225; therefore, the cost of
supplies used was $725.
i. Billed insurance companies for sales commissions earned, $6,350.
j. Withdrew cash for personal use, $2,000.
36 Chapter 1 • Introduction to Accounting and Business

Instructions
1. Indicate the effect of each transaction and the balances after each transaction, us-
ing the following tabular headings:

Assets  Liabilities  Owner’s Equity

Cash  Accounts Receivable  Supplies
Accounts Payable  Duane Mays, Capital

Explain the nature of each increase and decrease in owner’s equity by an ap-
propriate notation at the right of the amount.
2. Briefly explain why the owner’s investment and revenues increased
owner’s equity, while withdrawals and expenses decreased owner’s equity.

PROBLEM 1-2A The amounts of the assets and liabilities of Chickadee Travel Service at April 30,
Financial statements 2006, the end of the current year, and its revenue and expenses for the year are
Objective 8 listed below. The capital of Adam Cellini, owner, was $50,000 at May 1, 2005, the
beginning of the current year, and the owner withdrew $30,000 during the current
year.
Accounts payable $ 12,200 Supplies $ 3,350
Accounts receivable 31,350 Supplies expense 7,100
Cash 53,050 Taxes expense 5,600
!Net income: $55,550 Fees earned 263,200 Utilities expense 22,500
Miscellaneous expense 2,950 Wages expense 131,700
Rent expense 37,800

Instructions
1. Prepare an income statement for the current year ended April 30, 2006.
2. Prepare a statement of owner’s equity for the current year ended April 30, 2006.
3. Prepare a balance sheet as of April 30, 2006.

PROBLEM 1-3A Jeanine Sykes established Linchpin Computer Services on August 1, 2006. The effect
Financial statements of each transaction and the balances after each transaction for August are as follows:
Objective 8
Assets  Liabilities  Owner’s Equity

Accounts Accounts
Cash  Receivable  Supplies
Payable  Jeanine Sykes, Capital
a. 10,000 10,000 Investment
b. 1,440 1,440
!Net income: $5,950 Bal. 10,000 1,440 1,440 10,000
c.  9,000  9,000 Fees earned
Bal. 19,000 1,440 1,440 19,000
d.  3,600  3,600 Rent expense
Bal. 15,400 1,440 1,440 15,400
e.  500  500
Bal. 14,900 1,440 940 15,400
f. 7,500  7,500 Fees earned
Bal. 14,900 7,500 1,440 940 22,900
g.  2,300  1,550 Auto expense
 750 Misc. expense
Bal. 12,600 7,500 1,440 940 20,600
h.  4,000  4,000 Salaries expense
Bal. 8,600 7,500 1,440 940 16,600
i.  650  650 Supplies expense
Bal. 8,600 7,500 790 940 15,950
j.  2,000  2,000 Withdrawal
Bal. 6,600 7,500 790 940 13,950

Instructions
1. Prepare an income statement for the month ended August 31, 2006.
2. Prepare a statement of owner’s equity for the month ended August 31, 2006.
3. Prepare a balance sheet as of August 31, 2006.
 Chapter 1 • Introduction to Accounting and Business 37

PROBLEM 1-4A On August 1, 2006, Shad Menard established Centillion Realty. Shad completed the
Transactions; financial following transactions during the month of August:
statements
Objectives 7, 8 a. Opened a business bank account with a deposit of $15,000 from personal funds.
b. Paid rent on office and equipment for the month, $2,400.
c. Paid automobile expenses (including rental charge) for month, $750, and mis-
cellaneous expenses, $380.
d. Purchased supplies (pens, file folders, and copy paper) on account, $950.
e. Earned sales commissions, receiving cash, $17,350.
!Net income: $9,545 f. Paid creditor on account, $580.
g. Paid office salaries, $3,600.
h. Withdrew cash for personal use, $1,500.
i. Determined that the cost of supplies on hand was $275; therefore, the cost of
supplies used was $675.
Instructions
1. Indicate the effect of each transaction and the balances after each transaction, us-
ing the following tabular headings:
Assets  Liabilities  Owner’s Equity

Cash  Supplies
Accounts Payable  Shad Menard, Capital

Explain the nature of each increase and decrease in owner’s equity by an ap-
propriate notation at the right of the amount.
2. Prepare an income statement for August, a statement of owner’s equity for Au-
gust, and a balance sheet as of August 31.

PROBLEM 1-5A Eureka Dry Cleaners is owned and operated by Vince Fry. A building and equip-
Transactions; financial ment are currently being rented, pending expansion to new facilities. The actual
statements work of dry cleaning is done by another company at wholesale rates. The assets
Objectives 7, 8 and the liabilities of the business on June 1, 2006, are as follows: Cash, $8,600; Ac-
counts Receivable, $9,500; Supplies, $1,875; Land, $15,000; Accounts Payable, $4,100.
Business transactions during June are summarized as follows:
a. Paid rent for the month, $4,000.
b. Charged customers for dry cleaning sales on account, $8,150.
c. Paid creditors on account, $2,680.
!Net income: $7,850 d. Purchased supplies on account, $1,500.
e. Received cash from cash customers for dry cleaning sales, $17,600.
f. Received cash from customers on account, $8,450.
g. Received monthly invoice for dry cleaning expense for June (to be paid on July
10), $7,400.
h. Paid the following: wages expense, $2,800; truck expense, $825; utilities expense,
$710; miscellaneous expense, $390.
i. Determined that the cost of supplies on hand was $1,600; therefore, the cost of
supplies used during the month was $1,775.
j. Withdrew $3,500 for personal use.
Instructions
1. Determine the amount of Vince Fry’s capital as of June 1.
2. State the assets, liabilities, and owner’s equity as of June 1 in equation form sim-
ilar to that shown in this chapter. In tabular form below the equation, indicate
increases and decreases resulting from each transaction and the new balances af-
ter each transaction. Explain the nature of each increase and decrease in owner’s
equity by an appropriate notation at the right of the amount.
3. Prepare an income statement for June, a statement of owner’s equity for June,
and a balance sheet as of June 30.

PROBLEM 1-6A The financial statements at the end of Ameba Realty’s first month of operations are
Missing amounts from shown on the next page.
financial statements
38 Chapter 1 • Introduction to Accounting and Business

Objective 8
Ameba Realty
Income Statement
For the Month Ended June 30, 2006
Fees earned $18 8 0 0 00
Operating expenses:
!i. $40,440
Wages expense $ (a)
Rent expense 1 9 2 0 00
Supplies expense 1 6 0 0 00
Utilities expense 1 0 8 0 00
Miscellaneous expense 6 6 0 00
Total operating expenses 9 5 6 0 00
Net income (b)

Ameba Realty
Statement of Owner's Equity
For the Month Ended June 30, 2006
Terry Garcia, capital, June 1, 2006 $ (c)
Investment on June 1, 2006 $ (d)
Net income for June (e)
(f)
Less withdrawals (g)
Increase in owner's equity (h)
Terry Garcia, capital, June 30, 2006 (i)

Ameba Realty
Balance Sheet
June 30, 2006
Assets Liabilities
Cash $11 8 0 0 00 Accounts payable $ 9 6 0 00
Supplies 8 0 0 00 Owner's Equity
Land (j) Terry Garcia, capital (l)
Total liabilities and
Total assets (k) owner's equity (m)

Ameba Realty
Statement of Cash Flows
For the Month Ended June 30, 2006
Cash flows from operating activities:
Cash received from customers $ (n)
Deduct cash payments for expenses and
payments to creditors 9 4 0 0 00
Net cash flow from operating activities $ (o)
Cash flows from investing activities:
Cash payments for acquisition of land 28 8 0 0 00
Cash flows from financing activities:
Cash received as owner's investment 36 0 0 0 00
Deduct cash withdrawal by owner 4 8 0 0 00
Net cash flow from financing activities (p)
Net cash flow and June 30, 2006 cash balance (q)
 Chapter 1 • Introduction to Accounting and Business 39

Instructions
By analyzing the interrelationships among the four financial statements, determine
the proper amounts for (a) through (q).

Problems Series B
PROBLEM 1-1B On September 1 of the current year, Pamela Larsen established a business to man-
Transactions age rental property. She completed the following transactions during September:
Objective 7 a. Opened a business bank account with a deposit of $15,000 from personal funds.
!Cash bal. at end of Sept.: b. Purchased supplies (pens, file folders, and copy paper) on account, $1,350.
$13,775 c. Received cash from fees earned for managing rental property, $6,500.
d. Paid rent on office and equipment for the month, $2,500.
e. Paid creditors on account, $700.
f. Billed customers for fees earned for managing rental property, $1,250.
g. Paid automobile expenses (including rental charges) for month, $550, and mis-
cellaneous expenses, $675.
h. Paid office salaries, $1,800.
i. Determined that the cost of supplies on hand was $380; therefore, the cost of
supplies used was $970.
j. Withdrew cash for personal use, $1,500.
Instructions
1. Indicate the effect of each transaction and the balances after each transaction, us-
ing the following tabular headings:

Assets  Liabilities  Owner’s Equity

Cash  Accounts Receivable  Supplies
Accounts Payable  Pamela Larsen, Capital

Explain the nature of each increase and decrease in owner’s equity by an ap-
propriate notation at the right of the amount.
2. Briefly explain why the owner’s investment and revenues increased
owner’s equity, while withdrawals and expenses decreased owner’s equity.

PROBLEM 1-2B Following are the amounts of the assets and liabilities of Greco Travel Agency at
Financial statements December 31, 2006, the end of the current year, and its revenue and expenses for
Objective 8 the year. The capital of Petrea Kraft, owner, was $16,200 on January 1, 2006, the
beginning of the current year. During the current year, Kraft withdrew $47,000.

Accounts payable $ 5,120 Rent expense $36,000

Accounts receivable 31,200 Supplies 3,000
Cash 11,520 Supplies expense 4,500
Fees earned 188,000 Utilities expense 16,500
!Net income: $71,400
Miscellaneous expense 2,800 Wages expense 56,800

Instructions
1. Prepare an income statement for the current year ended December 31, 2006.
2. Prepare a statement of owner’s equity for the current year ended December 31,
2006.
3. Prepare a balance sheet as of December 31, 2006.

PROBLEM 1-3B Lynn Rosberg established Jack-in-the-Pulpit Financial Services on January 1, 2006.
Financial statements Jack-in-the-Pulpit Financial Services offers financial planning advice to its clients. The
Objective 8 effect of each transaction and the balances after each transaction for January are as
follows:
40 Chapter 1 • Introduction to Accounting and Business

Assets  Liabilities  Owner’s Equity

Accounts Accounts
Cash  Receivable  Supplies
Payable  Lynn Rosberg, Capital
a. 30,000 30,000 Investment
!Net income: $14,080 b. 3,180 3,180
Bal. 30,000 3,180 3,180 30,000
c.  2,000 2,000
Bal. 28,000 3,180 1,180 30,000
d. 21,000 21,000 Fees earned
Bal. 49,000 3,180 1,180 51,000
e.  6,000  6,000 Rent expense
Bal. 43,000 3,180 1,180 45,000
f.  3,800  3,000 Auto expense
 800 Misc. expense
Bal. 39,200 3,180 1,180 41,200
g.  5,000  5,000 Salaries expense
Bal. 34,200 3,180 1,180 36,200
h. 2,520  2,520 Supplies expense
Bal. 34,200 660 1,180 33,680
i. 10,400 10,400 Fees earned
Bal. 34,200 10,400 660 1,180 44,080
j.  7,000  7,000 Withdrawal
Bal. 27,200 10,400 660 1,180 37,080

Instructions
1. Prepare an income statement for the month ended January 31, 2006.
2. Prepare a statement of owner’s equity for the month ended January 31, 2006.
3. Prepare a balance sheet as of January 31, 2006.

PROBLEM 1-4B On July 1, 2006, Beth Nesbit established Patriotic Realty. Nesbit completed the fol-
Transactions; financial lowing transactions during the month of July:
statements
Objectives 7, 8 a. Opened a business bank account with a deposit of $18,000 from personal funds.
b. Purchased supplies (pens, file folders, fax paper, etc.) on account, $1,650.
c. Paid creditor on account, $1,100.
d. Earned sales commissions, receiving cash, $25,200.
e. Paid rent on office and equipment for the month, $7,200.
f. Withdrew cash for personal use, $10,000.
!Net income: $6,700 g. Paid automobile expenses (including rental charge) for month, $1,500, and mis-
cellaneous expenses, $750.
h. Paid office salaries, $8,000.
i. Determined that the cost of supplies on hand was $600; therefore, the cost of
supplies used was $1,050.
Instructions
1. Indicate the effect of each transaction and the balances after each transaction, us-
ing the following tabular headings:

Assets  Liabilities  Owner’s Equity

Cash  Supplies
Accounts Payable  Beth Nesbit, Capital

Explain the nature of each increase and decrease in owner’s equity by an ap-
propriate notation at the right of the amount.
2. Prepare an income statement for July, a statement of owner’s equity for July, and
a balance sheet as of July 31.

PROBLEM 1-5B Daisy Dry Cleaners is owned and operated by Gloria Carson. A building and equip-
Transactions; financial ment are currently being rented, pending expansion to new facilities. The actual
statements work of dry cleaning is done by another company at wholesale rates. The assets
Objectives 7, 8 and the liabilities of the business on March 1, 2006, are as follows: Cash, $7,150;
 Chapter 1 • Introduction to Accounting and Business 41

Accounts Receivable, $12,880; Supplies, $3,400; Land, $20,000; Accounts Payable,

$6,360. Business transactions during March are summarized as follows:
a. Received cash from cash customers for dry cleaning sales, $22,000.
b. Paid rent for the month, $3,500.
c. Purchased supplies on account, $2,100.
!Net income: $12,330 d. Paid creditors on account, $4,800.
e. Charged customers for dry cleaning sales on account, $11,700.
f. Received monthly invoice for dry cleaning expense for March (to be paid on April
10), $8,400.
g. Paid the following: wages expense, $3,400; truck expense, $1,580; utilities ex-
pense, $960; miscellaneous expense, $630.
h. Received cash from customers on account, $10,100.
i. Determined that the cost of supplies on hand was $2,600; therefore, the cost of
supplies used during the month was $2,900.
j. Withdrew $6,000 cash for personal use.
Instructions
1. Determine the amount of Gloria Carson’s capital as of March 1 of the current
year.
2. State the assets, liabilities, and owner’s equity as of March 1 in equation form
similar to that shown in this chapter. In tabular form below the equation, indi-
cate increases and decreases resulting from each transaction and the new bal-
ances after each transaction. Explain the nature of each increase and decrease in
owner’s equity by an appropriate notation at the right of the amount.
3. Prepare an income statement for March, a statement of owner’s equity for March,
and a balance sheet as of March 31.

PROBLEM 1-6B The financial statements at the end of Zeppelin Realty’s first month of operations
Missing amounts from are shown below and on the next page.
financial statements
Objective 8
Zeppelin Realty
Income Statement
For the Month Ended November 30, 2006
Fees earned $ (a)
!k. $30,000 Operating expenses:
Wages expense $8 5 0 0 00
Rent expense 3 2 0 0 00
Supplies expense (b)
Utilities expense 1 8 0 0 00
Miscellaneous expense 1 1 0 0 00
Total operating expenses 17 6 0 0 00
Net income $12 4 0 0 00

Zeppelin Realty
Statement of Owner's Equity
For the Month Ended November 30, 2006
Craig Haas, capital, November 1, 2006 $ (c)
Investment on November 1, 2006 $40 0 0 0 00
Net income for November (d)
(e)
Less withdrawals 6 0 0 0 00
Increase in owner's equity (f)
Craig Haas, capital, November 30, 2006 (g)
42 Chapter 1 • Introduction to Accounting and Business

Zeppelin Realty
Balance Sheet
November 30, 2006
Assets Liabilities
Cash $ 5 8 0 0 00 Accounts payable $ 1 6 0 0 00
Supplies 2 2 0 0 00 Owner's Equity
Land 40 0 0 0 00 Craig Haas, capital (i)
Total liabilities and
Total assets (h) owner's equity (j)

Zeppelin Realty
Statement of Cash Flows
For the Month Ended November 30, 2006
Cash flows from operating activities:
Cash received from customers $ (k)
Deduct cash payments for expenses and
payments to creditors 18 2 0 0 00
Net cash flow from operating activities $ (l)
Cash flows from investing activities:
Cash payments for acquisition of land (m)
Cash flows from financing activities:
Cash received as owner's investment (n)
Deduct cash withdrawal by owner (o)
Net cash flow from financing activities (p)
Net cash flow and November 30, 2006 cash balance (q)

Instructions
By analyzing the interrelationships among the four financial statements, determine
the proper amounts for (a) through (q).

C ontinuing Problem
Shannon Burns enjoys listening to all types of music and owns countless CDs and
tapes. Over the years, Shannon has gained a local reputation for knowledge of
music from classical to rap and the ability to put together sets of recordings that
appeal to all ages.
During the last several months, Shannon served as a guest disc jockey on a local
radio station. In addition, Shannon has entertained at several friends’ parties as the
host deejay.
On April 1, 2006, Shannon established a proprietorship known as Dancin Music.
Using an extensive collection of CDs and tapes, Shannon will serve as a disc jockey
!2. Net income: $530 on a fee basis for weddings, college parties, and other events. During April, Shan-
non entered into the following transactions:
April 1. Deposited $7,000 in a checking account in the name of Dancin Music.
2. Received $2,000 from a local radio station for serving as the guest disc
jockey for April.
 Chapter 1 • Introduction to Accounting and Business 43

April 2. Agreed to share office space with a local real estate agency, Folsom Realty.
Dancin Music will pay one-fourth of the rent. In addition, Dancin Music
agreed to pay a portion of the salary of the receptionist and to pay one-
fourth of the utilities. Paid $1,000 for the rent of the office.
4. Purchased supplies (blank cassette tapes, poster board, extension cords,
etc.) from Rockne Office Supply Co. for $350. Agreed to pay $100 within
10 days and the remainder by May 3, 2006.
6. Paid $600 to a local radio station to advertise the services of Dancin Music
twice daily for two weeks.
8. Paid $650 to a local electronics store for renting digital recording equip-
ment.
12. Paid $200 (music expense) to Rocket Music for the use of its current
music demos to make various music sets.
13. Paid Rockne Office Supply Co. $100 on account.
16. Received $150 from a dentist for providing two music sets for the dentist
to play for her patients.
22. Served as disc jockey for a wedding party. The father of the bride agreed
to pay $1,200 the 1st of May.
25. Received $500 from a friend for serving as the disc jockey for a cancer
charity ball hosted by the local hospital.
29. Paid $240 (music expense) to Score Music for the use of its library of
music demos.
30. Received $900 for serving as disc jockey for a local club’s monthly dance.
30. Paid Folsom Realty $400 for Dancin Music’s share of the receptionist’s
salary for April.
30. Paid Folsom Realty $300 for Dancin Music’s share of the utilities for April.
30. Determined that the cost of supplies on hand is $170. Therefore, the cost
of supplies used during the month was $180.
30. Paid for miscellaneous expenses, $150.
30. Paid $500 royalties (music expense) to Federated Clearing for use of vari-
ous artists’ music during the month.
30. Withdrew $250 of cash from Dancin Music for personal use.
Instructions
1. Indicate the effect of each transaction and the balances after each transaction, us-
ing the following tabular headings:

Assets  Liabilities  Owner’s Equity

Cash  Accounts Receivable  Supplies
Accounts Payable  Shannon Burns, Capital

Explain the nature of each increase and decrease in owner’s equity by an ap-
propriate notation at the right of the amount.
2. Prepare an income statement for Dancin Music for the month ended April 30,
2006.
3. Prepare a statement of owner’s equity for Dancin Music for the month ended
April 30, 2006.
4. Prepare a balance sheet for Dancin Music as of April 30, 2006.

Special Activities
ACTIVITY 1-1 Sue Alejandro, president of Tobago Enterprises, applied for a $300,000 loan from
Ethics and professional First National Bank. The bank requested financial statements from Tobago Enter-
conduct in business prises as a basis for granting the loan. Sue has told her accountant to provide the
bank with a balance sheet. Sue has decided to omit the other financial statements
because there was a net loss during the past year.
44 Chapter 1 • Introduction to Accounting and Business

In groups of three or four, discuss the following questions:

1. Is Sue behaving in a professional manner by omitting some of the financial state-
ments?
2. a. What types of information about their businesses would owners be willing to
provide bankers? What types of information would owners not be willing to
provide?
b. What types of information about a business would bankers want before ex-
tending a loan?
c. What common interests are shared by bankers and business owners?

ACTIVITY 1-2 Assume that you are the chief executive officer for Gold Kist Inc., a national poul-
Business strategy try producer. The company’s operations include hatching chickens through the use
of breeder stock and feeding, raising, and processing the mature chicks into finished
products. The finished products include breaded chicken nuggets and patties and
deboned, skinless, and marinated chicken. Gold Kist sells its products to schools,
military services, fast food chains, and grocery stores.
In groups of four or five, discuss the following business strategy and risk issues:
1. In a commodity business like poultry production, what do you think is the dom-
inant business strategy? What are the implications in this dominant strategy for
how you would run Gold Kist?
2. Identify at least two major business risks for operating Gold Kist.
3. How could Gold Kist try to differentiate its products?

ACTIVITY 1-3 On January 3, 2005, Dr. Rosa Smith established First Opinion, a medical practice or-
Net income ganized as a proprietorship. The following conversation occurred the following Au-
gust between Dr. Smith and a former medical school classmate, Dr. Brett Wommack,
at an American Medical Association convention in Nassau.
Dr. Wommack: Rosa, good to see you again. Why didn’t you call when you were
in Las Vegas? We could have had dinner together.
Dr. Smith: Actually, I never made it to Las Vegas this year. My husband and kids
went up to our Lake Tahoe condo twice, but I got stuck in New York. I
opened a new consulting practice this January and haven’t had any time for
myself since.
Dr. Wommack: I heard about it . . . First . . . something . . . right?
Dr. Smith: Yes, First Opinion. My husband chose the name.
Dr. Wommack: I’ve thought about doing something like that. Are you making any
money? I mean, is it worth your time?
Dr. Smith: You wouldn’t believe it. I started by opening a bank account with
$60,000, and my July bank statement has a balance of $240,000. Not bad for
seven months—all pure profit.
Dr. Wommack: Maybe I’ll try it in Las Vegas. Let’s have breakfast together tomor-
row and you can fill me in on the details.
Comment on Dr. Smith’s statement that the difference between the opening
bank balance ($60,000) and the July statement balance ($240,000) is pure profit.

ACTIVITY 1-4 Dawn Ivy, a junior in college, has been seeking ways to earn extra spending money.
Transactions and financial As an active sports enthusiast, Dawn plays tennis regularly at the Racquet Club,
statements where her family has a membership. The president of the club recently approached
Dawn with the proposal that she manage the club’s tennis courts. Dawn’s primary
duty would be to supervise the operation of the club’s four indoor and six outdoor
courts, including court reservations.
In return for her services, the club would pay Dawn $150 per week, plus Dawn
could keep whatever she earned from lessons and the fees from the use of the ball
machine. The club and Dawn agreed to a one-month trial, after which both would
consider an arrangement for the remaining two years of Dawn’s college career. On
 Chapter 1 • Introduction to Accounting and Business 45

this basis, Dawn organized Deuce. During June 2005, Dawn managed the tennis
courts and entered into the following transactions:
a. Opened a business account by depositing $1,000.
b. Paid $320 for tennis supplies (practice tennis balls, etc.).
c. Paid $160 for the rental of videotape equipment to be used in offering lessons
during June.
d. Arranged for the rental of two ball machines during September for $200. Paid
$140 in advance, with the remaining $60 due July 1.
e. Received $1,600 for lessons given during June.
f. Received $300 in fees from the use of the ball machines during June.
g. Paid $600 for salaries of part-time employees who answered the telephone and
took reservations while Dawn was giving lessons.
h. Paid $150 for miscellaneous expenses.
i. Received $600 from the club for managing the tennis courts during June.
j. Determined that the cost of supplies on hand at the end of the month totaled
$150; therefore, the cost of supplies used was $170.
k. Withdrew $800 for personal use on June 30.
As a friend and accounting student, you have been asked by Dawn to aid her in
assessing the venture.
1. Indicate the effect of each transaction and the balances after each transaction, us-
ing the following tabular headings:

Assets  Liabilities  Owner’s Equity

Cash  Supplies
Accounts Payable  Dawn Ivy, Capital

Explain the nature of each increase and decrease in owner’s equity by an ap-
propriate notation at the right of the amount.
2. Prepare an income statement for June.
3. Prepare a statement of owner’s equity for June.
4. Prepare a balance sheet as of June 30.
5. a. Assume that Dawn Ivy could earn $8 per hour working 30 hours as a wait-
ress. Evaluate which of the two alternatives, working as a waitress or operat-
ing Deuce, would provide Dawn with the most income per month.
b. Discuss any other factors that you believe Dawn should consider be-
fore discussing a long-term arrangement with the Racquet Club.

ACTIVITY 1-5 By satisfying certain specific requirements, accountants may become certified as pub-
Certification requirements lic accountants (CPAs), management accountants (CMAs), or internal auditors (CIAs).
for accountants Find the certification requirements for one of these accounting groups by accessing
the appropriate Internet site listed below.

Site Description

http://www.ais-cpa.com This site lists the address and/or Internet link for each state’s board
of accountancy. Find your state’s requirements.
http://www.imanet.org This site lists the requirements for becoming a CMA.
http://www.theiia.org This site lists the requirements for becoming a CIA.

ACTIVITY 1-6 Amazon.com, an Internet retailer, was incorporated in July 1994, and opened its
Cash flows virtual doors on the Web in July 1995. On the statement of cash flows, would you
expect Amazon.com’s net cash flows from operating, investing, and financing ac-
tivities to be positive or negative for each year, 1996, 1997, and 1998? Use the fol-
lowing format for your answers, and briefly explain your logic.

1998 1997 1996

Net cash flows from operating activities positive

Net cash flows from investing activities
Net cash flows from financing activities
46 Chapter 1 • Introduction to Accounting and Business

ACTIVITY 1-7 The now defunct Enron Corporation, headquartered in Houston, Texas, provided
Financial analysis of Enron products and services for natural gas, electricity, and communications to wholesale
Corporation and retail customers. Enron’s operations were conducted through a variety of sub-
sidiaries and affiliates that involved transporting gas through pipelines, transmitting
electricity, and managing energy commodities. The following data were taken from
Enron’s December 31, 2000 financial statements.

In millions

Total revenues $100,789

Total costs and expenses 98,836
Operating income 1,953
Net income 979

Total assets 65,503

Total liabilities 54,033
Total stockholders’ equity 11,470

Net cash flows from operating activities 4,779

Net cash flows from investing activities (4,264)
Net cash flows from financing activities 571
Net increase in cash 1,086

At the end of 2000, the market price of Enron’s stock was approximately $83 per
share. By March 15, 2002, Enron’s stock was selling for $0.22 per share.
Review the preceding financial statement data and search the Internet for
articles on Enron Corporation. Briefly explain why Enron’s stock dropped so dra-
matically in such a short time.

A nswers to Self-Examination Questions

1. D A corporation, organized in accordance with prietorship or partnership during a specific period
state or federal statutes, is a separate legal entity in of time. The statement of cash flows (answer D)
which ownership is divided into shares of stock summarizes the cash receipts and cash payments
(answer D). A proprietorship (answer A) is an un- for a specific period of time.
incorporated business owned by one individual. A 4. C The accounting equation is:
service business (answer B) provides services to its
Assets
Liabilities  Owner’s Equity
customers. It can be organized as a proprietorship,
partnership, corporation, or limited liability corpo- Therefore, if assets increased by $20,000 and lia-
ration. A partnership (answer C) is an unincorpo- bilities increased by $12,000, owner’s equity must
rated business owned by two or more individuals. have increased by $8,000 (answer C), as indicated
2. A The resources owned by a business are called in the following computation:
assets (answer A). The debts of the business are
called liabilities (answer B), and the equity of the Assets  Liabilities  Owner’s Equity
owners is called owner’s equity (answer D). The $20,000
$12,000  Owner’s Equity
relationship between assets, liabilities, and owner’s $20,000  $12,000
Owner’s Equity
equity is expressed as the accounting equation (an- $8,000
Owner’s Equity
swer C).
3. A The balance sheet is a listing of the assets, lia- 5. B Net income is the excess of revenue over ex-
bilities, and owner’s equity of a business at a spe- penses, or $7,500 (answer B). If expenses exceed
cific date (answer A). The income statement revenue, the difference is a net loss. Withdrawals
(answer B) is a summary of the revenue and ex- by the owner are the opposite of the owner’s in-
penses of a business for a specific period of time. vesting in the business and do not affect the amount
The statement of owner’s equity (answer C) sum- of net income or net loss.
marizes the changes in owner’s equity for a pro-