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1. Prepare a comparative income statement for Rulon Candies, Inc., for the years ended De-
Required:
cember 31, 2003 and 2002. Be sure to include figures for gross margin, operating in-
come, income before taxes, net income, and earnings per share.
2. Interpretive Question: What advice would you give Rulon Candies, Inc., to improve its
profitability for the year 2004?
67
f68 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle



PROBLEM 2-5 INCOME STATEMENT PREPARATION
The following information is taken from the records of Hill, Dunn, & Associates for the year
ended December 31, 2003.
Income taxes . . . . . . . . . . . . . $ 10,800
Service revenues . . . . . . . . . . 150,000
Rent expense . . . . . . . . . . . . . 5,500
Salaries expense . . . . . . . . . . 35,000
Miscellaneous expense . . . . . 380
Utilities expense . . . . . . . . . . 1,230
Administrative expense . . . . . 12,300

Prepare an income statement for Hill, Dunn, & Associates for the year ended December 31,
Required:
2003. (Assume that 4,000 shares of stock are outstanding.)

PROBLEM 2-6 EXPANDED ACCOUNTING EQUATION
At the end of 2003, Morgan Systems, Inc., had a fire that destroyed the majority of its ac-
counting records. Morgan Systems, Inc., was able to gather the following financial information
for 2003.

a. Retained earnings was changed only as a result of net income and a $50,000 dividend
payment to Morgan s investors.
b. All other account changes for the year are listed below. The amount of change for each
account is shown as a net increase or decrease.

Increase or
(Decrease)

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $025,000)
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,000)
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000)
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (22,500)
Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315,000)
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000)
Mortgage payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275,000)
Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (27,250)
Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,500)



Using the accounting equation, compute Morgan s net income for 2003.
Required:

PROBLEM 2-7 INCOME STATEMENT PREPARATION
Precision Corporation has been a leading supplier of magnetic storage disks for three years. Fol-
lowing are the results of Precision s operations for 2003.
Sales revenue . . . . . . . . . . $68,000
Advertising expense . . . . . 1,530
Income taxes. . . . . . . . . . . 4,360
Delivery expense . . . . . . . . 480
Packaging expense . . . . . . 355
Salaries expense . . . . . . . . 18,350
Supplies expense . . . . . . . 8,410
EPS $3.45

1. Prepare an income statement for the year ended December 31, 2003.
Required:
2. How many shares of stock were outstanding?
68 f69
Financial Statements: An Overview EOC Chapter 2
Financial Statements: An Overview



PROBLEM 2-8 STATEMENT OF CASH FLOWS
Southwestern Rentals, Inc., rents equipment to customers ranging from homeowners to large
construction companies. The financial information shown below was gathered from its ac-
counting records for 2003. Assume any increase or decrease in the balances from 1/1/03 to
12/31/03 resulted from either receiving or paying cash in the transaction. For example, during
2003 the balance on loans for land holdings increased $150,000 because the company received
$150,000 in cash by taking out an additional loan on the land.

Balance as of Balance as of
Items 1/1/03 12/31/03

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $020,000 $0,050,000
Cash receipts from customers . . . . . . . . . . . . . . . . . 600,000
Loans on land holdings . . . . . . . . . . . . . . . . . . . . . 100,000 250,000
Cash distributions to owners . . . . . . . . . . . . . . . . . . 150,000
Loan on building . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 70,000
Investments in securities. . . . . . . . . . . . . . . . . . . . . 850,000 1,050,000
Cash payments for other expenses . . . . . . . . . . . . . . 50,000
Cash payments for taxes. . . . . . . . . . . . . . . . . . . . . 55,000
Cash payments for operating expenses . . . . . . . . . . . . 135,000
Cash payments for wages and salaries . . . . . . . . . . . 100,000


1. Prepare a statement of cash flows for Southwestern Rentals, Inc., for the year ended De-
Required:
cember 31, 2003.
2. Interpretive Question: Does Southwestern Rentals, Inc., appear to be in good shape
from a cash flow standpoint? What other information would help you analyze the
situation?

PROBLEM 2-9 STATEMENT OF CASH FLOWS
The cash account for Kwon Enterprises shows the following for the year ended December 31,
2003.
Beginning cash balance . . . . . . $000?0000
Cash receipts during year from:
Services . . . . . . . . . . . . . . . . 1,351,000
Investments by owners . . . . . 82,000
Sale of land. . . . . . . . . . . . . . 135,000
Cash payments during year for:
Operating expenses. . . . . . . . 963,000
Taxes . . . . . . . . . . . . . . . . . . 114,000
Purchase of building . . . . . . . 326,000
Distributions to owners . . . . . 55,000
Ending cash balance. . . . . . . . . 850,000

Required: Prepare a statement of cash flows for Kwon Enterprises for the year ended December 31, 2003.

PROBLEM 2-10 UNIFYING CONCEPTS: NET INCOME AND FINANCIAL RATIO
ANALYSIS
A summary of the operations of Streuling Company for the year ended May 31, 2003, is shown
below.
Advertising expense . . . . . . . . . . $002,760
Supplies expense . . . . . . . . . . . . 37,820
Rent expense . . . . . . . . . . . . . . . 1,500
Salaries expense. . . . . . . . . . . . . 18,150
Miscellaneous expense . . . . . . . . 4,170
(continued)
69
f70 Financial Statements: An Overview
Part 1 EOC Financial Reporting and the Accounting Cycle


Dividends . . . . . . . . . . . . . . . . . $ 12,400
Retained earnings (6/1/02). . . . . . 156,540
Income taxes . . . . . . . . . . . . . . . 21,180
Consulting fees (revenues) . . . . . 115,100
Administrative expense . . . . . . . 7,250

1. Determine the net income for the year by preparing an income statement. (Assume that
Required:
3,000 shares of stock are outstanding.)
2. Compute the return on equity (ROE) for Streuling Company, assuming total owners eq-
uity is $255,000.
3. Interpretive Question: What does the ROE ratio explain about Streuling s profitability?
4. Interpretive Question: Assuming an operating loss for the year, is it a good idea for
Streuling to still pay its shareholders dividends?

PROBLEM 2-11 UNIFYING CONCEPTS: NET INCOME AND STATEMENT OF
RETAINED EARNINGS
A summary of the operations of Stellenbach Company for the year ended May 31, 2003, is
shown below.
Advertising expense. . . . . . . . . . $002,760
Supplies expense . . . . . . . . . . . . 37,820
Rent expense . . . . . . . . . . . . . . . 1,500
Salaries expense . . . . . . . . . . . . 18,150
Miscellaneous expense. . . . . . . . 4,170
Dividends . . . . . . . . . . . . . . . . . . 12,400
Retained earnings (6/1/02) . . . . . 156,540
Income taxes . . . . . . . . . . . . . . . 21,180
Consulting fees (revenues) . . . . . 115,100
Administrative expense . . . . . . . 7,250

1. Determine the net income for the year by preparing an income statement. (There are
Required:
2,000 shares of stock outstanding.)
2. Prepare a statement of retained earnings for the year ended May 31, 2003.
3. Prepare a statement of retained earnings assuming that Stellenbach had a net loss for the
year of $25,000.
4. Interpretive Question: Assuming a loss as in (3), is it a good idea for Stellenbach to still
pay its shareholders dividends?

PROBLEM 2-12 FINANCIAL RATIOS
The following information for High Flying Company is provided.

High Flying Company

Current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 145,000
Long-term assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
Current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000
Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000
Owners equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520,000
Sales for year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,425,000
Net income for year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000
Average market price per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145.00
Average number of shares outstanding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000



1. Compute the current ratio, debt ratio, return on sales, return on equity, asset turnover,
Required:
and price-earnings ratio.
2. Interpretive Question: What do these ratios show for High Flying Company?
70 f71
Financial Statements: An Overview EOC Chapter 2
Financial Statements: An Overview



PROBLEM 2-13 COMPREHENSIVE FINANCIAL STATEMENT PREPARATION
The following information was obtained from the records of Uptown, Inc., as of December 31,
2003.
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $037,500
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,050
Salaries expense . . . . . . . . . . . . . . . . . . . . . . 40,050
Utilities expense . . . . . . . . . . . . . . . . . . . . . . . 9,750
Accounts payable . . . . . . . . . . . . . . . . . . . . . . 25,650
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397,800
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,450
Retained earnings (1/1/03) . . . . . . . . . . . . . . . 272,550
Capital stock (1,000 shares outstanding) . . . . . 45,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . 46,500
Supplies expense . . . . . . . . . . . . . . . . . . . . . . 207,900
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?00
Notes payable (long-term) . . . . . . . . . . . . . . . 25,800
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . 25,650
Dividends in 2003 . . . . . . . . . . . . . . . . . . . . . . 60,750
Other expenses . . . . . . . . . . . . . . . . . . . . . . . 13,050
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . 52,800

1. Prepare an income statement for the year ended December 31, 2003.
Required:
2. Prepare a classified balance sheet as of December 31, 2003.
3. Compute the current ratio as of December 31, 2003.
4. Compute the debt ratio as of December 31, 2003.
5. Interpretive Question: What does the current ratio tell about Uptown s liquidity?
6. Interpretive Question: What does the debt ratio tell about Uptown s leverage?
7. Interpretive Question: Why is the balance in Retained Earnings so large as compared
with the balance in Capital Stock?

PROBLEM 2-14 ELEMENTS OF COMPARATIVE FINANCIAL STATEMENTS
The following report is supplied by Smith Brothers Company.

Smith Brothers Company
Comparative Balance Sheets
As of December 31, 2003 and 2002
Liabilities and
Assets 2003 2002 Owners Equity 2003 2002

Cash . . . . . . . . . . . . . $13,000 $15,000 Accounts payable. . . . . . . . . $05,000 $04,000
Accounts receivable . . 18,000 11,000 Salaries and commissions
Notes receivable . . . . 11,000 10,000 payable. . . . . . . . . . . . . . . 8,000 8,000
Land . . . . . . . . . . . . . 38,000 38,000 Notes payable . . . . . . . . . . . 25,000 27,000
Capital stock . . . . . . . . . . . . 20,000 20,000
Retained earnings . . . . . . . . 22,000 15,000
Total liabilities and
Total assets. . . . . . . $80,000 $74,000 owners equity . . . . . . . . . $80,000 $74,000


Operating expenses for the year included utilities of $4,500, salaries and commissions of
$44,800, and miscellaneous expenses of $1,500. Income taxes for the year were $3,000, and the
company paid dividends of $5,000.
1. Compute the total expenses, including taxes, incurred in 2003.
Required:
2. Compute the net income or net loss for 2003.
3. Compute the total revenue for 2003.
4. Interpretive Question: Why are comparative financial statements generally of more value
to users than statements for a single period?
71
f72 Financial Statements: An Overview
Part 1 CEO Financial Reporting and the Accounting Cycle



competency enhancement opportunities
LLLL




LLL
Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.
L




ANALYZING REAL COMPANY INFORMATION

Analyzing 2-1 (Microsoft)
The 1999 annual report for MICROSOFT is included in Appendix A. Locate that
annual report and answer the following questions:

1. Locate Microsoft s 1999 balance sheet. What percentage of its total assets
consists of cash and short-term investments? Compute Microsoft s current
ratio. How does its current ratio compare to yours? How much long-term
debt does Microsoft have?
2. Find Microsoft s 1999 income statement. Have revenues increased or de-
creased over the last three years? Is the rate of increase rising? Compute
Microsoft s return on sales. Is it increasing?
3. Compute Microsoft s return on equity. How does that return compare to
the rate of return you might earn if you were to invest your money in a
savings account at a local bank?
4. Review Microsoft s statement of cash flows. What activity generates most
of Microsoft s cash? What is Microsoft doing with all its money buying
back its own stock, investing in other companies, or something else?

Analyzing 2-2 (Safeway)
At the start of this chapter you learned a little about SAFEWAY and its history.
Now let s take a look at the company s financial performance in recent years.
Refer back to Safeway s income statement (on page 41) and balance sheet (on
page 38).
Based on information contained in these financial statements, answer the
following questions:

1. Compute Safeway s debt ratio for the past two years. Has this ratio in-
creased or decreased? Why?
2. Compute the company s current ratio. Do you notice anything unusual
about Safeway s current ratio? How can a company stay in business with
a current ratio this low?
3. Compute Safeway s return on sales for 1999. Does the size of this num-
ber surprise you? Now compute the company s asset turnover. Consid-
ering return on sales and asset turnover together, what does the result
indicate?
72 f73
Financial Statements: An Overview CEO Chapter 2
Financial Statements: An Overview




L
INTERNATIONAL CASE
Diageo
DIAGEO is a United Kingdom (UK) consumer products firm, best known in the
United States for the following brand names: Smirnoff, Johnnie Walker, J&B,
Gordon s, Guinness, Pillsbury, H agen-Dazs, and Burger King. Diageo s 1998
balance sheet is shown below.

Diageo
Consolidated Balance Sheet
30 June 1998
(in millions of pounds)
Fixed assets
Intangible assets 4,727)
Tangible assets 3,006)
Investments 1,244)
8,977)
Current assets
Stocks 2,236)
Debtors due within one year 2,037)
Debtors due after more than one year 999)
Debtors subject to financing arrangements
(franchisee loans of £145 million,
less non-returnable proceeds of
£127 million) 18)
Investments 484)
Cash at bank and in hand 2,503)
8,277)
Creditors due within one year
Borrowings (4,724)
Other creditors (3,524)
(8,248)
Net current assets 29)
Total assets less current liabilities 9,006)
)
Creditors due after more than one year
Borrowings (2,894)
Other creditors (243)
(3,137)
Provisions for liabilities and charges (705)
5,164)
Shareholders funds
Equity share capital 1,034)
Non-equity share capital 105)
Called-up share capital 1,139)
Share premium account 1,121)
Revaluation reserve 190)
Profit and loss account 2,179)
Reserves attributable to equity shareholders 3,490)
4,629)
Minority interests
Equity 169)
Non-equity 366)
535)
5,164)
73
f74 Financial Statements: An Overview
Part 1 CEO Financial Reporting and the Accounting Cycle




1. Can you identify any major differences between Microsoft s and Diageo s
balance sheets in terms of the order in which major categories are dis-
played?
2. What is Diageo s total assets? Is it as easy to determine as Microsoft s to-
tal assets?
3. Take a look at the following list of accounts and identify, given your knowl-
edge of assets, liabilities, and owners equity, what the American equiva-
lent of those accounts might be (you might want to reference Microsoft s
balance sheet for comparison):
Stocks
Debtors
Called-up share capital
Profit and loss account
L




ETHICS CASE
Violating a Covenant
Often banks will require a company that borrows money to agree to certain re-
strictions on its activities in order to protect the lending institution. These re-
strictions are called debt covenants. An example of a common debt covenant
is requiring a company to maintain its current ratio at a certain level, say, 2.0.
Your boss has just come to you and asked, How can you make our cur-
rent ratio higher? You know that the company has a line of credit with a lo-
cal bank that requires the company to maintain its current ratio at 1.5. You also
know that the company was dangerously close to violating this covenant dur-
ing the previous quarter. The end of the fiscal period is next week, and some
action must be taken to increase the current ratio. If the covenant is violated,
the lending agreement allows the bank to significantly modify the terms of the
debt (in the bank s favor) and also gives the bank a seat on the company s
board of directors. Management would prefer not to have the bank involved
in the day-to-day affairs of the business, nor do they want to alter the terms
of the lending agreement.
Identify ways in which the current ratio can be increased. Would any of the
alternatives you identify be good for the business, e.g., selling equipment might
raise the current ratio but would that be good for the business? Should a com-
pany engage in these types of transactions?
L




WRITING ASSIGNMENT
The Most Important Financial Statement
As you have discovered, there are three primary financial statements balance
sheet, income statement, and statement of cash flows. In no more than two
pages, answer the following question: If you could have access to only one of
the primary financial statements, which would it be and why? As you provide
support for the financial statement of your choice, also provide reasons as to
why you would not pick the other two statements.
L




THE DEBATE
Save the Notes
As pointed out in the chapter, IBM s annual report in 1920 included zero pages
of notes to the financial statements. In 1996, the notes had grown to 26 pages.
While the number of financial statements has remained constant, the number
of notes to the financial statements continues to grow.
74 f75
Financial Statements: An Overview CEO Chapter 2
Financial Statements: An Overview




Divide your group into two teams and prepare two-minute presentations
representing the following points of view.
The first team represents Kill the Notes. You are to take the position that
financial statements providing information relating to a firm s current as-
set and liability position, a summary of its operations, and its cash inflows
and outflows are all that is needed to make good resource allocation deci-
sions. The three primary financial statements are all that need to be pro-
vided to current and potential investors and creditors. In other words, the
notes do not add value to the financial reports.
The other team represents Save the Notes. You are to argue that the
notes represent essential information that must be used when interpreting
the data contained in the financial statements themselves.
L




CUMULATIVE SPREADSHEET PROJECT
Starting with this chapter, each chapter in this text will include a spreadsheet
assignment based on the financial information of a fictitious company named
Handyman. The first assignments are simple in this chapter you are asked to
do little more than set up financial statement formats and input some num-
bers. In succeeding chapters, the spreadsheets will get more complex so that
by the end of the course you will have constructed a spreadsheet that allows
you to forecast operating cash flow for five years in the future and adjust your
forecast depending on the operating parameters that you think are most rea-
sonable.
So, let s get started with the first spreadsheet assignment.

1. The following numbers are for Handyman Company for 2003:

Short-term Loans Payable $ 10 Long-term Debt $207
Interest Expense 9 Income Tax Expense 4
Paid in Capital 50 Retained Earnings (as of 1/1/03) 31
Cash 10 Receivables 27
Dividends 0 Sales 700
Accumulated Depreciation 9 Accounts Payable 74
Inventory 153 Property, Plant, & Equipment 199
Cost of Goods Sold 519 Other Operating Expenses 160

Your assignment is to create a spreadsheet containing a balance sheet and
an income statement for Handyman Company.
2. Handyman is wondering what its balance sheet and income statement
would have looked like if the following numbers were changed as indi-
cated:

CHANGE
From To

Sales 700 730
Cost of Goods Sold 519 550
Other Operating Expenses 160 165

Create a second spreadsheet with the numbers changed as indicated. Note:
After making these changes, your balance sheet may no longer balance.
Assume that any discrepancy is eliminated by increasing or decreasing
Short-term Loans Payable as much as necessary.
75
f76 Financial Statements: An Overview
Part 1 CEO Financial Reporting and the Accounting Cycle




L
INTERNET SEARCH
Microsoft
While you have a copy of MICROSOFT s annual report in Appendix A, let s go
see what its most current financial statements look like. Access Microsoft s Web
site at http://www.microsoft.com. Sometimes addresses change, so if this Mi-
crosoft address doesn t work, access the Web site for this textbook (http://
albrecht.swcollege.com) for an updated link to Microsoft.
Once you have accessed Microsoft s Web site, answer the following ques-
tions (you may have to search a bit to answer some of these questions):
1. When was Micro-Soft founded? (That s right, the company s name origi-
nally had a hyphen.)
2. Make your way to the shareholder information and locate the company s
most recent income statement. Detail the steps you had to take to find this
financial statement.
3. How has the company done since its 1999 financial statements were is-
sued? Are sales still increasing? Are profits still on the rise?
4. Microsoft was one of the first companies to provide an income statement
in multiple languages. Take a look at Microsoft s income statement based
on accounting principles accepted in the United Kingdom. Do you recog-
nize any of the terms? Now look at the German version of the income state-
ment. Even though you probably don t speak German, can you guess what
the German word is for revenues ?
The Mechanics
of Accounting

chapter



3
f3
learning objectives After studying this chapter, you should be able to:


1 Understand the process of 3 Record the effects of 5 Describe how technology
transforming transaction transactions using journal has affected the first three
data into useful accounting entries (step two of the steps of the accounting
information. accounting cycle). cycle.

2 Analyze transactions and 4 Summarize the resulting
determine how those journal entries through
transactions affect the posting and prepare a trial
accounting equation (step balance (step three of the
one of the accounting cycle). accounting cycle).
78 chapter f3
The Mechanics Of Accounting


Ray Kroc, a 51-year-old milkshake machine Santa Barbara in 1971. Not all of the Mc-
distributor, first visited the McDonald Donald s menu innovations caught on
brothers drive-in (in San Bernardino, Cal- the McLean Deluxe (a low-fat hamburger
ifornia) in July of 1954 because he wanted held together with a seaweed-based filler)
to know why a single hamburger stand and the Hulaburger, one of Ray Kroc s per-
needed ten milkshake machines. That first sonal favorites (a cheeseburger with a big
day, Kroc spent the lunch rush hour watch- slice of pineapple), are among the items
ing the incredible volume of business the that are no longer offered.
small drive-in was able to handle. By the The essence of McDonald s business
time he left town, Kroc had received a seems fairly simple: revenues come from
personal briefing on the McDonald s selling Big Macs, Happy Meals, Chicken
Speedee System from Dick and Mac Mc- McNuggets, etc.; operating costs include
Donald and had secured the rights to du- the costs of the raw materials to produce
plicate the system throughout the United the food items, labor costs, building
States. rentals, income taxes, and so forth. But the
In his first outlet in Chicago, Ray Kroc magnitude of McDonald s operations in
soon discovered that duplicating the Mc- terms of volume (sales average over $105
Donald s system involved more than just million per day) as well as geography (Mc-
signing a licensing agreement. Kroc s Donald s has locations in 118 countries
french fries, for example, were mushy, throughout the world) makes compiling
even though he closely copied the Mc- this information a challenge. In order to
Donald brothers process. Feverish detec- prepare its year-end financial reports, Mc-
tive work finally revealed that Dick and Donald s must accumulate financial infor-
Mac McDonald had been storing their mation from its various locations through-
potatoes in an outside bin before turning out the world, summarize that information
them into french fries. This aging process according to U.S. accounting standards,
allowed some of the natural sugars in the and make the report available to the pub-
potatoes to turn into starch, resulting in lic in less than four weeks. In fact, Mc-
fries that would cook all the way through Donald s annual report for the period
without burning. Further research revealed ended December 31, 1999, was finished on
setting the stage
the optimal temperature for the cooking January 26, 2000.
oil, the best type of potato to use, and how With the number of transactions that
to make frozen french fries that taste as occur on a daily basis, the accounting for
good as fresh. The end product, the MC- McDonald s would be impossible were it
not for a systematic method for analyzing
DONALD S french fry, was instrumental in
these transactions and collecting and
establishing the McDonald s reputation for
recording transaction-related information.
consistent quality.
What is the process by which McDonald s
As the number of McDonald s loca-
and other entities transform raw transac-
tions expanded (to 26,806 at the end of
tion data into useful information? Certainly,
1999), so did the menu. Originally, the Mc-
shareholders and others would not under-
Donald s menu contained just 15-cent
stand how McDonald s has performed if
hamburgers, 12-cent french fries, 20-cent
the company merely published volumes of
milkshakes, cheeseburgers, three flavors
raw transaction data. How are millions of
of soft drinks, milk, coffee, potato chips, accounting cycle The proce-
transactions summarized and eventually
and pie. The first addition to this menu was dure for analyzing, record-
reported in the primary financial state-
the Filet-O-Fish sandwich in the early ing, summarizing, and re-
ments? This transformation process is re-
1960s. The Big Mac started in Pittsburgh porting the transactions of
ferred to as the accounting cycle.
in 1967, and the Egg McMuffin debuted in a business.




In the first two chapters, we provided an overview of accounting. We discussed the environment of
accounting and its objectives, some basic concepts and assumptions of accounting, and the primary fi-
nancial statements. Now we begin our study of the accounting cycle. This simply means that we
will examine the procedures for analyzing, recording, summarizing, and reporting the transactions of
a business. In this chapter, we describe the first three steps in the cycle. The remaining step (prepar-
ing reports for external users) is explained in Chapter 4.
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f80 Part 1 The Mechanics Of Accounting
Financial Reporting and the Accounting Cycle



1 HOW CAN WE COLLECT ALL THIS
INFORMATION?
Understand the process of
transforming transaction
data into useful accounting
Suppose you were asked, What was the total cost, to the nearest dollar, of your college educa-
information.
tion last year? To answer this question would require that you (1) gather information (in the
form of receipts, credit card statements, and canceled checks) for all your expenditures, (2) an-
alyze that information to determine which outflows relate to your college education, and (3)
summarize those outflows into one number the cost of your college education. Once you have
answered that question, answer this one, How much did you spend on food last year? Again
you would have to go through the same process of collecting data, analyzing the information to
identify those expenditures relating to food, and then summarizing those expenditures into one
number. From these two examples you can see that, without a method for gathering and orga-
nizing day-to-day financial data, answers to seemingly routine questions can get quite complex.
Now you may be thinking, Doesn t my checkbook allow me to easily answer these ques-
tions? Your check register would certainly help, but it is limited in that it tracks only the trans-
actions that go through your checking account. It does not track the cash in your pocket, in
your savings accounts, or in other investment accounts. So, if any of your expenditures for food
were made with cash, your check register would understate the amount you spent for food. In
addition, you would still have to review each check and determine to what it related. Your check
register provides good information for calculating exactly how much money you have in your
checking account at any point in time, but it does not contain all the information necessary to
determine exactly how your money was spent.
Now consider the dilemma for businesses. They typically have far more transactions than
you, and the kinds of transactions are more varied. Businesses buy and sell goods or services;
borrow and invest money; pay wages to employees; purchase land, buildings, and equipment;
distribute earnings to owners; and pay taxes to the government. These activities are referred to
business documents
Records of transactions as exchange transactions because the entity is actually trading (exchanging) one thing for an-
used as the basis for other. A college bookstore, for example, exchanges textbooks for cash. Business documents,
recording accounting en-
such as a sales invoice, a purchase order, or a check stub, are often used (1) to confirm that an
tries; include invoices,
arm s-length transaction has occurred, (2) to establish the amounts to be recorded, and (3) to
check stubs, receipts, and
facilitate the analysis of business events.
similar business papers.


Businesses, such as a col-
lege bookstore, have
many exchange transac-
tions in which they trade
one thing for another like
textbooks for cash.
80 f81
The Mechanics Of Accounting Chapter 3
The Mechanics of Accounting


To determine how well an entity is managing its resources, the results of transactions must
be analyzed. The accounting cycle makes the analysis possible by recording and summarizing an
entity s transactions and preparing reports that present the summary results. Exhibit 3-1 shows
the sequence of the accounting cycle. Later, we will discuss these general categories and the spe-
cific steps of the cycle.
Keeping track of a company s transactions requires a system of accounting that is tailor-
made to the needs of that particular enterprise. Obviously, the accounting system of a large
multinational corporation with millions of business transactions each day will be much more
complex than the system needed by a small Internet start-up company. The more complex and
detailed the accounting system, the more likely it is to be automated. Historically, of course, all
accounting systems had to be maintained by hand. The image of the accountant with green eye-
shade and quill pen, sitting on a high stool, meticulously maintaining the accounting records,
reflects those early manual systems. Today, few accounting systems are completely manual. Even
small companies generally use some type of inexpensive accounting software. Such software helps
reduce the number of routine clerical functions and improves the accuracy and timeliness of the
accounting records.
Although a computer-based system is faster and requires less labor than a manual system,
the steps in the process are basically the same for both: transactions are recorded on source doc-
uments; they are then analyzed, journalized, and posted to the accounts; and the resulting in-
formation is summarized, reported, and used for evaluation purposes. The difference lies in who
(or what) does the work. With a computer-based system, the software transforms the recorded
data, summarizes the data into categories, and prepares the financial statements and other re-


Sequence of the Accounting Cycle
exhibit 3-1

Exchange Transactions
(Businesses enter into exchange transactions
signaling the beginning of the accounting cycle)




1 Analyze transactions.
Step




2
Step Record the effects of transactions.




3 Summarize the effects of transactions.
1. Posting journal entries.
Step
2. Preparing a trial balance.




4 Prepare reports.
1. Adjusting entries.
2. Preparing financial statements.
3. Closing the books.
Step
81
f82 Part 1 The Mechanics Of Accounting
Financial Reporting and the Accounting Cycle


ports. Nevertheless, human judgment is still essential in analyzing and recording transactions,
especially those of a nonroutine nature.
Because a manual accounting system is easier to understand, we will use a manual system
for the examples in this text. As you begin studying the steps in the accounting cycle, it is im-
portant that you understand the accounting equation and double-entry accounting more fully.
This concept was briefly introduced in Chapter 2. You will recall that the accounting model is
built on this basic equation. You now need to learn how to use the equation in accounting for
the transactions of a business.




to summarize
Businesses enter into exchange transactions. Evidence of these transactions is
provided by business documents. Accounting is designed to accumulate and
report in summary form the results of a company s transactions, therefore
transforming the financial data into useful information for decision making.




2 HOW DO TRANSACTIONS AFFECT THE
ACCOUNTING EQUATION?
Analyze transactions and
determine how those
transactions affect the
Suppose you are the keeper of the archives at MCDONALD S assigned to protect the secret in-
accounting equation (step
gredient mix for the Big Mac special sauce. You came to work this morning only to hear that
one of the accounting
cycle). BURGER KING has cracked the secret ingredient recipe and plans to come out with a Big Mac
clone at half the price. How would this event be reflected in the financial statements?
Often, the most difficult aspect of accounting is determining which events are to be re-
flected in the accounting records and which are not. In this example, the proliferation of Big
Mac clones could have a serious impact on the future of the firm. However, as discussed in
Chapter 2, events that cannot be measured in monetary terms will not be reflected in the fi-
nancial statements. It would be virtually impossible to reliably quantify the impact that Big Mac
net work
clones could have on the future profitability of McDonald s, and thus, that information would
Access MCDONALD S Web not be reflected in the financial statements.
site (http://www.mcdonalds.
Now you may be saying to yourself, We have an obligation to inform financial statement
com) and compare it to
users about this attack on the Big Mac. We would all agree that this information should be
BURGER KING s (http://
www.burgerking.com). shared, but the financial statements are not the place to do it. As you review MICROSOFT s
In your opinion, which Web
annual report (in Appendix A), you ll notice that the financial statements are only one part of
site is easier to navigate?
the information provided to users. Information relating to the competitive environment, prod-
How easy is it to find infor-
mation on, for example, nu- uct development, and marketing and sales efforts is included in the annual report, but not as
trition? Which site provides
part of the accounting information.
easier access to the com-
After quantifying an event s monetary impact, the event must be analyzed to determine if
pany s financial informa-
tion? an arm s-length transaction has occurred. Accounting is concerned primarily with reflecting the
effects of transactions between two independent entities. So a mining company s oil strike on
the North Slope of Alaska would not be reflected in the financial statements until that oil is
sold. Likewise, signing a promising young financial analyst directly out of college for a salary of
$80,000 per year involves an exchange of promises. No accounting entry would be made until
the analyst actually worked and received a paycheck.
Transactions between independent parties must be analyzed to determine their effect on the
accounting equation. This analysis is often what separates an accountant from a bookkeeper.
While many transactions are routine, some business events are quite complex and require a com-
prehensive analysis to determine how the event should be reflected in the financial statements.
Consider the following examples:
82 f83
The Mechanics Of Accounting Chapter 3
The Mechanics of Accounting



An employee works for one year, earning a base salary of $60,000. In addition, if the em-
ployee stays with the company for at least five years, the company promises to make a con-
tribution to the employee s pension fund equal to 15% of salary. Approximately 60% of
employees who start with the company stay for five years. Also, by working for one year,
the employee earns 15 extra vacation days. Those vacation days can be saved and used any
time in the future. How do we record compensation cost associated with this employee for
the year?
A company buys a building. In addition to paying $20,000 cash, the company agrees to
pay $10,000 per year for the next ten years. The company will also pay a $2,000 property
tax bill associated with the building from last year. As part of the purchase, the company
gave the former owners of the building 500 shares of stock. Finally, the building will re-
quire $23,000 worth of repairs and renovations before it can be used. How much should
be recorded as the cost of the building?
As these examples illustrate, transactions can become quite complex and the accounting for
these types of transactions reflects that complexity. The good news is that the transaction analy-
sis framework introduced in this chapter allows you to break complex transactions into man-
ageable pieces and also provides a self-checking mechanism to ensure that you haven t forgot-
ten anything. Once a transaction is properly analyzed and the affected accounts identified (along
with the direction of those effects), the remainder of the accounting cycle can proceed without
much difficulty.


The Accounting Equation
So let s begin our analysis of transactions by first reviewing some of the basics. Recall that the
fundamental accounting equation is:

Assets Liabilities Owners Equity
[Resources] Creditors claims Owners claims
against resources against resources

Because the accounting equation is an equality, it must always remain in balance. To see
how this balance is maintained when accounting for business transactions, consider the follow-
ing activities:



Effect in Terms of the
Business Activity (Transaction) Accounting Equation

1. Investment of $50,000 by owners Increase asset (Cash), increase owners equity
(Capital Stock): A+$50,000 OE+$50,000
2. Borrowed $25,000 from bank Increase asset (Cash), increase liability
(Notes Payable): A+$25,000 L+$25,000
3. Purchased $14,000 worth of inventory Increase asset (Inventory), increase liability
on credit. The inventory is to be resold (Accounts Payable): A+$14,000 L+$14,000
at a later date.
4. Purchased equipment costing $15,000 Decrease asset (Cash), increase asset
for cash (Equipment): A)$15,000 A+$15,000




For each of the transactions, the terms in parentheses are the specific accounts affected by the
transactions, as will be explained in the next section.
In each case, the equation remains in balance because an identical amount is added to both
sides, subtracted from both sides, or added to and subtracted from the same side of the equa-
tion. Following each transaction, we can ensure that the accounting equation balances. Note
how the following spreadsheet keeps track of the equality of the accounting equation:
83
f84 Part 1 The Mechanics Of Accounting
Financial Reporting and the Accounting Cycle



TRANSACTION # ASSETS LIABILITIES OWNERS EQUITY

Beginning Balance $00,000 $00,000 $00,000

1 50,000 50,000

Subtotal $50,000 $00,000 $50,000

2 25,000 25,000

Subtotal $75,000 $25,000 $50,000

3 14,000 14,000

Subtotal $89,000 $39,000 $50,000

4 15,000
15,000

Total $89,000 $39,000 $50,000



Using Accounts to Categorize Transactions
In Chapter 2, the balance sheet and the income statement were introduced as two of the three
primary financial statements, the third being the statement of cash flows. We learned that the
elements of the balance sheet are assets, liabilities, and owners equity; the elements of the in-
come statement are revenues and expenses. Now we must learn how each of these elements is
composed of many different accounts.
An account is a specific accounting record that provides an efficient way to categorize trans-
account An accounting
record in which the results actions. Thus, we may designate asset accounts, liability accounts, and owners equity accounts.
of transactions are accumu- Examples of asset accounts are Cash, Inventory, and Equipment. Liability accounts include Ac-
lated; shows increases, de-
counts Payable and Notes Payable. The equity accounts for a corporation are Capital Stock and
creases, and a balance.
Retained Earnings. You can think of an individual account as a summary of every transaction
affecting a certain item (such as cash); the summary may be recorded on one page of a book, or
in one computer file, or in one column of a spreadsheet (seen as follows).



business environment essay


AT&T s board of directors and management are
Do Accountants Record the Most Im-
considering breaking up the company by spinning
portant Events? Are all important eco-
off certain assets.
nomic events captured in a company s
FIRESTONE instigates the second biggest tire re-
accounting records? No. In fact, the ma-
call ever.
jority of events that affect the value of
The yield on 10-year Treasury notes fell to 5.754%,
a company may fall outside the scope
its lowest level this year.
of traditional financial reporting. Con-
KMART and LAND S END released operating re-
sider the following selection of business
sults that fell short of already lowered market ex-
events reported on the front page of The
pectations.
Wall Street Journal (Business and Fi-
Brazil s PETROBAS began trading on the NYSE.
nance column) on a typical day (Friday, August 11,
2000):
All of these events had impacts on the values of com-
panies. For example, Dell s announcement caused the
DELL s earnings rose 19%, exceeding estimates,
value of the company s shares to decrease by about
but revenue rose at its slowest rate in five years.
84 f85
The Mechanics Of Accounting Chapter 3
The Mechanics of Accounting



OWNERS
ASSETS LIABILITIES EQUITY

Accounts Notes Capital
Transaction # Cash Inventory Equipment Payable Payable Stock

Beginning
Balance $00,000 $00,000 $00,000 $00,000 $00,000 $ 0

1 50,000 50,000

Subtotal $50,000 $00,000 $00,000 $00,000 $00,000 $50,000

2 25,000 25,000

Subtotal $75,000 $00,000 $00,000 $00,000 $25,000 $50,000

3 14,000 14,000

Subtotal $75,000 $14,000 $00,000 $14,000 $25,000 $50,000

4 15,000 15,000

Total $60,000 $14,000 $15,000 $14,000 $25,000 $50,000




Using the previous transactions, we can easily see how the accounting equation can be ex-
panded to include specific accounts under the headings of assets, liabilities, and owners equity.
We can also see that after each transaction, the equality of the accounting equation can be de-
termined simply by adding up the balances of all the asset accounts and comparing the total to
the sum of all the liability and owners equity accounts.
Now suppose that a company has 200 accounts and 10,000 transactions each month this
spreadsheet would quickly get very big. Today, computers help in compiling this massive amount
of data. Five hundred years ago, when double-entry accounting was formalized, all the adding
and subtracting was done by hand. You can imagine the difficulties of tracking multiple ac-




5%. And yet none of these value-relevant events The challenge to accountants is to figure out how to
would have been recorded in the accounting records bring more business events into the accounting model
of any company anywhere in the world. in order to increase the relevance of the financial state-
Accounting academics have long been dismayed ments. The risk of doing nothing to improve ac-
by the weak connection between a company s re- counting is that potential investors and creditors will
ported accounting numbers and the company s mar- increasingly turn their backs on the financial state-
ket value. In a famous paper, Professor Baruch Lev ments when they can get more current, comprehen-
summarized this issue as follows: sive, and relevant information merely by using an In-
ternet search engine.
The correlation between earnings and
stock returns is very low, sometimes neg-
ligible. . . . [T]he possibility that the fault
Source: Baruch Lev, On the Usefulness of Earnings and Earnings
lies with the low quality . . . of reported Research: Lessons and Directions from Two Decades of Empirical Re-
earnings looms large. search, Journal of Accounting Research, Supplement 1989, p. 153.
85
f86 Part 1 The Mechanics Of Accounting
Financial Reporting and the Accounting Cycle


counts, involving hundreds of transactions, using the spreadsheet method described above while
doing all the computations by hand. Mixing and in one column would provide am-
ple opportunity to make mistakes.
This problem was solved by separating the and the for each account into sepa-
rate columns, totaling each column, and then computing the difference between the columns
to arrive at an ending balance. The simplest, most fundamental format is the configuration of
the letter T. This is called a T-account. Note that a T-account is an abbreviated representation
T-account A simplified de-
piction of an account in the of an actual account (illustrated later) and is used as a teaching and learning tool. The follow-
form of a letter T.
ing are examples of T-accounts, representing the transactions described previously.


Cash Inventory Equipment




Accounts Payable Notes Payable Capital Stock

debit An entry on the left
side of a T-account.

credit An entry on the right
side of a T-account.

The account title (Cash, for example) appears at the top of the T-account. Transac-
fyi tion amounts may be recorded on both the left side and the right side of the T-account.
Instead of using the terms left and right to indicate which side of a T-account is affected,
Where does the DR come
terms unique to accounting were developed. Debit is used to indicate the left side of a T-
from when the term debit
account, and credit is used to indicate the right side of a T-account. Debit means left,
doesn t have an r in it? Re-
credit means right nothing more, nothing less.
call that accounting, as we
Besides representing the left and right sides of an account, the terms debit (abbrevi-
know it today, was formalized ated DR) and credit (abbreviated CR) take on additional meaning when coupled with a
in the 1500s in Italy. The Italian specific account. By convention, for asset accounts, debits refer to increases and credits to
decreases. For example, to increase the cash account, we debit it; to decrease the cash ac-
and Latin (a common language
count, we credit it. Since we expect the total increases in the cash account to be greater
back then) verb forms of debit
than the decreases, the cash account will usually have a debit balance after accounting for
are addebitare and debere, re-
all transactions. Thus, we can make this generalization asset accounts will have debit bal-
spectively. Thus, the DR rep-
ances. The opposite relationship is true of liability and owners equity accounts; they are
resents an Italian or Latin ab-
decreased by debits and increased by credits. As a result, liability and owners equity ac-
breviation of debit.
counts will typically have credit balances. The effect of this system is shown here, with an
increase indicated by ( ) and a decrease by ( ).


Assets Liabilities Owners Equity

DR CR DR CR DR CR
() () () () () ()




caution
In addition to assets equaling liabilities and owners equity, debits also equal credits.
Just a reminder that asset ac- If you fully grasp the meaning of these two equalities, you are well on your way to mas-
counts will typically have debit tering the mechanics of accounting. Debits and credits allow us to take a shortcut to en-
sure that the accounting equation balances. If, for every transaction, debits equal credits,
balances, whereas liabilities and
then the accounting equation will balance.
owners equity accounts will
To understand why this happens, keep in mind three basic facts regarding double-
typically have credit balances.
entry accounting:
86 f87
The Mechanics Of Accounting Chapter 3
The Mechanics of Accounting


1. Debits are always entered on the left side of an account and credits on the right side.
fyi
2. For every transaction, there must be at least one debit and one credit.
The word credit is associated 3. Debits must always equal credits for each transaction.
with something good because
Now notice what this means for one of the business transactions shown earlier (page
your bank account increases
83): investment by owners. An asset account (Cash) is debited; it is increased. An own-
when the bank credits your
ers equity account (Capital Stock) is credited; it is also increased. There is both a debit
account. The bank uses this
and a credit for the transaction, and we have increased accounts on both sides of the equa-
term because, from its stand-
tion by an equal amount, thus keeping the accounting equation in balance.
point, your account represents
Be careful not to let the general, nonaccounting meanings of the words credit and
a liability the bank owes you debit confuse you. In general conversation, credit has an association with plus and debit
the amount of money in your with minus. But on the asset side of the accounting equation, where debit means increase
account. Thus, when the bank and credit means decrease, this association can lead you astray. In accounting, debit sim-
ply means left and credit simply means right. To make sure you understand the relation-
credits your account (a liabil-
ship between debits and credits, the various accounts, and the accounting equation, let us
ity), the bank is increasing the
examine further the transactions listed on page 83.
recorded amount it owes you.




Business Activity
(Transaction) Effect in Terms of the Accounting Equation

Assets Liabilities Owners Equity

Cash Capital
1. Investment by owners
DR ( ) Stock
CR ( )
2. Borrowed money from Cash Notes
bank DR ( ) Payable
CR ( )
3. Purchased inventory Inventory Accounts
on credit DR ( ) Payable
CR ( )
4. Purchased equipment Equipment Cash
for cash DR ( ) CR ( )


Note that every time an account is debited, other accounts have to be credited for the same
amount. This is the major characteristic of the double-entry accounting system: the debits must
always equal the credits. This important characteristic creates a practical advantage: the opportu-
nity for self-checking. If debits do not equal credits, an error has been made in analyzing and
recording the entity s activities.
Before proceeding any further, let s stop for a moment and review the relationship between
the various types of accounts and debits and credits. It is in your best interest not to go on un-
til you understand these relationships.

Debit or Ending
Account Type
Credit? Balance

( )
Increase results in Debit
Asset Debit
( )
Decrease results in Credit

( )
Increase results in Credit
Liability Credit
( )
Decrease results in Debit

( )
Increase results in Credit
Owners™ Equity Credit
( )
Decrease results in Debit
87
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Financial Reporting and the Accounting Cycle



Expanding the Accounting Equation to Include Revenues,
Expenses, and Dividends
At this point, we must bring revenues and expenses into the picture. Obviously, they are part
of every ongoing business. Revenues provide resource inflows; they are increases in resources
from the sale of goods or services. Expenses represent resource outflows; they are costs in-
caution curred in generating revenues. Note that revenues are not synonymous with cash or other
assets, but are a way of describing where the assets came from. For example, cash received
We stated previously that own-
from the sale of a product would be considered revenue. Cash received by borrowing from
ers equity accounts will have
the bank would not be revenue, but an increase in a liability. By the same token, expenses
credit balances. However, ex-
are a way of describing how an asset has been used. Thus, cash paid for interest on a loan
penses, a component of Re-
is an expense, but cash paid to buy a building represents the exchange of one asset for an-
tained Earnings, will almost al-
other.
ways have debit balances.
How do revenues and expenses fit into the accounting equation? Remember that rev-
Since revenues will usually ex-
enues minus expenses equals net income; and net income is a major source of change in
ceed expenses, the net effect
owners equity from one accounting period to the next. Revenues and expenses, then, may
on Retained Earnings will result
be thought of as temporary subdivisions of owners equity. Revenues increase owners eq-
in a credit balance. uity and so, like all owners equity accounts, are increased by credits. Expenses reduce
owners equity and are therefore increased by debits. As will be explained in Chapter 4,
all revenue and expense accounts are closed into the retained earnings account at the end of
the accounting cycle.
One other temporary account affects owners equity. It is the account that shows distribu-
tions of earnings to owners. For a corporation, this account is called Dividends. Since dividends
dividends Distributions to
the owners (stockholders) reflect payments to the owners, therefore reducing owners equity, the dividends account is in-
of a corporation. creased by a debit and decreased by a credit. The dividends account, like revenues and expenses,
is also closed into the retained earnings account.
Just a warning here: students who have trouble grasping debits and credits usually get hung
up on the revenue and expense accounts. Remember that revenues and expenses are subcate-
gories of Retained Earnings. When you credit a revenue account, you are essentially increasing
Retained Earnings. When you debit an expense account, you are increasing the amount of ex-
pense, which in turn reduces Retained Earnings.
Using the corporate form of business as an example, the accounting equation may be ex-
panded to include revenues, expenses, and dividends, as shown in Exhibit 3-2.
Keep in mind that in actual business practice, when a manual accounting system is used,
the T-account is an integral feature of a more formal and complete account. Exhibit 3-3 is an
example of such an account. Note that in addition to the debits and credits in the T-account
portion (drawn in heavy lines in this example), the account has a title, Cash; an account num-
ber, 101; and columns for a transaction date, an explanation of the transaction, a posting ref-
erence (a cross-reference to other accounting records), and a balance.


Why Should I Understand the Mechanics of Accounting?
If computers now take care of all the routine accounting functions, why does a businessperson
need to know anything about debits, credits, journals, posting, T-accounts, and trial balances?
Good question. First of all, even though computers now do most of the dirty work, the essence
of double-entry accounting is unchanged from the days of quill pens and handwritten ledgers.
Thus, understanding the process explained in this chapter is still relevant to a computer-based
accounting system. In addition, with or without computers, the use of debits, credits, and T-
accounts still provides an efficient and widely used shorthand method of analyzing transactions.
At a minimum, all businesspeople should be familiar enough with the language of accounting
to understand, for example, why a credit balance in Cash or a debit balance in Retained Earn-
ings is something unusual enough to merit investigation. Finally, an understanding of the ac-
counting cycle analyzing, recording, summarizing, and preparing gives one insight into how
information flows within an organization. And great advantages accrue to those who understand
information flow.
88 f89
The Mechanics Of Accounting Chapter 3
The Mechanics of Accounting



Expanded Accounting Equation
exhibit 3-2

Liabilities
Assets Owners™ Equity

CR
CR DR CR
DR DR
()
() () ()
() ()




Capital Stock Retained Earnings

CR
DR CR
DR
()
() ()
()



Expenses Revenues

CR
DR CR
DR
()
() ()
()



Dividends

CR
DR
()
()




Typical Account
exhibit 3-3


ACCOUNT: Cash ACCOUNT NO. 101

Post.
Date Explanation Ref. Debits Credits Balance




to summarize
Regardless of the size or complexity of a business, or the manner in which the
records are maintained (manual or automated system), the steps of the ac-
counting cycle are the same. The entire process is based on double-entry ac-
counting and the basic accounting equation. Accounts accumulate the results
89
f90 Part 1 The Mechanics Of Accounting
Financial Reporting and the Accounting Cycle



of transactions. Debits are always entered on the left side of an account, and
credits are always entered on the right side. Debits increase asset, expense,
and dividend accounts and decrease liability, owners equity, and revenue ac-
counts. Credits decrease asset, expense, and dividend accounts and increase
liability, owners equity, and revenue accounts. Revenues increase owners eq-
uity, whereas expenses and dividends decrease owners equity. Therefore, un-
der a double-entry system of accounting, it is always possible to check the ac-
counting records to see that Assets Liabilities Owners Equity and debits
equal credits.




3 HOW DO WE RECORD THE EFFECTS OF
TRANSACTIONS?
Record the effects of
transactions using journal
entries (step two of the
With our knowledge of the different types of accounts (assets, liabilities, and owners equity)
accounting cycle).
and the use of the terms debit and credit (debit means left and credit means right), we are now
ready to actually record the effects of transactions.
The second step in the accounting cycle is to record the results of transactions in a journal.
journal An accounting
record in which transactions Known as books of original entry, journals provide a chronological record of all entity transac-
are first entered; provides a
tions. They show the dates of the transactions, the amounts involved, and the particular accounts
chronological record of all
affected by the transactions. Sometimes a detailed description of the transaction is also included.
business activities.
This chronological recording of transactions provides a company with a complete record of
its activities. If amounts were recorded directly in the accounts, it would be difficult, if not im-
possible, for a company to trace a transaction that occurred, say, six months previously.
Smaller companies, such as a locally owned pizza restaurant, may use only one book of orig-
inal entry, called a general journal, to record all transactions. Larger companies having thou-
sands of transactions each year may use special journals (for example, a cash receipts journal) as
well as a general journal.
A specific format is used in journalizing (recording) transactions in a general journal. The debit
journalizing Recording
transactions in a journal. entry is listed first; the credit entry is listed second and is indented to the right. Normally, the date
and a brief explanation of the transaction are considered essential parts of the journal entry. (In the
journal entry A recording of
text, we often ignore dates and explanations to simplify the examples.) Dollar signs usually are omit-
a transaction where debits
ted. Unless otherwise noted, this format will be used whenever a journal entry is presented.
equal credits; usually in-
cludes a date and an expla-
nation of the transaction.
General Journal Entry Format
Date Debit Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xx
Credit Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xx
Explanation.



Exhibit 3-4 is a partial page from a general journal, showing typical journal entries. Study
this exhibit carefully because the entire accounting cycle is based on journal entries. If journal
entries are incorrect, the resulting financial information will be inaccurate.
To give you additional exposure to analyzing transactions and recording journal entries, we
are going to start our own business. Rather than spend the summer flipping burgers at the local
hamburger house, you decide that you want to have an outdoor job one that allows you to en-
joy the summer sun, engage in rigorous physical activity, and sharpen your skills as an entrepre-
neur. You are going to start your own landscaping business. This business will involve mowing
lawns, pulling weeds, trimming and planting shrubs, and so forth. We will use your new business
to illustrate the journal entries used to record some common transactions of a business enterprise.1


1 Normally, a small business like this one would be started as a sole proprietorship or as a partnership. We as-
sume a corporation here to show a complete set of transactions.
90 f91
The Mechanics Of Accounting Chapter 3
The Mechanics of Accounting



General Journal
exhibit 3-4


JOURNAL Page 1

Post.
Date Description Debits Credits
Ref.
2003
July 1 Cash 2,000
Capital Stock 2,000
Issued 200 shares of capital stock at $10 per share.

July 5 Truck 800
Cash 800
Purchased a used truck.

July 5 Equipment 250
Accounts Payable 250
Purchased a lawnmower on account.

July 5 Supplies 180
Cash 180
Purchased supplies for cash.




These transactions fit into the following four general categories: acquiring cash, acquiring other as-
sets, selling goods or providing services, and collecting cash and paying obligations. Obviously, we
cannot present all possible transactions in this chapter. In studying the illustrations, strive to un-
derstand the conceptual basis of transaction analysis rather than memorizing specific journal en-
tries. Pay particular attention to the dual effect of each transaction on the company in terms of
the basic accounting equation (that is, its impact on assets and on liabilities and owners equity).
Remember that business activity involves revenues, expenses, and distributions to owners as well,
and that these accounts eventually increase or decrease owners equity (the retained earnings ac-
count for a corporation).

Acquiring Cash, Either from Owners or by Borrowing
Your first task in starting this business is to acquire cash, either through owners investments or
by borrowing. Your parents indicate that they will match any funds that you are going to put
into your business. You have $1,000 in savings, and coupled with your parents matching funds,
you decide to issue 200 shares of stock.

The following transaction illustrates investments by owners:
EXAMPLE 1

assets ( ) Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
owners equity ( ) Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Issued 200 shares of capital stock at $10 per share.


This transaction increases cash as a result of capital stock being issued to investors, or stock-
holders. The cash account is debited, and the capital stock account is credited. The economic
impact of this situation may be summarized as follows:
91
f92 Part 1 The Mechanics Of Accounting
Financial Reporting and the Accounting Cycle



OWNERS
ASSETS LIABILITIES EQUITY

Accounts Notes Capital

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