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Debits Credits

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $004,500
Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000
Consulting Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $269,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,100
Utilities Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77,000
Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000
Office Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,400
Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000
Totals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $492,500 $324,500



Based solely on your assessment of Jay McMahon s understanding of accounting, would you
hire him as office manager? Explain. Prepare a corrected trial balance that you can use as a ba-
sis for your discussion with Jay and future applicants. Explain how the basic accounting equa-
tion and the system of double-entry accounting provide a check on the accounting records.

CASE 3-5 EXERCISING ACCOUNTING JUDGMENT
You have recently started business as an accounting consultant. Companies come to you when
they face difficult decisions about how to make certain journal entries. You are currently work-
ing on the following two problems, which are independent of one another.
a. Baggins Company sells hamburgers for $1.00 each. The cost of the materials used to make
each hamburger is 30 cents. Baggins has a compensation plan in which its employees are
paid in the form of cash and hamburgers. During 2003, Baggins paid cash salaries of
$500,000 and also issued certificates to employees entitling them to 200,000 free ham-
burgers. The certificates are not redeemable until 2004. What journal entry or entries should
Baggins make in 2003 to record this employee compensation information?
b. Radagast Company purchased a building for $100,000 cash on January 1, 2003. Because
of poor business decisions, as of December 31, 2003, the building is worthless. Make all
journal entries necessary in 2003 in connection with this building.




exercises

BASIC ACCOUNTING EQUATION
EXERCISE 3-1
The fundamental accounting equation can be applied to your personal finances. For each of
the following transactions, show how the accounting equation would be kept in balance. Ex-
ample: Paid for semester s tuition (decrease assets: cash account; decrease owners equity: ex-
pense account increases).
1. Took out a school loan for college.
2. Paid this month s rent.
3. Sold your old computer for cash at what it cost to buy it.
4. Received week s paycheck from part-time job.
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5. Received interest on savings account.
6. Paid monthly payment on car loan (part of the payment is principal; the remainder is in-
terest).

EXERCISE 3-2 ACCOUNTING ELEMENTS: INCREASE/DECREASE,
DEBIT/CREDIT RELATIONSHIPS
The text describes the following accounting elements: assets, liabilities, owners equity, capital
stock, retained earnings, revenues, expenses, and dividends. Which of these elements are in-
creased by a debit entry, and which are increased by a credit entry? Give a transaction for
each item that would result in a net increase in its balance.

EXERCISE 3-3 EXPANDED ACCOUNTING EQUATION
Payless Department Store had the following transactions during the year:
1. Purchased inventory on account.
2. Sold merchandise for cash, assuming a profit on the sale.
3. Borrowed money from a bank.
4. Purchased land, making cash down payment and issuing a note for the balance.
5. Issued stock for cash.
6. Paid salaries for the year.
7. Paid a vendor for inventory purchased on account.
8. Sold a building for cash and notes receivable at no gain or loss.
9. Paid cash dividends to stockholders.
10. Paid utilities.
Using the following column headings, identify the accounts involved and indicate the net
effect of each transaction on the accounting equation ( increase; decrease; 0 no effect).
Transaction 1 has been completed as an example.

Transaction Assets Liabilities Owners Equity
1 0
(Inventory) (Accounts
Payable)


EXERCISE 3-4 CLASSIFICATION OF ACCOUNTS
For each of the accounts listed, indicate whether it is an asset (A), a liability (L), or an own-
ers equity (OE) account. If it is an account that affects owners equity, indicate whether it is
a revenue (R) or expense (E) account.
1. Cash 8. Salaries and Wages 14. Interest Receivable
2. Sales Expense 15. Notes Payable
3. Accounts Receivable 9. Retained Earnings 16. Equipment
4. Cost of Goods Sold 10. Salaries Payable 17. Office Supplies
5. Insurance Expense 11. Accounts Payable 18. Utilities Expense
6. Capital Stock 12. Interest Revenue 19. Interest Payable
7. Mortgage Payable 13. Inventory 20. Rent Expense

EXERCISE 3-5 NORMAL ACCOUNT BALANCES
For each account listed in Exercise 3-4, indicate whether it would normally have a debit (DR)
balance or a credit (CR) balance.

EXERCISE 3-6 JOURNALIZING TRANSACTIONS
Record each of the following transactions in Chico s General Journal. (Omit explanations.)
1. Issued capital stock for $50,000 cash.
2. Borrowed $10,000 from a bank. Signed a note to secure the debt.
3. Purchased inventory from a supplier on credit for $8,000.
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4. Paid the supplier for the inventory purchased in (3) above.
5. Sold inventory that cost $1,200 for $1,500 on credit.
6. Collected $1,500 from customers on transaction (5) above.
7. Paid salaries and rent of $25,000 and $1,200, respectively.

EXERCISE 3-7 JOURNALIZING TRANSACTIONS
Silva Company had the following transactions:
1. Purchased a new building, paying $20,000 cash and issuing a note for $50,000.
2. Purchased $15,000 of inventory on account.
3. Sold inventory costing $5,000 for $6,000 on account.
4. Paid for inventory purchased on account (item 2).
5. Issued capital stock for $25,000.
6. Collected $4,500 of accounts receivable.
7. Paid utility bills totaling $360.
8. Sold old building for $27,000, receiving $10,000 cash and a $17,000 note (no gain or
loss on the sale).
9. Paid $2,000 cash dividends to stockholders.
Record the above transactions in general journal format. (Omit explanations.)

JOURNAL ENTRIES
EXERCISE 3-8
During June 2003, Husky, Inc., completed the following transactions. Prepare the journal en-
try for each transaction.
June 1 Received $200,000 for 2,000 shares of capital stock.
June 2 Purchased $50,000 of equipment, with 25% down and 75% on a note payable.
June 5 Paid utilities of $1,500 in cash.
June 9 Sold equipment for $25,000 cash (no gain or loss).
June 13 Purchased $100,000 of inventory, paying 50% down and 50% for credit.
June 14 Paid $5,000 cash insurance premium for June.
June 15 Sold inventory costing $30,000 for $45,000 to customers on account to be paid at
a later date.
June 20 Collected $3,000 from accounts receivable.
June 24 Sold inventory costing $50,000 for $69,500 to customers for cash.
June 25 Paid property taxes of $2,000.
June 30 Paid $50,000 of accounts payable for inventory purchased on June 13.

POSTING JOURNAL ENTRIES
EXERCISE 3-9
Post the journal entries prepared in Exercise 3-8 to T-accounts, and determine the final bal-
ance for each account. (Assume all beginning account balances are zero.)

CHALLENGING JOURNAL ENTRIES
EXERCISE 3-10
The accountant for Han Company is considering how to journalize the following transactions:

a. The employees of Han Company earned $105,000. The employees received $90,000 in
cash and were promised that they will receive the remaining $15,000 as a pension pay-
ment on the date that they retire.
b. On August 1, 2003, Han Company paid $1,800 cash for one year of rent on a building
it is using. This one year of rent is scheduled to be in effect for the 12 months starting
on August 1, 2003.

1. What journal entry should be made on the books of Han Company to record the em-
ployee compensation information in (a)?
2. Describe any assumptions necessary in making the employee compensation journal entry
in (1).
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3. Make the necessary journal entry on Han Company s books on August 1 to record the
payment for the building rent described in (b).
4. Consider the journal entry made in (3). Is any adjustment to Han s books necessary as of
December 31, 2003, as a consequence of the rent journal entry made on August 1?

EXERCISE 3-11 JOURNAL ENTRIES
The following transactions are for the Main Construction Corporation:
a. The firm purchased land for $300,000, $90,000 of which was paid in cash and a note
payable signed for the balance.
b. The firm bought equipment for $75,000 on credit.
c. The firm paid $15,000 it owed to its suppliers.
d. The firm arranged for a $100,000 line of credit (the right to borrow funds as needed)
from the bank. No funds have yet been borrowed.
e. One of the primary investors borrowed $50,000 from a bank. The loan is a personal loan.
f. The firm borrowed $65,000 on its line of credit.
g. The firm issued a $5,000 cash dividend to its stockholders.
h. An investor invested an additional $80,000 in the company in exchange for additional
capital stock.
i. The firm repaid $7,500 of its line of credit.
j. The firm sold some of its products for $15,000 $5,000 for cash, the remainder on ac-
count.
k. Cost of sales in (j) are $8,000.
l. The firm received a $1,000 deposit from a customer for a product to be sold and deliv-
ered to that customer next month.
Analyze and record the transactions as journal entries. (Omit explanations.)

EXERCISE 3-12 ANALYSIS OF JOURNAL ENTRIES
The following journal entries are from the books of Kara Rachel Company:
a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Capital Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
b. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Loan Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
c. Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Mortgage Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
d. Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
e. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
f. Salary Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
g. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
h. Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

For each of the journal entries, prepare an explanation of the business event that is being rep-
resented.

EXERCISE 3-13 JOURNALIZING AND POSTING TRANSACTIONS
Given the following T-accounts, describe the transaction that took place on each specified
date during July:
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Cash Accounts Receivable Inventory

7/5 9,500 7/1 3,420 7/14 18,000 7/5 9,500 7/10 20,000 7/14 15,000
7/28 8,000 7/23 2,000 7/28 8,000 Bal. 5,000
7/25 5,000 Bal. 500
7/30 5,500
Bal. 1,580


Equipment Land Accounts Payable

7/30 1,500 7/30 4,000 7/25 5,000 7/10 20,000
Bal. 15,000




Sales Revenue Cost of Goods Sold Rent Expense

7/14 18,000 7/14 15,000 7/23 2,000



Advertising Expense

7/1 3,420




EXERCISE 3-14 TRIAL BALANCE
The account balances from the ledger of Yakamoto, Inc., as of July 31, 2003, are listed here
in alphabetical order. The balance for Retained Earnings has been omitted. Prepare a trial bal-
ance, and insert the missing amount for Retained Earnings.
Accounts Payable . . . . . . . . . . . . . . $08,600 Land . . . . . . . . . . . . . . . . . . . . . . . . $19,000
Accounts Receivable . . . . . . . . . . . . 2,000 Miscellaneous Expenses . . . . . . . . . 1,400
Buildings . . . . . . . . . . . . . . . . . . . . 20,000 Mortgage Payable (due 2006). . . . . . 24,000
Capital Stock. . . . . . . . . . . . . . . . . . 10,000 Rent Expense. . . . . . . . . . . . . . . . . . 3,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . 19,600 Retained Earnings . . . . . . . . . . . . . . ?0 0
Equipment . . . . . . . . . . . . . . . . . . . 16,000 Salary Expense . . . . . . . . . . . . . . . . 10,000
Fees Earned . . . . . . . . . . . . . . . . . . 26,000 Supplies . . . . . . . . . . . . . . . . . . . . . 600
Insurance Expense . . . . . . . . . . . . . 3,600 Utilities Expense . . . . . . . . . . . . . . . 400




EXERCISE 3-15 TRIAL BALANCE
Assume you work in the accounting department at Marshall, Inc. Your boss has asked you to
prepare a trial balance as of November 30, 2003, using the following account balances from
the company s ledger. Prepare the trial balance and insert the missing amount for Cost of
Goods Sold.
Accounts Payable . . . . . . . . . . . . . $ 55,000 Notes Payable. . . . . . . . . . . . . . . . $250,000
Accounts Receivable . . . . . . . . . . . 25,000 Notes Receivable . . . . . . . . . . . . . 20,000
Advertising Expense . . . . . . . . . . . 5,000 Other Expenses . . . . . . . . . . . . . . 1,000
Buildings. . . . . . . . . . . . . . . . . . . . 150,000 Property Tax Expense . . . . . . . . . . 1,500
Capital Stock . . . . . . . . . . . . . . . . . 173,000 Rent Expense . . . . . . . . . . . . . . . . 7,500
Cash . . . . . . . . . . . . . . . . . . . . . . . 35,000 Retained Earnings. . . . . . . . . . . . . 40,000
Cost of Goods Sold. . . . . . . . . . . . ?0 0 Salaries Expense . . . . . . . . . . . . . 155,000
Equipment . . . . . . . . . . . . . . . . . . 55,000 Salaries Payable . . . . . . . . . . . . . . 2,000
Inventory . . . . . . . . . . . . . . . . . . . 200,000 Sales Revenue . . . . . . . . . . . . . . . 375,000
Land . . . . . . . . . . . . . . . . . . . . . . . 125,000 Short-Term Investments . . . . . . . . 15,000
Mortgage Payable . . . . . . . . . . . . . 95,000 Utilities Expense . . . . . . . . . . . . . . 7,000
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EXERCISE 3-16 RELATIONSHIPS OF THE EXPANDED ACCOUNTING EQUATION
Domino, Inc., had the following information reported. From these data, determine the
amount of:
1. Capital stock at December 31, 2002.
2. Retained earnings at December 31, 2003.
3. Revenues for the year 2003.


December 31, 2002 December 31, 2003

Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . $250,000 $300,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . $060,000 $070,000
Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . ? $050,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . $150,000 ?
Revenues for 2003 . . . . . . . . . . . . . . . . . . . . ?
Expenses for 2003. . . . . . . . . . . . . . . . . . . . . $205,000
Dividends paid during 2003. . . . . . . . . . . . . . $005,000



EXERCISE 3-17 JOURNAL ENTRY TO CORRECT AN ERROR
Legolas Company paid $5,000 cash for executive salaries. When the journal entry to record
this $5,000 payment was made, the payment was mistakenly added to the cost of land pur-
chased by Legolas. The $5,000 should have been recorded as salary expense. Make the journal
entry necessary to correct this error.




problems

PROBLEM 3-1 JOURNAL ENTRIES AND TRIAL BALANCE
As of January 1, 2003, Kendrick Corporation had the following balances in its general ledger:

Debits Credits

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $031,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92,000
Office Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208,000
Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $016,500
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,500
Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,500
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $355,000 $355,000


Kendrick had the following transactions during 2003. All expenses were paid in cash, un-
less otherwise stated.
a. Accounts Payable as of January 1, 2003, were paid off.
b. Purchased inventory for $35,000 cash.
c. Collected $21,000 of receivables.
d. Sold $185,000 of merchandise, 85% for cash and 15% for credit. The Cost of Goods
Sold was $98,500.
e. Paid $25,000 mortgage payment, of which $15,000 represents interest expense.
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f. Paid salaries expense of $60,000.
g. Paid utilities of $6,300.
h. Paid installment of $5,000 on note.
Required: 1. Prepare journal entries to record each listed transaction. (Omit explanations.)
2. Set up T-accounts with the proper account balances at January 1, 2003, post the journal
entries to the T-accounts, and prepare a trial balance for Kendrick Corporation at De-
cember 31, 2003.
3. Interpretive Question: If the debit and credit columns of the trial balance are in balance,
does this mean that no errors have been made in journalizing the transactions? Explain.

PROBLEM 3-2 JOURNALIZING AND POSTING
Assume you are interviewing for a part-time accounting job at Spilker & Associates, Inc., and
the interviewer gives you the following list of company transactions in September 2003.
Sept. 1
Received $150,000 for capital stock issued.
Sept. 2
Paid $20,000 cash to employees for wages earned in September 2003.
Sept. 4
Purchased $75,000 of running shoes and clothing on account for resale.
Sept. 5
Paid utilities of $1,800 for September 2003.
Sept. 9
Paid $1,500 cash for September s insurance premium.
Sept. 11
Sold inventory of running shoes and clothing costing $35,000 for $70,000, with
$20,000 received in cash and the remaining balance on credit.
Sept. 15 Purchased $2,500 of supplies on account.
Sept. 21 Received $25,000 from customers as payments on their accounts.
Sept. 25 Paid $75,000 of accounts payable.
Using this list, you have been asked to do the following in the interview:
Required: 1. Journalize each of the transactions for September. (Omit explanations.)
2. Set up T-accounts, and post each of the journal entries made in (1).
3. Interpretive Question: If the business owners wanted to know at any given time how
much cash the company had, where would you tell the owners to look? Why?

PROBLEM 3-3 JOURNAL ENTRIES FROM LEDGER ANALYSIS
T-accounts for RAM Technology, Inc., are shown below.

Cash Accounts Receivable Inventory

(a) 100,000 (b) 45,000 (e) 30,000 (i) 15,000 (d) 35,000 (e) 30,000
(c) 50,000 (d) 5,000
(e) 25,000 (f) 20,000
(i) 15,000 (g) 53,500
(h) 30,000

Building Accounts Payable Mortgage Payable

(b) 150,000 (h) 30,000 (d) 30,000 (b) 105,000



Notes Payable Capital Stock Sales Revenue

(g) 50,000 (c) 50,000 (a) 100,000 (e) 55,000



Cost of Goods Sold Interest Expense Wages Expense

(e) 30,000 (g) 3,500 (f) 20,000
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1. Analyze these accounts and detail the appropriate journal entries that must have been
Required:
made by RAM Technology, Inc. (Omit explanations.)
2. Determine the amount of net income/loss from the account information.

JOURNALIZING AND POSTING TRANSACTIONS
PROBLEM 3-4
Pat Bjornson, owner of Pat s Beauty Supply, completed the following business transactions dur-
ing March 2003.
Mar. 1 Purchased $53,000 of inventory on credit.
Mar. 4 Collected $5,000 from customers as payments on their accounts.
Mar. 5 Purchased equipment for $3,000 cash.
Mar. 6 Sold inventory that cost $30,000 to customers on account for $40,000.
Mar. 10 Paid rent for March, $1,050.
Mar. 15 Paid utilities for March, $100.
Mar. 17 Paid a $300 monthly salary to the part-time helper.
Mar. 20 Collected $33,000 from customers as payments on their accounts.
Mar. 22 Paid $53,000 cash on account payable. (See March 1 entry.)
Mar. 25 Paid property taxes for March of $1,200.
Mar. 28 Sold inventory that cost $20,000 to customers for $30,000 cash.
Required: 1. For each transaction, give the entry to record it in the company s general journal. (Omit
explanations.)
2. Set up T-accounts, and post the journal entries to their appropriate accounts.

PROBLEM 3-5 UNIFYING CONCEPTS: COMPOUND JOURNAL ENTRIES,
POSTING, TRIAL BALANCE
J&W Merchandise Company had the following transactions during 2003.
a. Sam Jeakins began business by investing the following assets, receiving capital stock in ex-
change:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $020,000*
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000*
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,500*
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000*
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500*
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $255,000*
*A note of $5,000 on the equipment was assumed by the company.

b. Sold merchandise that cost $30,000 for $45,000; $15,000 cash was received immediately,
and the other $30,000 will be collected in 30 days.
c. Paid off the note of $5,000 plus $300 interest.
d. Purchased merchandise costing $12,000, paying $2,000 cash and issuing a note for
$10,000.
e. Exchanged $2,000 cash and $8,000 in capital stock for office equipment costing
$10,000.
f. Purchased a truck for $15,000 with $3,000 down and a one-year note for the balance.
1. Journalize the transactions. (Omit explanations.)
Required:
2. Post the journal entries using T-accounts for each account.
3. Prepare a trial balance at December 31, 2003.

PROBLEM 3-6 UNIFYING CONCEPTS: T-ACCOUNTS, TRIAL BALANCE, AND
INCOME STATEMENT
The following list is a selection of transactions from Trafalga, Inc. s business activities during
2003, the first year of operations.
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a. Received $50,000 cash for capital stock.
b. Paid $5,000 cash for equipment.
c. Purchased inventory costing $18,000 on account.
d. Sold $25,000 of merchandise to customers on account. Cost of goods sold was
$15,000.
e. Signed a note with a bank for a $10,000 loan.
f. Collected $9,500 cash from customers who had purchased merchandise on account.
g. Purchased land, $10,000, and a building, $60,000, for $15,000 cash and a 30-year mort-
gage of $55,000.
h. Made a first payment of $2,750 on the mortgage principal plus $2,750 in interest.
i. Paid $12,000 of accounts payable.
j. Purchased $1,500 of supplies on account.
k. Paid $2,500 of accounts payable.
l. Paid $7,500 in wages earned during the year.
m. Received $10,000 cash and $3,000 of notes in settlement of customers accounts.
n. Received $3,250 in payment of a note receivable of $3,000 plus interest of $250.
o. Paid $600 cash for a utility bill.
p. Sold excess land for its cost of $3,000.
q. Received $1,500 in rent for an unused part of a building.
r. Paid off $10,000 note, plus interest of $1,200.
1. Set up T-accounts, and appropriately record the debits and credits for each transaction
Required:
directly in the T-accounts. Leave room for a number of entries in the cash account.
2. Prepare a trial balance.
3. Prepare an income statement for the period. (Ignore income taxes and the EPS computa-
tion.)

PROBLEM 3-7 TRANSACTION ANALYSIS AND JOURNAL ENTRIES
Pacific Motors, Inc., entered into the following transactions during the month of August:
a. Purchased $1,500 of supplies on account from Major Supply Company. The cost of the
supplies to Major Supply Company was $1,200.
b. Paid $600 to Valley Electric for the monthly utility bill.
c. Sold a truck to Fast Delivery, Inc. A $5,000 down payment was received with the bal-
ance of $12,000 due within 30 days. The cost of the delivery truck to Pacific Motors was
$11,000.
d. Purchased a total of eight new cars and trucks from Japanese Motors, Inc., for a total of
$96,000, one-half of which was paid in cash. The balance is due within 45 days. The to-
tal cost of the vehicles to Japanese Motors was $80,000.
e. Paid $1,875 to Silva s Automotive for repair work on cars for the current month.
f. Sold one of the new cars purchased from Japanese Motors to the town mayor, Ana
Mecham. The sales price was $17,500, and was paid by Mecham upon delivery of the
car. The cost of the particular car sold to Mecham was $12,100.
g. Borrowed $10,000 from a local bank to be repaid in one year with 12% interest.
1. For each of the transactions, make the proper journal entry on the books of Pacific Mo-
Required:
tors. (Omit explanations.)
2. For each of the transactions, make the proper journal entry on the books of the other
party to the transaction, for example, (a) Major Supply Company, (b) Valley Electric.
(Omit explanations.)
3. Interpretive Question: Why do some of the journal entries for Pacific Motors and other
companies involved appear to be mirror images of each other?

PROBLEM 3-8 CORRECTING A TRIAL BALANCE
The following trial balance was prepared by a new employee.
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f124 The Mechanics Of Accounting
Part 1 EOC Financial Reporting and the Accounting Cycle



Trial Balance
Alden Company, Inc.
For Year Ended November 30, 2003
Credits Debits

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $018,250
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $078,900
Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,600
Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,000
Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,900
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187,350
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148,000
Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,150
Notes Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,750
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,300
Rent Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,750
Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
Furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,950
Sales Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235,600
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104,700
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113,050
Property Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,850
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,400
Utilties Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Totals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $537,800 $756,200



Prepare the corrected company trial balance. (Assume all accounts have normal balances and
Required:
the recorded amounts are correct.)

PROBLEM 3-9 UNIFYING CONCEPTS: JOURNAL ENTRIES, T-ACCOUNTS,
TRIAL BALANCE
Downtown Company, a retailer, had the following account balances as of April 30, 2003:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,100
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,900
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Furniture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Notes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,000
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Capital Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000 $85,000

During May, the company completed the following transactions.
May 3 Paid one-half of 4/30/03 accounts payable.
May 6 Collected all of 4/30/03 accounts receivable.
May 7 Sold inventory costing $7,700 for $6,000 cash and $4,000 on account.
(continued)
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May 8 Sold one-half of the land for $13,000, receiving $8,000 cash plus a note for $5,000.
May 10 Purchased inventory on account, $10,000.
May 15 Paid installment of $5,000 on notes payable (entire amount reduces the liability
account).
May 21 Issued additional capital stock for $2,000 cash.
May 23 Sold inventory costing $4,000 for $7,500 cash.
May 25 Paid salaries of $2,000.
May 26 Paid rent of $500.
May 29 Purchased desk for $500 cash.
1. Prepare the journal entry for each transaction.
Required:
2. Set up T-accounts with the proper account balances at April 30, 2003, and post the en-
tries to the T-accounts.
3. Prepare a trial balance as of May 31, 2003.

UNIFYING CONCEPTS: FIRST STEPS IN THE ACCOUNTING
PROBLEM 3-10
CYCLE
The following balances were taken from the general ledger of Benson Company on January 1,
2003:


Debits Credits

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,500
Short-Term Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,500
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500
Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
Mortgage Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500
Capital Stock (7,000 shares outstanding). . . . . . . . . . . . . . . . . . . . . . . 70,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,000



During 2003, the company completed the following transactions:
a. Purchased inventory for $110,000 on credit.
b. Issued an additional $25,000 of capital stock (2,500 shares) for cash.
c. Paid property taxes of $4,500 for the year 2003.
d. Paid advertising and other selling expenses of $8,000.
e. Paid utilities expense of $6,500 for 2003.
f. Paid the salaries and wages owed for 2002. Paid additional salaries and wages of $18,000
during 2003.
g. Sold merchandise costing $105,000 for $175,000. Of total sales, $45,000 were cash sales
and $130,000 were credit sales.
h. Paid off notes of $17,500 plus interest of $1,600.
i. On November 1, 2003, received a loan of $10,000 from the bank.
j. On December 30, 2003, made annual mortgage payment of $2,500 and paid interest of
$3,700.
k. Collected receivables for the year of $140,000.
l. Paid off accounts payable of $112,500.
m. Received dividends and interest of $1,400 on short-term investments during 2003.
(Record as Miscellaneous Revenue.)
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f126 The Mechanics Of Accounting
Part 1 CEO Financial Reporting and the Accounting Cycle


n. Purchased additional short-term investments of $15,000 during 2003. (Note: Short-term
investments are current assets.)
o. Paid 2003 corporate income taxes of $11,600.
p. Paid cash dividends of $7,600.
1. Journalize the 2003 transactions. (Omit explanations.)
Required:
2. Set up T-accounts with the proper account balances at January 1, 2003, and post the
journal entries to the T-accounts.
3. Determine the account balances, and prepare a trial balance at December 31, 2003.
4. Prepare an income statement and a balance sheet. (Remember that the dividends account
and all revenue and expense accounts are temporary retained earnings accounts.)
5. Interpretive Question: Why are revenue and expense accounts used at all?




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 3-1 (Microsoft)
The 1999 annual report for MICROSOFT is included in Appendix A. Locate that
annual report and consider the following questions:

1. Find Microsoft s 1999 income statement. Assume that research and devel-
opment expenditures were paid in cash. What journal entry did Microsoft
make in 1999 to record research and development?
2. Find Microsoft s 1999 cash flow statement. What journal entry did Microsoft
make in 1999 to record the issuance of common stock?
3. Again, looking at the cash flow statement what journal entry did Microsoft
make in 1999 to record the purchase of property and equipment?
4. Using information from the cash flow statement, re-create the journal en-
try Microsoft made in 1999 to record the purchase of investments. Using
the beginning and ending balances from the balance sheet, comment on
the change in the balance of the equity and other investments account be-
tween the beginning of 1999 and the end of 1999.

Analyzing 3-2 (McDonald s)
A brief history of the origin of the MCDONALD S CORPORATION is given at the
start of this chapter. The following questions are adapted from information ap-
pearing in McDonald s 1999 annual report.
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The Mechanics Of Accounting CEO Chapter 3
The Mechanics of Accounting




1. In 1999, total sales at all McDonald s stores worldwide were $38.5 billion.
There were 26,806 McDonald s stores operating in 1999. Estimate how
many customers per day visit an average McDonald s store.
2. For the stores owned by the McDonald s Corporation (as opposed to those
owned by franchisees), total sales in 1999 were $9.512 billion, and total
cost of food and packaging was $3.205 billion. What journal entries would
McDonald s make to record a $10 sale and to record the cost of food and
packaging associated with the $10 sale?
3. McDonald s reported payment of cash dividends of $264.7 million in 1999.
What journal entry was required?
4. McDonald s reported that the total income tax it owed for 1999 was $936.2
million. However, only $642.2 million in cash was paid for taxes during the
year. What compound journal entry did McDonald s make to record its in-
come tax expense for the year?
L




INTERNATIONAL CASE
Shanghai Petrochemical Company Limited
In July 1993, SHANGHAI PETROCHEMICAL COMPANY LIMITED became the
first company organized under the laws of the People s Republic of China to
publicly issue its shares on the worldwide market. Shanghai Petrochemical s
shares now trade on the stock exchanges in Shanghai, Hong Kong, and New
York. The following questions are adapted from information appearing in
Shanghai Petrochemical s 1995 annual report.
1. In 1995, Shanghai Petrochemical reported sales of 11.835 billion renminbi
(US$ 1 8.33 RMB) and cost of sales of RMB 9.016 billion. Make the nec-
essary journal entries, using renminbi as the currency.
2. In 1995, Shanghai Petrochemical declared cash dividends of RMB 851.5 mil-
lion. However, cash paid for dividends during the year was only RMB 818.8
million. Make the necessary compound journal entry to record the decla-
ration and payment of cash dividends for the year.
3. In China, a 17% value added tax (VAT) is added to the invoiced value of all
sales. This VAT is collected by the seller from the buyer and then held to
be forwarded to the government. What journal entry would Shanghai Petro-
chemical make to record the sale, on account, of crude oil with an invoice
sales value of $100 and a cost of $70?
L




ETHICS CASE
Should You Go the Extra Mile?
You work in a small convenience store. The store is very low-tech; you ring up
the sales on an old-style cash register that merely records the amount of the
sale. The store owner uses this cash register tape at the end of each day to
verify that the correct amount of cash is in the cash register drawer. On a day-
to-day basis, no other financial information is collected about store operations.
Since you started studying accounting, you have become a bit uneasy about
your job because you see many ways that store operations could be improved
through the gathering and use of financial information. Even though you are
not an expert, you are quite certain that you could help the store owner set up
an improved information system. However, you also know that this will take
extra effort on your part, with no real possibility of receiving an increase in
pay.
Should you say anything to the store owner, or should you just keep quiet
and save yourself the trouble?
127
f128 The Mechanics Of Accounting
Part 1 CEO Financial Reporting and the Accounting Cycle




L
WRITING ASSIGNMENT
Accounting Is Everywhere!
Financial accounting information is frequently used in newspaper and maga-
zine articles to provide background data on companies. Prepare a one-page re-
port on the use of financial accounting data by the press. Proceed as follows:
1. Scan the articles in a recent copy of one of the popular business periodi-
cals (such as The Wall Street Journal, Forbes, Fortune, or Business Week)
for examples of the use of financial accounting data.
2. Identify and describe three interesting examples:
Detail the nature of the accounting data used.
Outline the point that the writer is trying to make by using the partic-
ular accounting data.
L




THE DEBATE
Are Computers the Hero or the Villain?
As explained in the body of the chapter, computers have revolutionized the ac-
counting process. In addition to taking over the mundane jobs of posting and
report formatting, computers have also changed the way we think about in-
formation. When accounting was done by hand, it was not possible to match
individual sales with specific products, specific customers, the exact time of
day of the sale, the income level of the customer, the customer s favorite TV
shows and magazines, and the like. In short, computers have made it possible
to use the raw financial data to track much more than just revenues and ex-
penses. How far should the use of computers go?
Divide your group into two teams.
One team represents the computer technology group, To Infinity, and Be-
yond! Prepare a two-minute oral presentation supporting the notion that
firms have a right to use their computer database systems to gather as
much information about customers as possible, and even to sell that in-
formation to other firms. Now is the Information Age, and computers have
made it possible to easily buy and sell information just like any other com-
modity.
The other team represents Right to Privacy. Prepare a two-minute oral
presentation arguing that firms have no right to maintain databases con-
taining individual customer information. A company s information system
should relate to that company s products and processes, and customers
have the right to interact with the firm anonymously.
L




CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignment
given in Chapter 2. If you completed that spreadsheet, you have a head start
on this one.
1. Refer back to the financial statement numbers for Handyman Company for
2003 [given in part (1) of the Cumulative Spreadsheet Project assignment
in Chapter 2]. Using the balance sheet and income statement created with
those numbers, create spreadsheet cell formulas to compute and display
values for the following ratios:
a. Current ratio
b. Debt ratio
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The Mechanics Of Accounting CEO Chapter 3
The Mechanics of Accounting




c. Asset turnover
d. Return on equity
2. Determine the impact of each of the following transactions on the ratio val-
ues computed in (1). Treat each transaction independently, meaning that
before determining the impact of each new transaction, you should reset
the financial statement values to their original amounts. Each of the hypo-
thetical transactions is assumed to occur on the last day of the year.
a. Collected $20 cash from customer receivables.
b. Purchased $30 in inventory on account.
c. Purchased $100 in property, plant, and equipment. The entire amount
of the purchase was financed with a mortgage. Principal repayment for
the mortgage is due in 10 years.
d. Purchased $100 in property, plant, and equipment. The entire amount
of the purchase was financed with new stockholder investment.
e. Borrowed $20 with a short-term loan payable. The $20 was paid out as
a dividend to stockholders.
f. Received $20 as an investment from stockholders. The $20 was paid
out as a dividend to stockholders.
L




INTERNET SEARCH
McDonald s
Access MCDONALD S Web site at http://www.mcdonalds.com. Sometimes
Web addresses change, so if this McDonald s address doesn t work, access the
Web site for this textbook (http://albrecht.swcollege.com) for an updated link
to McDonald s.
Once you ve gained access to McDonald s Web site, answer the following
questions:
1. Which has more calories two hamburgers or one Big Mac?
2. How much money do you need to purchase a McDonald s franchise in the
United States? What else is required to purchase a franchise?
3. Sometimes it isn t easy to find a company s financial statements in its Web
site. Describe what you had to do to find a copy of McDonald s most re-
cent annual report.
4. What information is contained in McDonald s most recent financial press
release?
Completing the
Accounting Cycle

chapter



4
f4
learning objectives After studying this chapter, you should be able to:

prepaid expenses, and
1 Describe how accrual 5 Complete the closing
unearned revenues.
accounting allows for timely process in the accounting
reporting and a better cycle.
3 Explain the preparation of
measure of a company s the financial statements, the 7 Make adjusting entries for
6 Understand how all the
economic performance. explanatory notes, and the prepaid expenses and
steps in the accounting cycle
audit report. unearned revenues when
2 Explain the need for fit together.
the original cash amounts
adjusting entries and make
4 Perform a systematic are recorded as expenses
adjusting entries for analysis of financial
and revenues.
unrecorded receivables, statements.
unrecorded liabilities,
130 chapter f4
Completing The Accounting Cycle


tion to implementing the DuPont system
GENERAL MOTORS, the brainchild of
of evaluation and control, Sloan also for-
William Durant, was formed through the
malized the caste system among GM s dif-
acquisition of a number of preexisting car
ferent automobile lines. For example,
makers. BUICK and OLDSMOBILE were ac-
Chevrolets were targeted at the lower-
quired in 1908; CADILLAC and PONTIAC
income end of the market, while Cadillacs
(originally called OAKLAND) were added
were aimed at the higher end. Sloan was
in 1909. With so many acquisitions in
also instrumental in creating the annual rit-
those early years, General Motors financ-
ual of the car model year to encourage
ing was quickly depleted, and Durant lost
owners of older models to trade them in
control of his company. With Durant fight-
on new cars with the latest innovations.
ing to regain the reins of General Motors,
Although General Motors global mar-
the company was in such turmoil that, at
ket share has declined with stiff competition
one point, CHEVROLET MOTOR COM-
from Japanese, European (including DAIM-
PANY (another Durant creation) owned a
LERCHRYSLER), and domestic (FORD) com-
majority of GM stock. After many deals,
petitors, General Motors still sells more
Durant found himself back in charge in
cars and trucks than any other company in
1916, and Chevrolet became a subsidiary
the world. In 1999, GM sold 8.7 million ve-
of GM in 1918.
hicles, 15.8% of the worldwide total. GM
Following the end of World War I, an
also remains one of the largest private em-
economic slowdown stretched Durant s fi-
ployers in the United States, ranking sec-
nancial resources past the breaking point,
ond behind WAL-MART in the 2000 For-
and in 1920 he lost control of General Mo-
tune 500 listing (see Exhibit 4-1).
tors for good. Pierre S. du Pont, a GM in-
In addition to being the most prolific
vestor since 1914, became the company s
car maker in the world, General Motors
new president. Du Pont brought to Gen-
has the unenviable distinction of having
eral Motors the financial resources and
posted the world record largest annual net
business connections associated with his
loss. In 1992, GM reported a loss for the
own family s chemical empire. He was also
year of $23.5 billion. This record loss fol-
instrumental in instituting the du Pont
lowed losses of $2.0 billion in 1990 and
style of management and control. Imple-
setting the stage
$4.5 billion in 1991.
mented at General Motors by Alfred P.
How was General Motors able to stay
Sloan (who later went on to head GM un-
in business while reporting these huge
til 1956), this system emphasized decen-
losses? During the same period it was re-
tralized decision making; evaluations of
porting large losses on its income state-
managers of autonomous divisions were
ment, GM was reporting healthy cash from
based on reaching specific financial goals.
operations on its cash flow statement. In
This DuPont system of evaluation is dis-
fact, in 1992 (the year of the record loss),
cussed later in the chapter.
GM s positive cash from operations was
Under Sloan s leadership, General
$9.8 billion. This strong cash flow enabled
Motors became the dominant car maker in
GM to continue normal operations, pay its
the world, a position it still holds. In addi-


U.S. Companies with the Most Employees, 1999
exhibit 4-1



Company Number of Employees

Wal-Mart 1,140,000
General Motors 388,000
Ford Motor 364,550
United Parcel Service 344,000
General Electric 340,000
Sears Roebuck 326,000
IBM 307,401
McDonald˜s 300,000

Source: 2000 Fortune 500 listing available at http://www.fortune.com
131
f132 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle


suppliers, repay its loans, and maintain investor confi- won t actually have to make the cash payments related
dence even while reporting significant losses. to these benefits until the employees retire in the future.
Where did these losses come from if they weren t The benefits have already been earned, however, so they
the result of a shortfall in cash from operations? The should be reported as a cost of business now. The art of
losses came from business expenses that General Mo- accounting involves recording all business expenses
tors had incurred as part of its operations but which had both those that are paid in cash and those that involve
not yet been paid in cash. For example, the record $23.5 promises of payment in the future. As GM s $23.5 billion
billion loss was primarily due to recording the large busi- loss illustrates, those promises of future payment can re-
ness expense from postretirement medical benefits that ally add up.
have been promised to GM employees. General Motors




As the General Motors scenario illustrates, adjustments (to the raw transaction data recorded in the
accounts) usually are needed so that the financial statements will accurately reflect a company s eco-
nomic performance during the period and its economic condition as of the end of the period. This is
a part of completing the accounting cycle. In addition, certain accounts must be closed at the end
of an accounting period to prepare the records for a new accounting cycle. The nature of year-end ad-
justments, the remaining steps in the accounting cycle, and general techniques for analyzing the in-
formation contained in financial statements are discussed in this chapter.


1 ACCRUAL ACCOUNTING
Describe how accrual
In 2002, two brothers sign a contract for a consulting project. The total contract price is $20,000.
accounting allows for
timely reporting and a The brothers do most of the consulting work in 2002 and finish the job in 2003. They receive
better measure of a
a $2,000 cash payment from the contract in 2002 and receive the remaining $18,000 cash in
company s economic
2003. On December 31, 2002, the brothers prepare a 2002 income statement to use in apply-
performance.
ing for a bank loan. What amount of revenue should the brothers report for 2002?
This example illustrates why accounting is much more than merely tabulating cash receipts
and cash payments. A proper measure of the brothers economic performance in 2002 requires
estimating the value of the work completed in 2002; to report 2002 revenue as only the $2,000
cash received grossly understates the actual economic output produced during the year. In ad-
dition, the need for the year-end income statement means that the brothers can t wait until af-
ter the final contract payment is received before preparing a summary of their activities; the bank
wants the income statement now.
Accrual accounting is the process of adjusting raw transaction data into refined measures of
a firm s past economic performance and current economic condition. As the following sections
explain, this accrual process is necessary because a business requires periodic, timely financial re-
ports and accrual information better measures a firm s performance than do cash flow data.
The difficulty in using accrual accounting to generate a performance measure is represented
in Exhibit 4-2. Each horizontal bar in the exhibit represents a business deal such as the pro-
duction and sale of a car, the delivery of legal services for a specific lawsuit, or the development,
delivery, and support of a piece of software. Some deals last less than a day from start to finish,
such as when a barber provides a haircut in exchange for cash. The obligations and responsibil-
ities associated with other deals can stretch on for years. For example, when you buy a GEN-
ERAL MOTORS car, the deal is not done from your standpoint until four or five years later
after you have received all of the GM warranty services promised to you. And, from GM s stand-
point, the deal is not done until 40 or 50 years later after GM has paid the assembly-line work-
ers all of the pension benefits they earned through the labor hours spent assembling your car.
Even though the economic loose ends of some business deals extend for years, financial state-
ment users still require periodic reports about a company s operating performance. As you can
see in Exhibit 4-2, the beginning and the end of a year are arbitrary breaks in the life of an on-
going business. The job of accountants is to consider all business deals that were at least par-
132 f133
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle



The Problem of Income Measurement
exhibit 4-2




Business Deals
Business Deals




End of Year
Beginning of Year




tially completed during a year and to measure the profit associated with those deals. This profit
is then reported as net income for the year. As you can see, accrual accounting is much more
than mere bean counting.

Periodic Reporting
time-period concept The
idea that the life of a busi-
All businesses, large or small, periodically issue their financial statements so that users can make
ness is divided into distinct
sound economic decisions. Current owners, prospective investors, bankers, and others need up-
and relatively short time
to-date reports in order to compare and judge a company s financial position and operating re-
periods so that accounting
information can be timely. sults on a continuing, timely basis. They need to know the financial position of a company (from
the balance sheet), the relative success or failure of current operations (from the income state-
fiscal year An entity s re-
ment), and the nature and extent of cash flows (from the statement of cash flows).
porting year, covering a 12-
The financial picture of a company its success or failure in meeting its economic objec-
month accounting period.
tives cannot really be complete until the life of a business is over. However, managers, own-
calendar year An entity s
ers, and creditors cannot wait 10, 20, or 100 years to receive an exact accounting of a business.
reporting year, covering 12
In order to provide timely accounting information, the time-period concept divides the life of
months and ending on De-
an enterprise into distinct and relatively short (generally 12 months or less) accounting periods.
cember 31.
The 12-month accounting period is referred to as the fiscal year. When an entity closes
fyi its books on December 31, its reports are based on a calendar year.
Most large corporations, and even many small companies, issue a report to stock-
As mentioned in Chapter 2,
holders as of a fiscal year-end. As noted in Chapters 1 and 2, this annual report includes
about two-thirds of large U.S.
the primary financial statements (balance sheet, income statement, and statement of cash
companies choose December
flows) and other financial data, such as a management discussion and analysis of opera-
31 as the end of their fiscal year.
tions. Other financial reports are prepared more frequently, perhaps quarterly or monthly.
Indeed, some reports, such as sales reports for use by management, may be prepared on
a daily basis.
Although periodic reporting is vital to a firm s success, the frequency of reporting forces ac-
countants to use some data that are based on judgments and estimates. As you
Since almost all compa-
will see, the shorter the reporting period (for example, a month instead of a
nies have their financial records on com- year), the less exact are the measurements of assets and liabilities and the recog-
puter, what stops them from preparing fi- nition of revenues and expenses. Ideally, accounting judgments are made care-
fully and estimates are based on reliable evidence, but the limitations of ac-
nancial statements every day?
counting reports should be understood and kept in mind.
accrual-basis accounting A
system of accounting in
Accrual- versus Cash-Basis Accounting
which revenues and ex-
penses are recorded as they
Closely related to the time-period concept is the concept of accrual-basis accounting. This im-
are earned and incurred,
portant characteristic of the traditional accounting model simply means that revenues are rec-
not necessarily when cash
ognized (recorded) when earned without regard for when cash is received; expenses are recorded
is received or paid.
133
f134 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



business environment essay


Net Income versus Cash Flow and EVA¬ Recently, accrual accounting has been attacked
from another direction. STERN STEWART & COM-
Accountants are proud of the set of ac-
PANY has marketed an alternative measure of finan-
crual accounting rules that they have
cial performance that it claims is superior to the net
developed over the years. According to
income number computed by accountants. The Stern
accountants, when these rules are ap-
Stewart measure is called Economic Value Added, or
plied to raw cash flow data, the result-
EVA¬. Many prominent companies, including COCA-
ing net income number provides a
COLA, AT&T, and SPRINT, have paid Stern Stewart
superior measure of a company s per-
& Company for the right to use EVA¬ as an internal
formance. Some financial analysts and
performance measure. Stern Stewart & Company
many finance professors have long
claims that EVA¬ is almost 50% better than its closest
been skeptical about the value of accrual accounting.
accounting-based competitor in explaining changes
These skeptics contend that an investor is better off
in shareholder wealth.
analyzing a company using cash flow data because
Three accounting professors decided to test the
the accounting rules distort a company s reported per-
validity of these challenges to the usefulness of ac-
formance.




as incurred without regard for when they are paid. Accrual accounting requires that revenues
and expenses be assigned to their proper accounting periods, which do not necessarily coincide
with the periods in which cash is received or paid.

How do we assign revenues to particular periods? First, we must
REVENUE RECOGNITION
determine when revenues have actually been earned. The revenue recognition principle states
revenue recognition princi-
ple The idea that revenues that revenues are recorded when two main criteria have been met.
should be recorded when
1. The earnings process is substantially complete; generally, a sale has been made or services
(1) the earnings process
has been substantially com- have been performed.
pleted and (2) cash has ei-
2. Cash has been collected or collectibility is reasonably assured.
ther been collected or col-
lectibility is reasonably These two criteria ensure that both parties to the transaction have fulfilled their commit-
assured.
ment or are formally obligated to do so. In simple terms, satisfying the first criterion demon-
strates that the seller has done something; satisfying the second criterion demonstrates that the
buyer has done something. The seller generally records sales revenue when goods are shipped or
when services are performed. When this occurs, the seller has completed his or her part of the
transaction. The seller assumes, when shipment is made or services performed, that the buyer
has given a valid promise to pay (if this promise is not implied, then the seller probably will not
ship). The promise to pay, or the actual payment, would complete the buyer s part of the trans-
action. If, for example, General Motors sold and shipped $800 million of cars in 2003, but will
not receive the cash proceeds until 2004, the $800 million would still be recognized as revenue
in 2003, when it is earned and a promise of payment is received. Both of the revenue recogni-
tion principle criteria have been met. On the other hand, if General Motors is paid in 2003 for
cars to be shipped in 2004, it would not record those payments as revenues until the cars are
actually shipped.

Once a company determines which revenues should be rec-
THE MATCHING PRINCIPLE
matching principle The con-
cept that all costs and ex- ognized during a period, how does it identify the expenses incurred? The matching principle
penses incurred in generat- requires that all costs and expenses incurred to generate revenues must be recognized in the same
ing revenues must be
accounting period as the related revenues. The cost of the merchandise sold, for example, should
recognized in the same re-
be matched to the revenue derived from the sale of that merchandise during the period. Ex-
porting period as the re-
penses that cannot be matched with revenues are assigned to the accounting period in which
lated revenues.
134 f135
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle




crual accounting. Professors Biddle, Bowen, and market value. The computed adjusted R2 values
Wallace constructed statistical tests to determine were:
which performance measure accrual accounting
Net income (excluding extraordinary items) 12.8%
net income, EVA¬, or cash flow from operations is
EVA¬ 6.5%
most closely associated with the ultimate perfor-
Cash flow from operations 2.8%
mance measure, the annual change in the market
value of a company. Using data for 773 U.S. com- So, accrual accounting is still the undisputed cham-
panies for 11 years, Professors Biddle, Bowen, and pion of performance measures.
Wallace computed a statistic called adjusted R2,
which reflects the degree of association between a
Source: Gary C. Biddle, Robert M. Bowen, and James S. Wallace.
performance measure number for a given company Does EVA¬ Beat Earnings? Evidence on Associations with Stock Re-
in a given year and the company s market value turns and Firm Values, Journal of Accounting and Economics, De-
change in the same year. The higher the adjusted R2 cember 1997, p. 301.

value, the closer the association between the per-
formance measure and the company s change in




they are incurred. For example, the exact amount of electricity used to make an automobile gen-
erally cannot be determined, but since the amount used for a month or a year is known, that
amount can be matched to the revenues earned during the same period.
As shown in Exhibit 4-3, this process of matching expenses with recognized revenues de-
termines the amount of net income reported on the income statement. Net income is the most
widely used indicator of how well a company has performed during a period. The subject of in-
come determination, including revenue recognition and expense matching, is discussed more
completely in Chapters 6, 7, and 8.
To illustrate the difference between cash- and accrual-basis accounting, and to demonstrate
why accrual-basis accounting provides a more meaningful measure of income, assume that Karas
Brothers billed clients $50,500 for consulting services in 2003. By December 31, Karas had re-
ceived $22,000, with the $28,500 balance expected in 2004. During 2003, Karas paid $21,900
for various expenses. At December 31, Karas still owed $11,200 for additional expenses incurred.
These expenses will be paid during January 2004. How much income should Karas Brothers re-
port for 2003? The answer depends on whether cash-basis or accrual-basis accounting is used.
As shown on the next page, with cash-basis accounting, reported income would be $100. With
accrual-basis accounting, reported income would be $17,400.


Determining Accrual Income
exhibit 4-3

Beginning of End of
reporting period reporting period
Recognized
revenues

Net income
for period

Matched
expenses

Recognized Revenues Matched Expenses Net Income for Period
135
f136 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



Karas Brothers
Reported Income for 2003
cash-basis accounting A Cash-Basis Accounting Accrual-Basis Accounting
system of accounting in
Cash receipts . . . . . . . . . . . . . . . . . $22,000 Revenues earned . . . . . . . . . . . . . . $50,500
which transactions are
recorded and revenues and Cash disbursements . . . . . . . . . . . 21,900 Expenses incurred . . . . . . . . . . . . . 33,100
expenses are recognized Income . . . . . . . . . . . . . . . . . . . . . $00,100 Income . . . . . . . . . . . . . . . . . . . . . $17,400
only when cash is received
or paid.

How do we explain this $17 ,300 difference? Under cash-basis accounting, Karas
caution Brothers would report only $22,000 in revenue, the total amount of cash received during
2003. Similarly, the company would report only $21,900 of expenses (the amount actually
Although accrual-basis net in-
paid) during 2003. The additional $11,200 of expenses incurred but not yet paid would
come is the measure of Karas
not be reported. Using accrual-basis accounting, however, Karas earned $50,500 in rev-
Brothers economic perfor-
enues, which is the total increase in resources for the period (an increase of $22,000 in cash
mance for the year, the cash
plus $28,500 in receivables). Similarly, Karas incurred a total of $33,100 in expenses, which
flow information is useful in
should be matched with revenues earned to produce a realistic income measurement. The
evaluating the need to obtain
combined result of increasing revenues by $28,500 while increasing expenses by only
short-term loans, the ability to
$11,200 creates the $17 ,300 difference in net income ($28,500 $11,200 $17 ,300).
repay existing loans, and the
As this example shows, accrual-basis accounting provides a more accurate picture of
like. The statement of cash a company s profitability. It matches earned revenues with the expenses incurred to gen-
flows is an essential compan- erate those revenues. This helps investors, creditors, and others to better assess the oper-
ion to the accrual-basis income ating results of a company and make more informed judgments concerning its profitabil-
ity and earnings potential. Accrual-basis accounting is required by generally accepted
statement.
accounting principles (GAAP).



to summarize
Users of accounting information need timely, periodic financial reports to make
decisions. The revenue recognition and matching principles provide guidelines
for assigning the appropriate amounts of revenues and expenses to each pe-
riod under accrual accounting. Accrual-basis accounting provides a better mea-
sure of net income than does cash-basis accounting; it is therefore required by
GAAP in reporting the results of company operations.




2 ADJUSTING ENTRIES
Explain the need for
As discussed in Chapter 3, transactions generally are recorded in a journal in chronological or-
adjusting entries and make
adjusting entries for der and then posted to the ledger accounts. The entries are based on the best information avail-
unrecorded receivables,
able at the time. Although the majority of accounts are up-to-date at the end of an accounting
unrecorded liabilities,
period and their balances can be included in the financial statements, some accounts require ad-
prepaid expenses, and
unearned revenues. justment to reflect current circumstances. In general, these accounts are not updated through-
out the period because it is impractical or inconvenient to make such entries on a daily or weekly
basis. At the end of each accounting period, in order to report all asset, liability, and owners
adjusting entries Entries re-
equity amounts properly and to recognize all revenues and expenses for the period on an accrual
quired at the end of each
basis, accountants are required to make any necessary adjustments prior to preparing the finan-
accounting period to recog-
nize, on an accrual basis, cial statements. The entries that reflect these adjustments are called adjusting entries.
revenues and expenses for One difficulty with adjusting entries is that the need for an adjustment is not signaled by
the period and to report
a specific event such as the receipt of a bill or the receipt of cash from a customer. Rather, ad-
proper amounts for asset,
justing entries are recorded on the basis of an analysis of the circumstances at the close of each
liability, and owners equity
accounting period. This analysis involves just two steps:
accounts.
136 f137
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle


1. Determine whether the amounts recorded for all assets and liabilities are correct. If not,
debit or credit the appropriate asset or liability account. In short, fix the balance sheet.
2. Determine what revenue or expense adjustments are required as a result of the changes in
recorded amounts of assets and liabilities indicated in step 1. Debit or credit the appropri-
ate revenue or expense account. In short, fix the income statement.
It should be noted that these two steps are interrelated and may be reversed. That is, revenue
and expense adjustments may be considered first to fix the income statement, indicating which
asset and liability accounts need adjustment to fix the balance sheet. As you will see, each ad-
justing entry involves at least one income statement account and one balance sheet account.
T-accounts are helpful in analyzing adjusting entries and will be used in the illustrations that
follow.
The areas most commonly requiring analysis to see whether adjusting entries are needed
are:
1. Unrecorded receivables 3. Prepaid expenses
2. Unrecorded liabilities 4. Unearned revenues
As we illustrate and discuss adjusting entries, remember that the basic purpose of adjust-
ments is to make account balances current in order to report all asset, liability, and owners eq-
uity amounts properly and to recognize all revenues and expenses for the period on an accrual
basis. This is done so that the income statement and the balance sheet will reflect the proper
operating results and financial position, respectively, at the end of the accounting period.

Unrecorded Receivables
In accordance with the revenue recognition principle of accrual accounting, revenues should be
recorded when earned, regardless of when the cash is received. If revenue is earned but not yet
collected in cash, a receivable exists. To ensure that all receivables are properly reported on the
balance sheet in the correct amounts, an analysis should be made at the end of each accounting
period to see whether there are any revenues that have been earned but have not yet been col-
lected or recorded. These unrecorded receivables are earned and represent amounts that are re-
unrecorded receivables
Revenues earned during a ceivable in the future; therefore, they should be recognized as assets.
period that have not been
To illustrate, we will pick up with the landscaping business we started in Chapter 3. Recall
recorded by the end of that
that we mow lawns, pull weeds, plant shrubs, and perform other related services. We are able to
period.
provide these services year round because we live in a region with a very mild climate. Our com-
pany reports on a calendar-year basis and has determined the following on December 31, 2003:
On November 1, we entered into a year-long contract with an apart-
ment complex to provide general landscaping services each week and
bill the customer every three months. The terms of the contract state
that we will earn $400 per month. As of December 31, Lawn Care Rev-
enue of $800 ($400 for November and $400 for December) has not
been recorded and will not be received until the end of January 2004.
No entry has been made with regard to the contract.
As of year-end, no asset has been recorded, but an $800 receivable exists ($400 2), be-
cause two months worth of revenue has been earned. To record this receivable, we must debit
(increase) the asset Accounts Receivable for $800. With the debit, we have accomplished step 1
by fixing the balance sheet with regard to this transaction. Step 2 requires that we use the other
half of the adjusting entry, the credit of $800, to fix the income statement. We know that the
credit must be to a revenue or an expense account, and the nature of the transaction suggests
that we should credit Lawn Care Revenue for $800. The adjusting entry is:

Dec. 31 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Lawn Care Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
To record earned revenue not yet received.
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Financial Reporting and the Accounting Cycle


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