Principles of Accounting I PDF

PRINCIPLES OF ACCOUNTING I BRIEF CONTENTS Chapter 1 Accounting Information and Decision 3 Making Chapter 2 56 The Recording Process Chapter 3 116 Adjusting the Accounts Chapter 4 Completing the Accounting Cycle...

PRINCIPLES OF ACCOUNTING I BRIEF CONTENTS Chapter 1 Accounting Information and Decision 3 Making Chapter 2 56 The Recording Process Chapter 3 116 Adjusting the Accounts Chapter 4 Completing the Accounting Cycle 165 Closing and Correcting Entries |Page1  Chapter 1 Accounting Information and Decision Making |Page2  Chapter 1 Accounting Information and Decision Making Learning Objectives After studying this chapter, you should be able to: 1. Explain the nature of accounting and its main functions. 2. Identify the users and uses of accounting information. 3. Explain generally accepted accounting principles. 4. Explain the main assumptions of accounting. 5. State the accounting equation and define its components. 6. Analyze the effects of business transactions on the accounting equation. 7. Understand the four financial statements and how they are prepared. What is accounting? Accounting is one of the top career opportunities in business. People choose accounting because they want to understand what was happening financially to their organizations. Accounting is the financial information system that provides these insights. Accounting is often called the “language of businesses”. A language is a means of social communication and involves a flow of information from one person to one or more other people. |Page3 Accounting Activities: Accounting consists of three basic activities, it identifies, records, and communicates the economic events of an organization to interested users. Let’s take a closer look at these three activities. To identify economic events, a company selects the economic events relevant to its business. Examples of economic events are the providing of goods or rendering services to the customers, and payment of wages. Once the enterprise identifies economic events, it records those events to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in dollars and cents. In recording, the enterprise also classifies and summarizes economic events. Finally, the enterprise communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, the enterprise reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, PepsiCo accumulates all sales transactions over a certain period and reports the data as one amount in the company’s financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful. A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. |Page4 Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. The accounting process includes the bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events. The users of accounting information: The information that a user of financial information needs depends upon the kinds of decisions the user makes. There are two broad groups of users of financial information: internal users and external users. Internal Users: Internal users of accounting information are those individuals inside a company who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users must answer many important questions. To answer these and other questions, internal users need detailed information on a timely basis. Managers must have financial data for planning and controlling the operations of the business entity and hence need answers to such questions as follows. How much profit is being earned? What products should be produced? What resources are available? What is the most efficient production process? |Page5  How much does it cost to reduce carbon emissions from the production process? What will be the effect of increasing or decreasing selling prices? Will cash be available to pay debts as they fall due? What are the benefits of purchasing an asset as opposed to leasing it? Managerial accounting provides internal reports to help users make decisions about their companies. External Users: External decision makers such as resource providers (creditors and investors), recipients of goods and services (customers) and reviewers and overseers of business entities (employers, unions, government agencies) need accounting information for making decisions concerning granting credit, investing, purchasing goods and services, and complying with tax laws and other regulatory requirements. Questions raised by external users include the following. Should I invest money in this business? Am I likely to be paid my wages? Will the business be able to repay money lent to it? What are the company’s earnings prospects? Is the business financially sound? Financial accounting provides economic and financial information for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities want to know |Page6 whether the company complies with tax laws. Regulatory agencies, such as the Securities and Exchange Commission, want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like General Motors will continue to honor product warranties and support its product lines. Labor unions want to know whether the owners can pay increased wages and benefits. Reports provided for external users include financial statements. These are often called general purpose financial statements because they provide general information for use by all external users. General purpose financial statements are designed to meet the information needs of a wide range of users who are unable to command the preparation of reports tailored to satisfy their individual specific needs for information. An accountant follows certain Accounting Principles and accounting standards in reporting financial information. Generally Accepted Accounting Principles (GAAP): The accounting profession has developed principles that are generally accepted and universally practiced. This common set of standards is called generally accepted accounting principles (GAAP). These principles indicate how to report economic events. The Cost Principle: One important accounting principle is the cost principle. The cost principle (or historical cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. For example, if the Company purchases land for $150,000, the company initially reports it in its accounting records at $150,000. But what does company do if, by the |Page7 end of the next year, the land has increased in value to $180,000? Under the cost principle it continues to report the land at $150,000. Critics contend the cost principle is misleading. They argue that market value (the value determined by the market at any time) is more useful to financial decision makers than is cost. Those who favor the cost principle counter that cost is the best measure. The reason: Cost can be easily verified; whereas market value is often subjective (it depends on who you ask). Recently, the IASB has changed some accounting rules and now requires that certain investment securities be recorded at their market value. The Basic Assumptions of Accounting: Assumptions provide a foundation for the accounting process. The main assumptions are the monetary unit assumption, the economic entity assumption, the going concern assumption, the accrual basis assumption, and the period assumption. Monetary Unit Assumption: The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the cost principle. This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company’s owner, the quality of service, and the morale of employees are not included. The reason: Companies cannot quantify this |Page8 information in money terms. Though this information is important, companies record only events that can be measured in money. Accounting Entity Assumption: An accounting entity can be any organization or unit in society. If the transactions of an entity are to be recorded, classified, and summarized into financial statements, the accountant must be able to clearly identify the boundaries of the entity being accounted for. Under the accounting entity assumption, the entity (Al Assiuty TV Repairs, for example) is considered a separate entity distinguishable from its owner and from all other entities. It is assumed that each entity controls its assets and incurs its liabilities. The records of assets, liabilities and business activities of the entity are kept separate from those of the owner of the entity as well as from those of other entities. The accounting entity may be in the form of Proprietorship, Partnership or Corporation: A business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. Small service-type businesses (beauty salons, auto repair shops, farms, small retail stores, and clothing stores) are often proprietorships. - Usually only a relatively small amount of money (capital) is necessary to start in business as a proprietorship. - The owner (proprietor) receives any profits, suffers any losses, and - The owner is personally liable for all debts of the business. |Page9  There is no legal distinction between the business as an economic unit and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner. Partnership: A business owned by two or more persons associated as partners is a partnership. In most respects a partnership is like a proprietorship except that: - More than one owner is involved. - A partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. - Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants). Corporation: A business organized as a separate legal entity under state corporation law and having ownership divided into transferable shares of stock. - The holders of the shares (stockholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. - Stockholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with | P a g e 10  which ownership can change adds to the attractiveness of investing in a corporation. - Because ownership can be transferred without dissolving the corporation, the corporation enjoys an unlimited life. The accrual basis assumption: The financial statements of an entity are assumed to be prepared on the accrual basis. Under the accrual basis the effects of all transactions and events are recognized in accounting records when they occur, and not when the cash is received or paid. Hence, financial statements report not only on cash transactions but also on obligations to pay cash in the future and on resources that represent receivables of cash in future. It is argued that accounting on an accrual basis provides information about the transactions and other events that is most useful for decision making by. The going concern assumption: According to the going Concern assumption, financial reports are prepared normally on the assumption that the existing entity will continue to operate in the future. In other words: It is assumed that the entity will not be wound up in the near future but will continue its activities, and so the liquidation values of the entity’s assets are not generally reported. When management plans the sale or liquidation of the entity, the going concern assumption is set aside and the financial statements are prepared based on estimated sales or liquidation values. The statements should then clearly identify the basis on which asset values are determined. For decision makers to understand | P a g e 11 information contained in financial reports, it is important that they know whether assets are valued at cost, at fair values, or on some other basis. The period assumption: All entities need to report their results in the form of either profit or operating surplus. Profit is determined for period of time, such as a month or a year, in order to get comparability of results. There are also statutory requirements for entities to determine periodic profit figures, such as for taxation. This division of the life of the entity into equal time intervals is known as the period assumption. As a result of this assumption, profit determination involves a process of recognizing the income for a period and deducting the expenses incurred for that same period. The Basic Accounting Equation: The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. For example, Google has total assets of approximately $18.4 billion. Liabilities and owner’s equity are the rights or claims against these resources. Thus, Google has $18.4 billion of claims against its $18.4 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called owner’s equity. Google has liabilities of $1.4 billion and owners’ equity of $17 billion. We can express the relationship of assets, liabilities, and owner’s equity as an equation, as shown in Illustration 1. Assets = Liabilities + Owner’s Equity Illustration 1: the basic accounting equation | P a g e 12  This relationship is the basic accounting equation. Assets must equal the sum of liabilities and owner’s equity. Liabilities appear before owner’s equity in the basic accounting equation because they are paid first if a business is liquidated. The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small proprietorship such as a corner grocery store as well as to a giant corporation such as PepsiCo. The equation provides the underlying framework for recording and summarizing economic events. Let’s look in more detail at the categories in the basic accounting equation. Assets: As noted above, assets are resources a business owns. The business uses its assets in carrying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits. In a business, that service potential or future economic benefit eventually results in cash inflows (receipts). For example, Campus Pizza owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables, chairs, cash register, oven, tableware, and, of course, cash. Liabilities: Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts: | P a g e 13  Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit from suppliers. These obligations are called accounts payable. Campus Pizza also has a note payable to First National Bank for the money borrowed to purchase the delivery truck. Campus Pizza may also have wages payable to employees and real estate taxes payable. All these persons or entities to whom Campus Pizza owes money are its creditors. Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims. Owner’s Equity: The ownership claim on total assets is owner’s equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or owners. To find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from assets. The remainder is the owner’s claim on the assets—the owner’s equity. Since the claims of creditors must be paid before ownership claims, owner’s equity is often referred to as residual equity. Increases in Owner’s Equity: In a proprietorship, owner’s investments and revenues increase owner’s equity. Investments by owner are the assets the owner puts into the business. These investments increase owner’s equity. They are recorded in a category called owner’s capital. Revenues: are the gross increase in owner’s equity resulting from business activities entered for the purpose of earning income. Generally, | P a g e 14 revenues result from selling merchandise, performing services, renting property, and lending money. Common sources of revenue are sales, fees, services, commissions, interest, dividends, royalties, and rent. Revenues usually result in an increase in an asset. They may arise from different sources and are called various names depending on the nature of the business. Campus Pizza, for instance, has two categories of sales revenues—pizza sales and beverage sales. Decreases in Owner’s Equity: In a proprietorship, owner’s drawings and expenses decrease owner’s equity. Drawings: An owner may withdraw cash or other assets for personal use. Drawings decrease owner’s equity. Expenses: are the cost of assets consumed or services used in the process of earning revenue. They are decreases in owner’s equity that result from operating the business. For example, Campus Pizza recognizes the following expenses: cost of ingredients (meat, flour, cheese, tomato paste, mushrooms, etc.); cost of beverages; wages expense; utility expense (electric, gas, and water expense); telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies expense (napkins, detergents, aprons, etc.); rent expense; interest expense; and property tax expense. In summary, owner’s equity is increased by an owner’s investments and by revenues from business operations. Owner’s equity is decreased by an owner’s withdrawals of assets and by expenses. Illustration 2 expands the basic accounting equation by showing the | P a g e 15 accounts that comprise owner’s equity. This format is referred to as the expanded accounting equation. Assets= Liabilities +Equities (owner’s capital +revenues- expenses-drawings) Using the Accounting Equation: Transactions (business transactions) are a business’s economic events recorded by accountants. Transactions may be external or internal. External transactions involve economic events between the e enterprise and some outside enterprise. For example, Campus Pizza’s purchase of cooking equipment from a supplier, payment of monthly rent to the landlord, and sale of pizzas to customers are external transactions. Internal transactions are economic events that occur entirely within one company. The use of cooking and cleaning supplies are internal transactions for Campus Pizza. Companies carry on many activities that do not represent business transactions. Examples are hiring employees, answering the telephone, talking with customers, and placing merchandise orders. Some of these activities may lead to business transactions: Employees will earn wages, and suppliers will deliver ordered merchandise. The company must analyze each event to find out if it affects the components of the accounting equation. If it does, the company will record the transaction. Each transaction must have a dual effect on the accounting equation. For example, if an asset is increased, there must be a corresponding: (1) decrease in another asset, or (2) increase in a specific liability, or (3) increase in owner’s equity. Two or more items could be affected. For example, as one asset is increased $10,000, another asset | P a g e 16 could decrease $6,000 and a liability could increase $4,000. Any change in a liability or ownership claim is subject to similar analysis. Transaction Analysis: The following examples are business transactions for a computer programming business during its first month of operations. Transaction (1): Investment by Owner. Ray Neal decides to open a computer programming service which he names Data Care. On September 1, 2020, he invests $15,000 cash in the business. This transaction results in an equal increase in assets and owner’s equity. The asset Cash increases $15,000, as does the owner’s equity, identified as R. Neal, Capital. The effect of this transaction on the basic equation is: Assets = Liabilities + Owner’s Equity R. Neal, Cash = Capital (1) $15,000 $15,000 Observe that the equality of the accounting equation has been maintained. Note that the investments by the owner do not represent revenues, and they are excluded in determining net income. Therefore it is necessary to make clear that the increase is an investment (increasing R. Neal, Capital) rather than revenue. Transaction (2): Purchase of Equipment for Cash. Data Care purchases computer equipment for $7,000 cash. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes: Cash decreases $7,000, and the asset Equipment | P a g e 17  increases $7,000. The specific effect of this transaction and the cumulative effect of the first two transactions are: Owner’s Assets = Liabilities + Equity R. Neal, Cash + Equipment = Capital $15,000 $15,000 (2) -7,000 +$7,000 $ 8,000 + $7,000 = $15,000 $15,000 Observe that total assets are still $15,000. Neal’s equity also remains at $15,000, the amount of his original investment. Transaction (3). Purchase of Supplies on Credit. Data Care purchases for $1,600 from Acme Supply Company computer paper and other supplies expected to last several months. Acme agrees to allow Data Care to pay this bill in October. This transaction is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using the paper and supplies, and liabilities increase by the amount due Acme Company. The asset Supplies increases $1,600, and the liability Accounts Payable increases by the same amount. The effect on the equation is: | P a g e 18  Assets = Liabilities + Owner’s Equity Accounts R. Neal, Cash + Supplies + Equipment = Payable + Capital Old Bal. $8,000 $7,000 $15,000 (3) +$1,600 +$1,600 New Bal. $8,000 + $1,600 + $7,000 = $1,600 + $15,000 $16,600 $16,600 Total assets are now $16,600. This total is matched by a $1,600 creditor’s claim and a $15,000 ownership claim. Transaction (4). Services Provided for Cash. Data Care receives $1,200 cash from customers for programming services it has provided. This transaction represents Soft byte's principal revenue-producing activity. Recall that revenue increases owner’s equity. In this transaction, Cash increases $1,200, and revenues (specifically, Service Revenue) increase $1,200. The new balances in the equation are: Assets = Liabilities + Owner’s Equity Accounts R. Neal, Cash + Supplies + Equipment = Payable + Capital + Revenues Old Bal. $8,000 $1,600 $7,000 $1,600 $15,000 (4) +$1,200 +$1,200 New Bal. $9,200 + $1,600 + $7,000 = $1,600 + $15,000 + $1,200 $17,800 $17,800 | P a g e 19  The two sides of the equation balance at $17,800. Service Revenue is included in determining Data Care's net income. Note that we do not have room to give details for each individual revenue and expense account in this illustration. Thus, revenues (and expenses when we get to them) are summarized under one column heading for Revenues and one for Expenses. However, it is important to keep track of the category (account) titles affected (e.g., Service Revenue) as they will be needed when we prepare financial statements later in the chapter. Transaction (5): Purchase of Advertising on Credit. Data Care receives a bill for $250 from the Daily News for advertising but postpones payment until a later date. This transaction results in an increase in liabilities and a decrease in owner’s equity. The specific categories involved are Accounts Payable and expenses (specifically, Advertising Expense). The effect on the equation is: Assets = Liabilities + Owner’s Equity Accounts R. Neal, Cash + Supplies + Equipment = Payable + Capital + Revenues - Expenses Old Bal. $9,200 $1,600 $7,000 $1,600 $15,000 $1,200 (5) +.250 -$250 New Bal. $9,200 $1,600 $7,000 = $1,850 + $15,000 + $1,200 - $250 $17,800 $17,800 The two sides of the equation still balance at $17,800. Owner’s equity decreases when Data Care incurs the expense. Expenses are not always paid in cash at the time they are incurred. When Data Care pays later, the liability Accounts Payable will decrease, and the asset Cash will decrease. The cost of advertising is an expense (rather than an asset) because the company has used the benefits. Advertising Expense is included in determining net income. | P a g e 20  Transaction (6): Services Provided for Cash and Credit. Data Care provides $3,500 of programming services for customers. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on account. This transaction results in an equal increase in assets and owner’s equity. Three specific items are affected: Cash increases $1,500; Accounts Receivable increases $2,000; and Service Revenue increases $3,500. The new balances are as follows. Assets = Liabilities + Owner’s Equity Accounts Accounts R. Neal, Cash + Receivable + Supplies + Equipment = Payable + Capital + Revenues - Expenses Old Bal. $9,200 $1,600 $7,000 $1,850 $15,000 $1,200 $250 (6) +1,500 +$2,000 +3,500 New Bal. $10,700 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $250 $21,300 $21,300 Data Care earns revenues when it provides the service, and therefore it recognizes $3,500 in revenue. In exchange for this service, it received $1,500 in Cash and Accounts Receivable of $2,000. This Accounts Receivable represents customers’ promise to pay $2,000 to Data Care in the future. When it later receives collections on account, Data Care will increase Cash and will decrease Accounts Receivable. Transaction (7): Payment of Expenses. Data Care pays the following Expenses in cash for September: store rent $600, salaries of employees $900, and utilities $200. These payments result in an equal decrease in assets and expenses. Cash decreases $1,700, and | P a g e 21 the specific expense categories (Rent Expense, Salaries Expense, and Utility Expense) decrease owner’s equity by the same amount. The effect of these payments on the equation is: Assets = Liabilities + Owner’s Equity Accounts Accounts R. Neal, Cash + Receivable + Supplies + Equipment = Payable + Capital + Revenues - Expenses Old Bal. $10,700 $2,000 $1,600 $7,000 $1,850 $15,000 $4,700 $ 250 (7) -1,700 -600 -900 -200 New Bal. $9,000 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $1,950 $19,600 $19,600 The two sides of the equation now balance at $19,600. Three lines in the analysis indicate the different types of expenses that have been incurred. | P a g e 22  Transaction (8). Payment of Accounts Payable. Data Care pays its $250 Daily News bill in cash. The company previously recorded the bill as an increase in Accounts Payable and a decrease in owner’s equity. This payment “on account” decreases the asset Cash by $250 and also decreases the liability Accounts Payable by $250. The effect of this transaction on the equation is: Assets = Liabilities + Owner’s Equity Accounts Accounts R. Neal, Cash + Receivable + Supplies + Equipment = Payable + Capital + Revenues - Expenses Old Bal. $9,000 $2,000 $1,600 $7,000 $1,850 $15,000 $4,700 $1,950 (8) -250 -250 New Bal. $8,750 + $2,000 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 $19,350 $19,350 | P a g e 23  Observe that the payment of a liability related to an expense that has previously been recorded does not affect owner’s equity. The company recorded this expense in Transaction (5) and should not record it again. Transaction (9): Receipt of Cash on Account. Data Care receives $600 in cash from customers who had been billed for services. This does not change total assets, but it changes the composition of those assets. Cash increases $600 and Accounts Receivable decreases $600. The new balances are: Assets = Liabilities + Owner’s Equity Accounts Accounts R. Neal, Cash + Receivable + Supplies + Equipment = Payable + Capital + Revenues - Expenses Old Bal. $8,750 $2,000 $1,600 $7,000 $1,600 $15,000 $4,700 $1,950 (9) +600 -600 New Bal. $9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950 $19,350 $19,350 Note that the collection of an account receivable for services previously billed and recorded does not affect owner’s equity. Data Care already recorded this revenue in Transaction (6) and should not record it again. Transaction (10): Withdrawal of Cash by Owner. Ray Neal withdraws $1,300 in cash from the business for his personal use. This transaction results in an equal decrease in assets and owner’s equity. Both Cash and R. Neal, Capital decrease $1,300, as shown below. | P a g e 24  Assets = Liabilities + Owner’s Equity Accounts Accounts R. Neal, R. Neal, Cash + Receivable + Supplies + Equipment = Payable + Capital - Drawings + Revenues - Expenses Old Bal. $9,350 $1,400 $1,600 $7,000 $1,600 $15,000 $4,700 $1,950 (10) -$1,300 -$1,300 New Bal. $8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 - $1,300 + $4,700 - $1,950 $18,050 $18,050 Observe that the effect of a cash withdrawal by the owner is the opposite of the effect of an investment by the owner. Owner’s drawings are not expenses. Expenses are incurred for the purpose of earning revenue. Drawings do not generate revenue. They are a disinvestment. Like owner’s investment, the company excludes owner’s drawings in determining net income. Summary of Transactions Illustration 3 summarizes the September transactions of Data Care to show their cumulative effect on the basic accounting equation. It also indicates the transaction number and the specific effects of each transaction. | P a g e 25  Assets = Liabilities + Owner’s Equity Accounts Accounts R. Neal, R. Neal, Cash + Receivable + Supplies + Equipment = Payable + Capital - Drawings + Revenues - Expenses (1) +$15,000 +$15,000 (2) -7,000 +$7,000 (3) +$1,600 +$1,600 (4) +1,200 +$1,200 (5) +250 -$250 (6) +1,500 +$2,000 +$3,500 (7) -600 -600 -900 -900 -200 -200 (8) -250 -250 (9) +600 -600 (10) -1,300 -$1,300 $8,050 + $1,400 + $1,600 + +$7,000 = $1,600 + $15,000 - $1,300 + $4,700 - $1,950 $18,050 $18,050 Illustration 3 Tabular summary of Data Care transactions | P a g e 26 Illustration 3 demonstrates some significant facts: 1. Each transaction is analyzed in terms of its effect on: a- the three components of the basic accounting equation. b- specific items within each component. 2. The two sides of the equation must always be equal. | P a g e 27 Financial Statements Companies prepare four financial statements from the summarized accounting data: 1. An income statement presents the revenues and expenses and resulting net income or net loss for a specific period. 2. An owner’s equity statement summarizes the changes in owner’s equity for a specific period. 3. A balance sheet reports the assets, liabilities, and owner’s equity at a specific date. 4. A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period. These statements provide relevant financial data for internal and external users. Illustration 4 shows the financial statements of Data Care. Note that the statements are interrelated: 1. Net income of $2,750 on the income statement is added to the beginning balance of owner’s capital in the owner’s equity statement. 2. Owner’s capital of $16,450 at the end of the reporting period shown in the owner’s equity statement is reported on the balance sheet. 3. Cash of $8,050 on the balance sheet is reported on the statement of cash flows. Also, explanatory notes and supporting schedules are an integral part of every set of financial statements. We describe the essential features of each in the following sections. | P a g e 28  DATA CARE Income Statement For the Month Ended September 30, 2022 Revenues Service revenue $4,700 Expenses Salaries expense $900 Rent expense 600 Advertising expense 250 Utilities expense 200 Total expenses 1,950 Net income $2,750 DATA CARE Owner’s Equity Statement For the Month Ended September 30, 2022 R. Neal, Capital September 1 $-0- Add: Investments $15,000 Net income 2,750 17,750 17,750 Less: Drawings 1,300 R. Neal, Capital, September 30 $16,450 DATA CARE Balance Sheet September 30, 2022 Assets Cash $8,050 2 Accounts receivable 1,400 Supplies 1,600 Equipment 7,000 Total assets $18,050 Liabilities and Owner’s Equity Liabilities Accounts payable $1,600 Owner’s equity R. Neal, Capital 16,450 Total liabilities and owner’s equity $18,050 | P a g e 29  DATA CARE Statement of Cash Flows For the Month Ended September 30, 2022 Cash flows from operating activities Cash receipts from revenues $ 3,300 Cash payments for expenses (1,950) Net cash provided by operating activities 1,350 Cash flows from investing activities Purchase of equipment (7,000) Cash flows from financing activities Investments by owner $15,000 Drawings by owner (1,300) 13,700 Net increase in cash 8,050 Cash at the beginning of the period 0 Cash at the end of the period $8,050 Illustration 4 Financial statements and their interrelationships Income Statement The income statement reports the revenues and expenses for a specific period of time. (In DATA CARE’s case, this is “For the Month Ended September 30, 2022.”) DATA CARE’s income statement is prepared from the data appearing in the owner’s equity columns of Illustration 3. The income statement lists revenues first, followed by expenses. Finally, the statement shows net income (or net loss). Net income results when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Although practice varies, we have chosen in our illustrations and homework solutions to list expenses in order of magnitude. (We will consider alternative formats for the income statement in later chapters.) Note that the income statement does not include investment and withdrawal transactions between the owner and the business in measuring net income. For example, as explained earlier, Ray Neal’s withdrawal of cash from DATA CARE was not regarded as a business expense. | P a g e 30 Owner’s Equity Statement The owner’s equity statement reports the changes in owner’s equity for a specific period of time. The time period is the same as that covered by the income statement. Data for the preparation of the owner’s equity statement come from the owner’s equity columns of the tabular summary (Illustration 3) and from the income statement. The first line of the statement shows the beginning owner’s equity amount (which was zero at the start of the business). Then come the owner’s investments, net income (or loss), and the owner’s drawings. This statement indicates why owner’s equity has increased or decreased during the period. What if DATA CARE had reported a net loss in its first month? Let’s assume that during the month of September 2022, DATA CARE lost $10,000. Illustration 5 shows the presentation of a net loss in the owner’s equity statement. DATA CARE Owner’s Equity Statement For the Month Ended September 30, 2022 R. Neal, Capital September 1 $-0- Add: Investments 15,000 15,000 Less: Drawings $1,300 Net loss $10,000 11,300 R. Neal, Capital, September 30 $3,700 Illustration 5 Presentation of net loss If the owner makes any additional investments, the company reports them in the owner’s equity statement as investments. Balance Sheet DATA CARE’s balance sheet reports the assets, liabilities, and owner’s equity at a specific date (in DATA CARE’s case, September 30, 2022). The company prepares the balance sheet from the column headings of the tabular summary (Illustration 3) and the month-end data shown in its last line. Observe that the balance sheet lists assets at the top, followed by liabilities and owner’s equity. Total assets must equal total liabilities and owner’s equity. DATA CARE reports only one liability—accounts payable—in its balance sheet. In most cases, | P a g e 31 there will be more than one liability. When two or more liabilities are involved, a customary way of listing is as follows. Liabilities Notes payable $10,000 Accounts payable 63,000 Salaries payable 18,000 Total liabilities $91,000 Illustration 6 Presentation of liabilities The balance sheet is a snapshot of the company’s financial condition at a specific moment in time (usually the month-end or year-end). Statement of Cash Flows The statement of cash flows provides information on the cash receipts and payments for a specific period of time. The statement of cash flows reports (1) the cash effects of a company’s operations during a period, (2) its investing transactions, (3) its financing transactions, (4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the period. Reporting the sources, uses, and change in cash is useful because investors, creditors, and others want to know what is happening to a company’s most liquid resource. The statement of cash flows provides answers to the following simple but important questions. 1. Where did cash come from during the period? 2. What was cash used for during the period? 3. What was the change in the cash balance during the period? As shown in DATA CARE’s statement of cash flows, cash increased $8,050 during the period. Net cash flow provided from operating activities increased cash $1,350. Cash flow from investing transactions decreased cash $7,000. And cash flow from financing transactions increased cash $13,700. At this time, you need not be concerned with how these amounts are determined. | P a g e 32 Solved Examples: 1- Classify the following items as investment by owner (I), owner’s drawings (D), revenues (R), or expenses (E). Then indicate whether each item increases or decreases owner’s equity. (1) Rent Expense (3) Drawings (2) Service Revenue (4) Salaries Expense Solution 1. Rent Expense is an expense (E); it decreases owner’s equity. 2. Service Revenue is revenue (R); it increases owner’s equity. 3. Drawings is owner’s drawings (D); it decreases owner’s equity. 4. Salaries Expense is an expense (E); it decreases owner’s equity. 2- Transactions made by Assiu-Tech Co., a public accounting firm, for the month of August are shown below. Prepare a tabular analysis which shows the effects of these transactions on the expanded accounting equation. 1. The owner invested $25,000 cash in the business. 2. The company purchased $7,000 of office equipment on credit. 3. The company received $8,000 cash in exchange for services performed. 4. The company paid $850 for this month’s rent. 5. The owner withdrew $1,000 cash for personal use. Solution Assets = Liabilities + Owner’s Equity Office Accounts Owner’s Owner’s, Cash + Equipment = Payable Capital - Drawings + Revenues - Expenses 1. +$25,000 +$25,000 2. +$7,000 +$7,000 3. +8,000 +$8,000 4. -850 -850 5. -1,000 -1,000 $31,150 + $7,000 = $7,000 +$25,000 - $1,000 + $8,000 - $850 $38,150 $38,150 | P a g e 33 3- Presented below is selected information related to Al Fairoze Company at December 31, 2022. Al Fairoze reports financial information monthly. Office Equipment $10,000 Utilities Expense $ 4,000 Cash 8,000 Accounts Receivable 9,000 Service Revenue 36,000 Wages Expense 7,000 Rent Expense 11,000 Notes Payable 16,500 Accounts Payable 2,000 Drawings 5,000 (a) Determine the total assets of Al Fairoze Company on December 31, 2022. (b) Determine the net income that Al Fairoze Company reported for December 2022. (c) Determine the owner’s equity of Al Fairoze Company on December 31, 2022. Solution (a) The total assets are $27,000, comprised of Cash $8,000, Accounts Receivable $9,000, and Office Equipment $10,000. (b) Net income is $14,000, computed as follows: Revenues Service revenue $36,000 Expenses Rent expense $11,000 Wages expense 7,000 Utilities expense 4,000 Total expenses 22,000 Net income $14,000 (c) The ending owner’s equity of Al Fairoze Company is $8,500. By rewriting the accounting equation, we can compute owner’s equity as assets minus liabilities, as follows: Total assets [as computed in (a)] $27,000 Less: Liabilities Notes payable $16,500 Accounts payable 2,000 18,500 Owner’s equity $ 8,500 Note that it is not possible to determine the company’s owner’s equity in any other way, because the beginning total for owner’s equity is not provided. | P a g e 34 4- Kareem opens his own law office on July 1, 2023. During the first month of operations, the following transactions occurred. 1. Kareem invested $11,000 in cash in the law practice. 2. Paid $800 for July rent on office space. 3. Purchased office equipment on account $3,000. 4. Provided legal services to clients for cash $1,500. 5. Borrowed $700 cash from a bank on a note payable. 6. Performed legal services for client on account $2,000. 7. Paid monthly expenses: salaries $500, utilities $300, and telephone $100. 8. Kareem withdraws $1,000 cash for personal use. Instructions (a) Prepare a tabular summary of the transactions. (b) Prepare the income statement, owner’s equity statement, and balance sheet at July 31 for Kareem, Attorney. | P a g e 35 Solution (a) Assets = Liabilities + Owner’s Equity Trans- Accounts Note Accounts Kareem, Kareem, Actio Receivable + + - Drawings + Revenues - Expenses Cash + Equipment = Payable Payable + Capital n 1. +$11,000 = +$11,000 2. -800 = -800 3. +3,000 = +3,000 4. +1,500 +$1,500 5. +700 +$700 6. +$2,000 +2,000 7. -500 -500 -300 -300 -100 -100 8. -1,000 -$1,000 $10,500 + $2,000 + $3,000 = $700 + $3,000 + $11,000 - $1,000 + $3,500 - $1,700 $15,500 $15,500 | P a g e 36 (b) KAREEM ATTORNEY Income Statement Month Ended July 31, 2023 Revenues Service revenue $3,500 Expenses Rent expense $800 Salaries expense 500 Utilities expense 300 Telephone expense 100 Total expenses 1,700 Net income $1,800 | P a g e 37  KAREEM, ATTORNEY STATEMENT OF OWNER’S EQUITY Month Ended July 31, 2023 KAREEM, Capital, July 1 $0 Add: Investments $11,000 Net income 1,800 12,800 12,800 Less: Drawings 1,000 KAREEM, Capital, July 31 $11,800 KAREEM, ATTORNEY BALANCE SHEET July 31, 2023 Assets Cash $10,500 Accounts receivable 2,000 Equipment 3,000 Total assets $15,500 Liabilities and Owner’s Equity Liabilities Notes payable $700 Accounts payable 3,000 Total liabilities 3,700 Owner’s equity Kareem, Capital 11,800 Total liabilities and owner’s equity $15,500 | P a g e 38 5. Match the following terms and definitions. a. Accounts receivable c. Accounts payable b. Creditor d. Note payable _______ (1) Amounts due from customers _______ (2) Amounts owed to suppliers for goods and services purchased _______ (3) Amounts owed to bank _______ (4) Party to whom money is owed Solution 5 1. a 2. c 3. d 4. b 6. Use the accounting equation to answer the following questions. 1. West World Sails Co. has total assets of $120,000 and total liabilities of $35,000. What is owner’s equity? 2. Mercy Family Center has total assets of $225,000 and owner’s equity of $105,000. What are total liabilities? 3. Cucina Med Restaurant has total liabilities of $40,000 and owner’s equity of $95,000. What are total assets? Solution 6: 1. $120,000 – $35,000 = $85,000 owner’s equity 2. $225,000 – $105,000 = $120,000 total liabilities 3. $40,000 + $95,000 = $135,000 total assets | P a g e 39  GLOSSARY Accounting: The information system that identifies, records, and communicates the economic events of an organization to interested users. Assets: Resources a business owns. Balance sheet: A financial statement that reports the assets, liabilities, and owner’s equity at a specific date. Basic accounting equation: Assets = Liabilities + Owner’s Equity. Bookkeeping: A part of accounting that involves only the recording of economic events. Corporation: A business organized as a separate legal entity under state corporation law, having ownership divided into transferable shares of stock. Cost principle: An accounting principle that states that companies should record assets at their cost. Drawings: Withdrawal of cash or other assets from an unincorporated business for the personal use of the owner(s). Economic entity assumption: An assumption that requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. Expenses: The cost of assets consumed or services used in the process of earning revenue. Financial accounting: The field of accounting that provides economic and financial information for investors, creditors, and other external users. Generally accepted accounting principles (GAAP): Common standards that indicate how to report economic events. Income statement: A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. | P a g e 40 International Accounting Standards Board (IASB): An accounting standard- setting body that issues a c c o u n t i n g standards adopted by many countries all over the world Investments by owner: The assets an owner puts into the business. Liabilities Creditor claims on total assets. Managerial accounting: The field of accounting that provides internal reports to help users make decisions about their companies. Monetary unit assumption: An assumption stating that companies include in the accounting records only transaction data that can be expressed in terms of money. Net income: The amount by which revenues exceed expenses. Net loss: The amount by which expenses exceed revenues. Owner’s equity: The ownership claim on total assets. Owner’s equity statement: A financial statement that summarizes the changes in owner’s equity for a specific period of time. Partnership: A business owned by two or more persons as- sociated as partners. Proprietorship: A business owned by one person. Revenues: The gross increase in owner’s equity resulting from business activities entered into for the purpose of earning income. | P a g e 41 Discussion Questions: 1. Discuss the significance of the following assumptions in the preparation of an entity’s financial statements. (a) Entity assumption (b) Accrual basis assumption (c) Going concern assumption (d) Period assumption 2. “Accounting is ingrained in our society, and it is vital to our economic system.” Do you agree? Explain. 3. What uses of financial accounting information are made by (a) investors and (b) creditors? 4. Distinguish between book-keeping and accounting 5. Which of the following items are liabilities of AL Safa Jewelry Stores? (a) Cash. (b) Accounts payable. (c) Drawings. (d) Accounts receivable. (e) Supplies. (f) Equipment. 6. Indicate how the following business transactions affect the basic accounting equation. (a) Paid cash for janitorial services. (b) Purchased equipment for cash. (c) Invested cash in the business. (d) Paid accounts payable in full. 7. For the following accounts please indicate whether the normal balance is a debit or a credit: A. Sales B. Office Supplies | P a g e 42  C. Retained Earnings D. Accounts Receivable E. Prepaid Rent F. Prepaid Insurance G. Wages Payable H. Building I. Wages Expense True-False Statements: 1. Private accountants are accountants who are not employees of business enterprises. 2. The cost and fair market value of an asset are the same at the time of acquisition and in all subsequent periods. 3. A partnership must have more than one owner. 4. The economic entity assumption requires that the activities of an entity be kept separate and distinct from the activities of its owner and all other economic entities. 5. The monetary unit assumption states that transactions that can be measured in terms of money should be recorded in the accounting records. 6. To possess future service potential, an asset must have physical substance. 7. Owners' claims to total business assets take precedence over the claims of creditors because owners invest assets in the business and are liable for losses. 8. The basic accounting equation states that Assets = Liabilities. 9. At the time an asset is acquired, cost and fair value should be the same. 10. The monetary unit assumption requires that all dollar amounts be rounded to the nearest dollar. 11. The basic accounting equation is in balance when the creditor and ownership claim against the business equal the assets. 12. External transactions involve economic events between the company and some other enterprise or party. | P a g e 43 13. In the owner's equity statement, revenues are listed first, followed by expenses, and net income (or net loss). 14. The purchase of office equipment on credit increases total assets and total liabilities. 15. The primary purpose of the statement of cash flows is to provide information about the cash receipts and cash payments of a company during a period. 16. Net income for the period is determined by subtracting total expenses and drawings from total revenues. 17. The hiring of a new company president is an economic event recorded by the financial information system. 18. Management of a business enterprise is the major external user of information. 19. Financial statements are the major means of communicating accounting information to interested parties. 20. Bookkeeping and accounting are one and the same because the bookkeeping function includes the accounting process. Multiple Choice Questions: 1. Which of the following is not a step in the accounting process? a. identification. b. recording. c. verification. d. communication. 2. Which of the following statements about basic assumptions is correct? a. Basic assumptions are the same as accounting principles. b. The economic entity assumption states that there should be a particular unit of accountability. c. The monetary unit assumption enables accounting to measure employee morale. d. Partnerships are not economic entities. 3. Communication of economic events is the part of the accounting process that involves a. identifying economic events. | P a g e 44  b. quantifying transactions into dollars and cents. c. preparing accounting reports. d. recording and classifying information. 4. Which of the following events cannot be quantified into dollars and cents and recorded as an accounting transaction? a. The appointment of a new CPA firm to perform an audit. b. The purchase of a new computer. c. The sale of store equipment. d. Payment of income taxes. 5. The accounting process is correctly sequenced as a. identification, communication, recording. b. recording, communication, identification. c. identification, recording, communication. d. communication, recording, identification. 6. Bookkeeping differs from accounting in that bookkeeping primarily involves which part of the accounting process? a. Identification b. Communication c. Recording d. Analysis 7. Generally accepted accounting principles are a. income tax regulations of the Internal Revenue Service. b. standards that indicate how to report economic events. c. theories that are based on physical laws of the universe. d. principles that have been proven correct by academic researchers. 8. The cost principle requires that when assets are acquired, they be recorded at a. appraisal value. b. exchange price paid. | P a g e 45  c. selling price. d. list price. 9. The cost of an asset and its fair market value are a. never the same. b. the same when the asset is sold. c. irrelevant when the asset is used by the business in its operations. d. the same on the date of acquisition. 10. GAAP stands for: a. Generally Accepted Auditing Procedures. b. Generally Accepted Accounting Principles. c. Generally Accepted Auditing Principles. d. Generally Accepted Accounting Procedures. 11. The XYZ Company has five plants nationwide that cost $100 million. The current market value of the plants is $500 million. The plants will be recorded and reported as assets at a. $100 million. b. $600 million. c. $400 million. d. $500 million. 12. A basic assumption of accounting that requires activities of an entity be kept separate from the activities of its owner is referred to as the a. stand alone concept. b. monetary unit assumption. c. corporate form of ownership. d. economic entity assumption. 13. The basic accounting equation may be expressed as a. Assets = Equities. b. Assets + Liabilities = Owner's Equity. | P a g e 46  c. Assets = Liabilities + Owner's Equity. d. all of these. 14. If total liabilities increased by $15,000 and owner’s equity increased by $5,000 during a period of time, then total assets must change by what amount and direction during that same period? a. $20,000 decrease b. $20,000 increase c. $25,000 increase d. $30,000 increase 15. If total liabilities decreased by $15,000 and owner’s equity increased by $5,000 during a period of time, then total assets must change by what amount and direction during that same period? a. $20,000 increase b. $10,000 decrease c. $10,000 increase d. $15,000 decrease 16. As of June 30, 2022, Abu Ghaly Company has assets of $100,000 and owner’s equity of $5,000. What are the liabilities for Abu Ghaly Company as of June 30, 2022? a. $85,000 b. $90,000 c. $95,000 d. $100,000 17. Collection of a $500 Accounts Receivable: a. increases an asset $500; decreases an asset $500. b. increases an asset $500; decreases a liability $500. c. decreases a liability $500; increases owner's equity $500. d. decreases an asset $500; decreases a liability $500. | P a g e 47 18. Revenues are: a. the cost of assets consumed during the period. b. gross increases in owner's equity resulting from business activities. c. the cost of services used during the period. d. actual or expected cash outflows. 19. Financial accounting information ________. A. should be incomplete in order to confuse competitors B. should be prepared differently by each company C. provides investors guarantees about the future D. summarizes what has already occurred 20. Which of the following groups would have access to managerial accounting information? A. bankers B. investors C. competitors of the business D. managers | P a g e 48  Exercises: 1. Sarah Hodge is a self-employed piano teacher operating her business from home. She keeps her accounting records for business activities separate from her records for personal activities. On 30 June 2022, Sarah had business assets and liabilities worth $62 500 and $41 000 respectively. On 30 June 2023, Sarah had business assets and liabilities worth $56 000 and $38 000 respectively. Required (a) Assuming Sarah did not contribute to or withdraw from the business during the financial year, determine the profit/loss for the year. (b) Assuming Sarah had withdrawn $15 000 during the year, determine the profit/loss for the year. (c) Assuming Sarah had contributed $20 000 and withdrawn $12 000, prepare a statement of changes in equity for the year. 2. Use the expanded accounting equation to answer each of the following questions: (a) The liabilities of El Assiuty Company are $90,000. El Assiuty’s capital account is $150,000; drawings are $40,000; revenues, $450,000; and expenses, $320,000. What is the amount of El Assiuty Company’s total assets? (b) The total assets of Peter Company are $57,000. Peter’s capital account is $25,000; drawings are $7,000; revenues, $50,000; and expenses, $35,000. What is the amount of the company’s total liabilities? (c) The total assets of Yaser Co. are $600,000 and its liabilities are equal to two-thirds of its total assets. What is the amount of Yaser Co.’s owner’s equity? 3. Classify each of the following items as owner’s drawing (D), revenue (R), or expense (E). _______(a) Advertising expense. _______(b) Commission revenue. | P a g e 49  _______(c) Insurance expense. _______(d) Salaries expense. _______(e) Bergman, Drawing. _______(f) Rent revenue. _______(g) Utilities expense. 4. In alphabetical order below are balance sheet items for Lopez Company at December 31, 2023, Prepare a balance sheet. Accounts payable $90,000 Accounts receivable $72,500 Cash $49,000 Lopez, Capital $31,500 5. Martin Store has the following balance sheet items: Accounts payable. Cash. Accounts receivable. Salaries payable. Cleaning equipment. Notes payable. Martin, Capital. Cleaning supplies. Instructions Classify each item as an asset, liability, or owner’s equity. 6. Bebeto Compu Tech entered into the following transactions during May 2023. 1. Purchased computer terminals for $20,000 from Digital Equipment on account. 2. Paid $4,000 cash for May rent on storage space. 3. Received $15,000 cash from customers for contracts billed in April. 4. Provided computer services to Fisher Construction Company for $3,000 cash. | P a g e 50  5. Paid Northern States Power Co. $11,000 cash for energy usage in May. 6. Bebeto invested an additional $32,000 in the business. 7. Paid Digital Equipment for the terminals purchased in (1) above. 8. Incurred advertising expense for May of $1,200 on account. Instructions Indicate with the appropriate letter whether each of the transactions above results in: (a) an increase in assets and a decrease in assets. (b) an increase in assets and an increase in owner’s equity. (c) an increase in assets and an increase in liabilities. (d) a decrease in assets and a decrease in owner’s equity. (e) a decrease in assets and a decrease in liabilities. (f) an increase in liabilities and a decrease in owner’s equity. (g) an increase in owner’s equity and a decrease in liabilities. | P a g e 51 7. The following information relates to Al Farouk Co. for the year 2022. Al Farouk, Capital, January 1, 2022 $ 48,000 Advertising expense 1,800 Al Farouk, Drawing during 2022 6,000 Rent expense 10,400 Service revenue 62,500 Utilities expense 3,100 Salaries expense 30,000 Instructions: After analyzing the data, prepare an income statement and an owner’s equity statement for the year ending December 31, 2022. 8. Presented below is information related to the sole proprietorship of Omar, attorney. Legal service revenue—2022 $350,000 Total expenses—2022 211,000 Assets, January 1, 2022, 85,000 Liabilities, January 1, 2022 62,000 Assets, December 31, 2022 168,000 Liabilities, December 31, 2022 85,000 Drawings—2022 ?????? Instructions prepare the 2022 owner’s equity statement for Omar’s legal practice. 9. Classify each item as an asset, liability, common stock, revenue, or expense. a. Notes Payable b. Cost of renting property. | P a g e 52  c. Amounts owed to suppliers. d. Issuance of ownership shares. e. Truck purchased. f. Amount earned from performing service. 10. Match each item with the appropriate concept or principle: 1. Belief that a company will continue to operate for the foreseeable future. 2.. The reporting of all information that would make a difference to financial statement users. 3. The practice of preparing financial statements at regular intervals. 4. Belief that items should be reported on the balance sheet at the price that was paid to acquire the item. 5. Reporting only those things that can be measured in dollars. 11. A business has the following transactions: The business is started by receiving cash from an investor in exchange for common stock $20,000 The business purchases supplies on account $500 The business purchases furniture on account $2,000 The business renders services to various clients on account totaling $9,000 The business pays salaries $2,000 The business pays this month’s rent $3,000 The business pays for the supplies purchased on account. The business collects from one of its clients for services rendered earlier in the month $1,500. What is total income for the month? 12. Brandon Computer Timeshare Company entered into the following transactions during May 2023. 1. Purchased computer terminals for $20,000 from Digital Equipment on | P a g e 53  account. 2. Paid $4,000 cash for May rent on storage space. 3. Received $15,000 cash from customers for contracts billed in April. 4. Provided computer services to Fisher Construction Company for $3,000 cash. 5. Paid Northern States Power Co. $11,000 cash for energy usage in May. 6. Brandon invested an additional $32,000 in the business. 7. Paid Digital Equipment for the terminals purchased in (1) above. 8. Incurred advertising expense for May of $1,200 on account. Instructions Indicate with the appropriate letter whether each of the transactions above results in: (a) an increase in assets and a decrease in assets. (b) an increase in assets and an increase in owner’s equity. (c) an increase in assets and an increase in liabilities. (d) a decrease in assets and a decrease in owner’s equity. (e) a decrease in assets and a decrease in liabilities. (f) an increase in liabilities and a decrease in owner’s equity. (g) an increase in owner’s equity and a decrease in liabilities. 13. Cairo Company performs the following accounting tasks during the year. Analyzing and interpreting information. Classifying economic events. Explaining uses, meaning, and limitations of data. Keeping a systematic chronological diary of events. Measuring events in dollars and cents. Preparing accounting reports. Reporting information in a standard format. Selecting economic activities relevant to the company. | P a g e 54  Summarizing economic events Accounting is “an information system that identifies, records, and communicates the economic events of an organization to interested users.” Instructions Categorize the accounting tasks performed by Urlacher as relating to either the identification (I), recording (R), or communication (C) aspects of accounting. | P a g e 55  Chapter 2 The Recording Process | P a g e 56  Chapter 2 The Recording Process Learning Objectives: After studying this chapter, you should be able to: 1. describe the accounting cycle used to record, classify and summarize transactions. 2. Define debits and credits and explain their use in recording business transactions. 3. Identify the basic steps in the recording process. 4. Explain what a journal is and how it helps in the recording process. 5. Explain what a ledger is and how it helps in the recording process. 6. Explain what posting is and how it helps in the recording process. 7. Discuss the purpose of a trial balance and how to prepare it. The Accounting Cycle: During the life of the entity, financial statement users must regularly make decisions regarding the entity, and therefore must be provided with timely information on a periodic basis. To report on the periodic progress of the entity over time, its life is divided into arbitrary time periods of equal length called accounting periods. Accounting periods need to be of equal length so that statement users can compare financial performance in the current period with that of previous periods. During each period, steps and procedures are followed within the accounting function to ensure that all transactions are properly recorded, and records are kept ensuring that the financial statements can be prepared at the end of the accounting period. These steps and procedures, culminating in the preparation of financial statements, are referred to as the accounting cycle. | P a g e 57 The Account: An account is an accounting record of increases and decreases in a specific asset, liability, or owner’s equity item. For example, Data Care (the company discussed in Chapter one) would have separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, and Salaries Expense. In its simplest form, an account consists of three parts: (1) a title, (2) a left or debit side, and (3) a right or credit side. Because the format of an account resembles the letter T, we refer to it as a T account. Illustration 1 shows the basic form of an account. Title of Account Left or debit Left or debit Dr. side side Cr. Illustration 1 Basic form of account The ( T )account helps make clear the effects of transactions on individual accounts. We will use it often throughout this book to explain basic accounting relationships. Debits and Credits The terms debit and credit are directional signals: Debit indicates left, and credit indicates right. They indicate which side of a T account a number will be recorded on. Entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account. We commonly abbreviate debit as Dr. and credit as Cr. Having debits on the left and credits on the right is an accounting custom, or rule. This rule applies to all accounts. Illustration 2 shows the recording of debits and credits in an account for the cash | P a g e 58 transactions of Data Care. The data are taken from the cash column of the tabular summary in Illustration (Chapter 1), which is reproduced here. Tabular Summary Account Form Cash Cash $15,000 (Debits) 15,000 (Credits) 7,000 –7,000 1,200 1,700 1,200 1,500 250 1,500 600 1,300 –1,700 Balance 8,050 –250 (Debit) 600 –1,300 $ 8,050 Illustration 2 Tabular summary compared to account form In the tabular summary, every positive item represents Data Care’s receipt of cash; every negative amount represents a payment of cash. In the account form we record the increases in cash as debits, and the decreases in cash as credits. Having increases on one side and decreases on the other helps determine the total of each side as well as the overall account balance. The balance, a debit of $8,050, indicates that Data Care has had $8,050 more increases than decreases in cash. When the totals of the two sides of an account are compared, an account will have a debit balance if the total of the debit amounts exceeds the credits. An account will have a credit balance if the credit amounts exceed the debits. The account in Illustration 2 has a debit balance. Debit and Credit Procedure | P a g e 59  In Chapter 1 you learned the effect of a transaction on the basic accounting equation. Remember that each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits in the accounts. The equality of debits and credits provides the basis for the double- entry system of recording transactions. In the double-entry system the dual (two-sided) effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. It also helps ensure the accuracy of the recorded amounts. The sum of all the debits to the accounts must equal the sum of all the credits. The double-entry system for determining the equality of the accounting equation is much more efficient than the plus/minus procedure used in Chapter 1. On the following pages, we will illustrate debit and credit procedures in the double-entry system. Assets and Liabilities. Both sides of the accounting equation (Assets Liabilities Owner’s equity) must be equal. It follows, then, that we must record increases and decreases in assets opposite from each other. In Illustration 2, Data Care entered increases in cash (an asset) on the left side, and decreases in cash on the right side. Therefore, we must enter increases in liabilities on the right or credit side, and decreases in liabilities on the left or debit side. Illustration 3 summarizes the effects that debits and credits have on assets and liabilities. Debits Credits Increase assets Decrease assets Decrease Increase liabilities liabilities Illustration 3 Debit and credit effects— assets and liabilities Debits to a specific asset account should exceed the credits to that account. Credits to a liability account should exceed debits to that account. The normal balance of an | P a g e 60 account is on the side where an increase in the account is recorded. Thus, asset accounts normally show debit balances, and liability accounts normally show credit balances. Illustration 4 shows the normal balances for assets and liabilities. Assets Liabilities Debit for Credit for Debit for Credit for increase decrease decrease increase Normal Normal balance balance Illustration 4 Normal balances—assets and liabilities Knowing the normal balance in an account may help you trace errors. For example, a credit balance in an asset account such as Land would indicate a recording error. Similarly, a debit balance in a liability account such as Wages Payable would indicate an error. Occasionally, though, an abnormal balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance (i.e., written a “bad” check). (Notice that when we are referring to a specific account, we capitalize its name.) Owner’s Equity: as mentioned in previous Chapter indicated, owner’s investments and revenues increase owner’s equity. Owner’s drawings and expenses decrease owner’s equity. Companies keep accounts for each of these types of transactions. Owner’s Capital. Investments by owners are credited to the Owner’s Capital account. Credits increase this account, and debits decrease it. When an owner invests cash in the business, the company debits (increases) Cash and credits (increases) Owner’s Capital. When the owner’s investment in the business is reduced, Owner’s Capital is debited (decreased). | P a g e 61  Illustration 5 shows the rules of debit and credit for the Owner’s Capital account. Debits Credits Decrease Owner’s Increase Owner’s Capital Capital Illustration 5 Debit and credit effects— Owner’s Capital We can diagram the normal balance in Owner’s Capital as follows. Owner’s Capital Debit Credit for for decreas increase e Normal balance Illustration 6 Normal balance—Owner’s Capital Owner’s Drawing. An owner may withdraw cash or other assets for personal use. Withdrawals could be debited directly to Owner’s Capital to indicate a decrease in owner’s equity. However, it is preferable to use a separate account, called Owner’s Drawing. This separate account makes it easier to determine total withdrawals for each accounting period. Owner’s Drawing is increased by debits and decreased by credits. Normally, the drawing account will have a debit balance. Illustration 7 shows the rules of debit and credit for the drawing account. | P a g e 62  Debits Credits Increase Owner’s Decrease Owner’s Drawing Drawing Illustration 7 Debit and credit effects—Owner’s Drawing We can diagram the normal balance as follows. Owner’s Drawing Debit for Credit for increase decrease Normal balance Illustration 8 Normal balance—Owner’s Drawing The Drawing account decreases owner’s equity. It is not an income statement account like revenues and expenses. Revenues and Expenses: The purpose of earning revenues is to benefit the owner(s) of the business. When a company earns revenues, owner’s equity increases. Therefore, the effect of debits and credits on revenue accounts is the same as their effect on Owner’s Capital. That is, revenue accounts are increased by credits and decreased by debits. Expenses have the opposite effect: Expenses decrease owner’s equity. Since expenses decrease net income, and revenues increase it, it is logical that the increase and decrease sides of expense accounts should be the reverse of revenue accounts. Thus, expense accounts are increased by debits and decreased by credits. Illustration 9 shows the rules of debits and credits for revenues and expenses. | P a g e 63  Debits Credits Decrease Increase revenues revenues Increase expenses Decrease expenses Illustration 9 Debit and credit effects— revenues and expenses Credits to revenue accounts should exceed debits. Debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. We can diagram the normal balances as follows. Revenues Expenses Debit Credit Debit Credit for for for for decrease increase increase decrease Normal Normal balance balance Illustration 10 Normal balances—revenues and expenses Summary of Debit/Credit Rules Illustration 11 shows a summary of the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of the double- entry system: | P a g e 64 Basic Liabiliti Equation Assets = es + Owner’s Equity Owner Owner’ ’s Expanded Asset Liabili s Drawin Reven Equation s = ties + Capital - g + ues - Expenses Debit / Credit Effects D C Dr Cr D D D C Dr Cr. Cr. Cr. r. r... r. r. r. r.. + -