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Fundamental Accounting Principles

24th edition

John J. Wild University of Wisconsin at Madison

Ken W. Shaw University of Missouri at Columbia

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To my students and family, especially Kimberly, Jonathan, Stephanie, and Trevor. To my wife Linda and children Erin, Emily, and Jacob.

FUNDAMENTAL ACCOUNTING PRINCIPLES, TWENTY-FOURTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2017, 2015, and 2013. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-1-259-91696-0 (combined bound edition) MHID 1-259-91696-0 (combined bound edition) ISBN 978-1-260-15855-7 (combined loose-leaf edition) MHID 1-260-15855-1 (combined loose-leaf edition) ISBN 978-1-260-15860-1 (principles bound edition, chapters 1-17) MHID 1-260-15860-8 (principles bound edition, chapters 1-17) ISBN 978-1-260-15861-8 (principles loose-leaf edition, chapters 1-17) MHID 1-260-15861-6 (principles loose-leaf edition, chapters 1-17)

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Compositor: Aptara®, Inc.

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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

   

Library of Congress Cataloging-in-Publication Data

Names: Wild, John J., author. | Shaw, Ken W., author. Title: Fundamental accounting principles / John J. Wild, University of  Wisconsin at Madison, Ken W. Shaw, University of Missouri at Columbia. Description: 24th edition. | Dubuque, IA : McGraw-Hill Education, [2018] |  Revised edition of Fundamental accounting principles, [2017] Identifiers: LCCN 2018016853 | ISBN 9781259916960 (alk. paper) | ISBN  1259916960 (alk. paper) | ISBN 9781260158601 (alk. paper) | ISBN  1260158608 (alk. paper) Subjects: LCSH: Accounting. Classification: LCC HF5636 .W675 2018 | DDC 657—dc23 LC record available at https://lccn.loc.gov/2018016853     The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.     mheducation.com/highered

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https://lccn.loc.gov/2018016853
http://mheducation.com/highered
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About the Authors

Courtesy of John J. Wild

JOHN J. WILD is a distinguished professor of accounting at the University of Wisconsin at Madison. He previously held appointments at Michigan State University and the University of Manchester in England. He received his BBA, MS, and PhD from the University of Wisconsin.

John teaches accounting courses at both the undergraduate and graduate levels. He has received numerous teaching honors, including the Mabel W. Chipman Excellence-in- Teaching Award and the departmental Excellence-in-Teaching Award, and he is a two-time recipient of the Teaching Excellence Award from business graduates at the University of Wisconsin. He also received the Beta Alpha Psi and Roland F. Salmonson Excellence-in- Teaching Award from Michigan State University. John has received several research honors, is a past KPMG Peat Marwick National Fellow, and is a recipient of fellowships from the American Accounting Association and the Ernst and Young Foundation.

John is an active member of the American Accounting Association and its sections. He has served on several committees of these organizations, including the Outstanding Accounting Educator Award, Wildman Award, National Program Advisory, Publications, and Research Committees. John is author of Financial Accounting, Managerial Accounting, Financial and Managerial Accounting, and College Accounting, all published by McGraw- Hill Education.

John’s research articles on accounting and analysis appear in The Accounting Review; Journal of Accounting Research; Journal of Accounting and Economics; Contemporary Accounting Research; Journal of Accounting, Auditing and Finance; Journal of Accounting and Public Policy; Accounting Horizons; and other journals. He is past associate editor of Contemporary Accounting Research and has served on several editorial boards including The Accounting Review and the Journal of Accounting and Public Policy.

In his leisure time, John enjoys hiking, sports, boating, travel, people, and spending time with family and friends.

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Using Learning Science and Data Analytics

Courtesy of Ken W. Shaw

KEN W. SHAW is an associate professor of accounting and the KPMG/Joseph A. Silvoso Distinguished Professor of Accounting at the University of Missouri. He previously was on the faculty at the University of Maryland at College Park. He has also taught in international programs at the University of Bergamo (Italy) and the University of Alicante (Spain). He received an accounting degree from Bradley University and an MBA and PhD from the University of Wisconsin. He is a Certified Public Accountant with work experience in public accounting.

Ken teaches accounting at the undergraduate and graduate levels. He has received numerous School of Accountancy, College of Business, and university-level teaching awards. He was voted the “Most Influential Professor” by four School of Accountancy graduating classes and is a two-time recipient of the O’Brien Excellence in Teaching Award. He is the advisor to his school’s chapter of the Association of Certified Fraud Examiners.

Ken is an active member of the American Accounting Association and its sections. He has served on many committees of these organizations and presented his research papers at national and regional meetings. Ken’s research appears in the Journal of Accounting Research; The Accounting Review; Contemporary Accounting Research; Journal of Financial and Quantitative Analysis; Journal of the American Taxation Association; Strategic Management Journal; Journal of Accounting, Auditing, and Finance; Journal of Financial Research; and other journals. He has served on the editorial boards of Issues in Accounting Education; Journal of Business Research; and Research in Accounting Regulation. Ken is co-author of Financial and Managerial Accounting, Managerial Accounting, and College Accounting, all published by McGraw-Hill Education.

In his leisure time, Ken enjoys tennis, cycling, music, and coaching his children’s sports teams.

Author Letter

We use data to make decisions and maximize performance. Like the mountain biker on the cover who uses data to track his progress, we used student performance data to identify content areas that can be made more direct, concise, and systematic.

Learning science reveals that students do not read large chunks of text, so we streamlined this edition to present it in a more focused, succinct, blocked format to improve student learning and retention. Our new edition delivers the same content in 115

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fewer pages. Visual aids and numerous videos offer additional learning aids. New summary Cheat Sheets conclude each chapter to visually reinforce key concepts and procedures.

Our new edition has over 1,500 videos to engage students and improve outcomes:

Concept Overview Videos—cover each chapter’s learning objectives with multimedia presentations that include Knowledge Checks to engage students and assess comprehension. Need-to-Know Demos—walk-through demonstrations of key procedures and analysis to ensure success with assignments and tests. Guided Examples (Hints)—step-by-step walk-through of assignments that mimic Quick Studies, Exercises, and General Ledger.

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Difference Makers in Teaching . . . Learning Science Learning analytics show that students learn better when material is broken into “blocks” of content. Each chapter opens with a visual preview. Learning objective numbers highlight the location of related content. Each “block” of content concludes with a Need- to-Know (NTK) to aid and reinforce student learning. Visual aids and concise, bullet-point discussions further help students learn.

New Revenue Recognition

Wild uses the popular gross method for merchandising transactions (net method is covered in an appendix). The gross method is widely used in practice and best for student success. Adjusting entries for new revenue recognition rules are included in an appendix. Assignments are clearly marked and separated. Wild is GAAP compliant.

Up-to-Date This book reflects changes in accounting for revenue recognition, investments, leases,

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and extraordinary items. It is important that students learn GAAP accounting.

Less Is More Wild has markedly fewer pages than competing books covering the same material.

The text is to the point and uses visuals to aid student learning. Bullet-point discussions and active writing aids learning. The 24th edition has 115 fewer pages than the 23rd edition—a 10% reduction!

Visual Learning

Learning analytics tell us today’s students do not read large blocks of text. Wild has adapted to student needs by having informative visual aids throughout. Many visuals and exhibits are new to this edition.

Videos

A growing number of students now learn accounting online. Wild offers over 1,500 videos designed to increase student engagement and improve outcomes. Hundreds of hint videos or Guided Examples provide a narrated, animated, step-by- step walk-through of select exercises similar to those assigned. These short presentations, which can be turned on or off by instructors, provide reinforcement when students need it most. (Exercise PowerPoints are available for instructors.) Concept Overview Videos cover each chapter’s learning objectives with narrated, animated presentations that frequently assess comprehension. Wild has concept overview presentations covering 228 Learning Objectives broken down into over 700 videos.

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Need-to-Know Demos Need-to-Know demonstrations are located at key junctures in each chapter. These demonstrations pose questions about the material just presented—content that students “need to know” to learn accounting. Accompanying solutions walk students through key procedures and analysis necessary to be successful with homework and test materials. Need-to-Know demonstrations are supplemented with narrated, animated, step-by-step walk-through videos led by an instructor and available via Connect.

Comprehensive Need-to-Know Comprehensive Need-to-Knows are problems that draw on material from the entire chapter. They include a complete solution, allowing students to review the entire problem-solving process and achieve success.

Driving Decisions Whether we prepare, analyze, or apply accounting information, one skill remains essential: decision making. To help develop good decision-making habits and to show the relevance of accounting, we use a learning framework.

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Decision Insight provides context for business decisions. Decision Ethics and Decision Maker are role-playing scenarios that show the relevance of accounting. Decision Analysis provides key tools to assess company performance.

Accounting Analytics New to this edition, Accounting Analysis assignments have students evaluate the most current financial statements from Apple, Google, and Samsung. Students compute key metrics and compare performance between companies and industry. These assignments are auto-gradable in Connect and are included after Problem Set B in the text.

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Keep It Real Research shows that students learn best when using current data from real companies. Wild uses the most current data from real companies for assignments, examples, and analysis in the text. See Chapter 17 for use of real data.

Cheat Sheets New to this edition, Cheat Sheets are provided at the end of each chapter. Cheat Sheets are roughly one page in length and include key procedures, concepts, journal entries, and formulas.

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Doing What’s Right Companies increasingly issue sustainability reports, and accountants are being asked to prepare, analyze, and audit them. Wild includes brief sections in the managerial chapters. This material focuses on the importance of sustainability within the context of accounting, including standards from the Sustainability Accounting Standards Board (SASB). Sustainability assignments cover chapter material with a social responsibility twist.

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SUPERIOR ASSIGNMENTS Connect helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. Connect grades homework automatically and gives immediate feedback.

Wild has auto-gradable and algorithmic assignments; most focus on one learning objective and are targeted at introductory students. 90% of Wild’s Quick Study, Exercise, and Problem Set A assignments are available in Connect with algorithmic options. Over 210 assignments new to this edition—all available in Connect with algorithmic options. Nearly all are Quick Studies (brief exercises) and Exercises.

NEW! Concept Overview Videos Concept Overview Videos teach each chapter’s learning objectives through an engaging multimedia presentation. These learning tools enhance the text through video, audio, and checkpoint questions that can be graded—ensuring students complete and comprehend the material. Concept Overview Videos harness the power of technology to appeal to all learning styles and are ideal in all class formats. The Concept Overview Videos replace the previous edition’s Interactive Presentations.

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General Ledger Problems General Ledger Problems offer students the ability to record financial transactions and see how these transactions flow into financial statements. Easy minimal-scroll navigation, instant “Check My Work” feedback, and fully integrated hyperlinking across tabs show how inputted data affects each stage of the accounting process. General Ledger Problems expose students to general ledger software similar to that in practice, without the expense and hassle of downloading additional software. Algorithmic versions are available. All are auto-gradable.

Applying Excel Applying Excel enables students to work select chapter problems or examples in Excel. These problems are assignable in Connect and give students instant feedback as they work through the problem in Excel. Accompanying Excel videos teach students how to use Excel and the primary functions needed to complete the assignment. Short assessments can be assigned to test student comprehension of key Excel skills.

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Excel Simulations Simulated Excel Questions, assignable within Connect, allow students to practice their Excel skills—such as basic formulas and formatting—within the context of accounting. These questions feature animated, narrated Help and Show Me tutorials (when enabled), as well as automatic feedback and grading for both students and professors. These questions differ from Applying Excel in that students work in a simulated version of Excel. Downloading the Excel application is not required to complete Simulated Excel Questions.

Guided Examples The Guided Examples (Hints) in Connect provide a narrated, animated, step-by-step walk- through of most Quick Studies, Exercises, and General Ledger Problems similar to those assigned. These short presentations can be turned on or off by instructors and provide reinforcement when students need it most.

Exercise Presentations Animated PowerPoints, created from text assignments, enable instructors to be fully prepared for in-class demonstrations. Instructors also can use these with Tegrity (in Connect) to record online lectures.

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Content Revisions Enhance Learning Instructors and students guided this edition’s revisions. Revisions include

New Cheat Sheets at each chapter-end visually reinforce key chapter concepts. More concise text covering the same content. New 24th edition has 115 fewer pages than 23rd edition. Over 210 new assignments—all available in Connect with algorithmic options. Gross method is used for merchandising transactions, reflecting practice—adjusting entries for new revenue recognition rules are set in an appendix. Many new Need-to-Know (NTK) demos and accompanying videos to reinforce learning. Revised the Investments chapter for the new standard. New assignments that focus on financial statement preparation. Many new and revised General Ledger and Excel assignments. New Accounting Analysis assignments—all available in Connect— using real-world data from Apple, Google, and Samsung. Updated videos for each learning objective in new Concept Overview Video format.

Chapter 1 Updated opener—Apple and entrepreneurial assignment. Updated salary info for accountants. Revised business entity section along with adding LLC. Updated section on FASB objectives and accounting constraints. New layout for introducing the expanded accounting equation. New layout for introducing financial statements. Updated Apple numbers for NTK 1-5. New Cheat Sheet reinforces chapter content. Updated return on assets analysis using Nike and Under Armour. Added a new Exercise assignment and Quick Study assignment. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 2 NEW opener—Fitbit and entrepreneurial assignment. New visual for process to get from transactions to financial statements. New layout on four types of accounts that determine equity. Improved presentation of “Double-Entry System” section.

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Updated Apple data for NTK 2-4. Updated debt ratio analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added three new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 3 NEW opener—Urban One and entrepreneurial assignment. Revised learning objectives and chapter preview—each type of adjusting entry is assigned its own learning objective. Updated “Recognizing Revenues and Expenses” section. New streamlined “Framework for Adjustments” section. Continued emphasis of 3-step adjusting process. Enhanced Exhibit 3.12 on summary of adjustments. Updated profit margin analysis using Visa and Mastercard. Improved layouts for Exhibits 3A.1 through 3A.5. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 4 NEW opener—Snapchat and entrepreneurial assignment. New Decision Insight on women in accounting. Shortened discussion of closing entries. Exhibit 4.5 color-coded all adjustments. Enhanced Exhibit 4.7 on steps of accounting cycle with images. Streamlined section on classified balance sheet. Updated current ratio analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 5 NEW opener—Build-A-Bear and entrepreneurial assignment. Updated introduction for servicers vs. merchandisers using Liberty Tax and Nordstrom. Revised NTK 5-1 covers basics of merchandising. Reorganized “Purchases” section to aid learning. New Decision Insight on growing number of returns for businesses.

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Enhanced entries on payment of purchases within discount period vs. after discount period. Improved discussion of entries for sales with discounts vs. sales without discounts. Color-coded Exhibit 5.12 highlights different merchandising transactions. Updated acid-test ratio and gross margin analysis using Nike and Under Armour. Appendix 5B explains adjusting entries for future sales discounts, returns, and allowances. Appendix 5C covers the net method. Appendix 5D moved to online only. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 6 NEW opener—Shake Shack and entrepreneurial assignment. New Ethical Risk on the alleged fraud of Homex. Simplified introduction to inventory costing. Shortened explanation for specific identification. Enhanced layout to explain effects of inventory errors across years. Updated inventory turnover and days’ sales in inventory analysis using Costco and Walmart. Added colored arrow lines to Exhibits 6A.3 and 6A.4 to show cost flows from purchases to sales. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 7 Updated opener—Box and entrepreneurial assignment. Revised learning objectives and chapter preview—each type of journal is assigned its own learning objective. New Decision Insight on financial impact of Pokémon Go for Nintendo. Streamlined presentation of system principles and system components. Enhanced “Basics of Special Journals” and “Subsidiary Ledgers” sections to improve learning. New simplified designs for Exhibits 7.5, 7.7, 7.9, and 7.11 to improve student comprehension. Removed discussion of sales tax and postponed it to the current liabilities chapter. New section on Data Analytics and Data Visualization. New days’ payable outstanding analysis using Costco and Walmart. New Cheat Sheet reinforces chapter content. Added five new Quick Studies.

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Added three new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 8 NEW opener—Care.com and entrepreneurial assignment. New COSO framework to guide internal control, including COSO cube. New discussion of internal control failure at Amazon that cost customers $150 million. Simplified bank statement for learning. Revised “Bank Reconciliation” section to separate bank balance adjustments and book balance adjustments. New summary image on adjustments for bank balance and for book balance. Removed collection expenses and NSF fees—most are immaterial and covered in advanced courses. Updated days’ sales uncollected analysis using Starbucks and Jack in the Box. New Cheat Sheet reinforces chapter content. Added three new Quick Studies. Added eight new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 9 NEW opener—Facebook and entrepreneurial assignment. Updated company data in Exhibit 9.1. Streamlined direct write-off method. Enhanced Exhibit 9.6 showing allowances set aside for future bad debts along with journal entries. New calendar graphic added as learning aid with Exhibit 9.12. New Excel demo to compute maturity dates. Updated accounts receivable analysis using Visa and Mastercard. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 10 NEW opener—New Glarus Brewery and entrepreneurial assignment. Updated company data in Exhibit 10.1. Added entry with Exhibit 10.3 and Exhibit 10.4. Simplified “Partial-Year Depreciation” section. Added margin table to Exhibit 10.14 as a learning aid. New Decision Insight box on extraordinary repairs to SpaceX’s reusable orbital rocket. New simple introduction to finance leases and operating leases for the new standard.

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Updated asset turnover analysis using Starbucks and Jack in the Box. Simplified Appendix 10A by postponing exchanges without commercial substance to advanced courses. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added one new Exercise. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 11 NEW opener—Pandora and entrepreneurial assignment. Updated data in Exhibit 11.2. Streamlined “Short-Term Notes Payable” section. Simplified explanation of FICA taxes. Updated payroll tax rates and explanations. Revised NTK 11-4. New W-4 form added to Appendix 11A. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 12 Updated opener—Scholly and entrepreneurial assignment. Streamlined partnership characteristics and types of organizations. Simplified graphic on business entity characteristics. Enhanced partnership formation example to emphasize partner investments are recorded at market value. Revised NTK 12-1. Shortened “Partner Withdrawal” section. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 13 NEW opener—Yelp and entrepreneurial assignment. New Decision Insight on bots investing in stocks based on erroneous news. New AT&T stock quote explanation. New graphic visually depicting cash dividend dates.

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New table summarizing differences between small stock dividends, large stock dividends, and stock splits. Updated Apple statement of equity in Exhibit 13.10. Updated PE ratio and dividend yield using Amazon, Altria, Visa, and Mastercard. Simplified book value per share explanation and computations. New Cheat Sheet reinforces chapter content. Added six new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 14 NEW opener—e.l.f. Cosmetics and entrepreneurial assignment. Updated IBM bond quote data. Simplified numbers in Exhibit 14.7. Simplified Exhibit 14.10 on premium bonds. Simplified numbers in Exhibit 14.11. Bond pricing moved to Appendix 14A. Simplified Exhibit 14.12 for teaching the note amortization schedule. Updated debt-to-equity analysis using Nike and Under Armour. New Excel computations for bond pricing in Appendix 14A. Simplified numbers in Exhibits 14B.1 and 14B.2. Revised Appendix 14C for new standard on finance leases and operating leases. New Cheat Sheet reinforces chapter content. Added five new Quick Studies. Added four new Exercises. Added four new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 15 Updated opener—Echoing Green and entrepreneurial assignment. New learning objective P4 for new category of stock investments. Revised and simplified Exhibit 15.2 for new standard on investments. Reorganized text to first explain debt securities and then stock securities. Revised trading and available-for-sale securities to cover only debt securities given the new standard. New section on stock investments with insignificant influence. New Exhibit 15.6 to describe accounting for equity securities by ownership level. Updated component-returns analysis using Costco and Walmart. Investments in international operations set online as Appendix 15A. New Cheat Sheet reinforces chapter content. Added three new Quick Studies.

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Added four new Exercises. Added two new Problems. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 16 NEW opener—Vera Bradley and entrepreneurial assignment. New box on Tesla’s cash outflows and growing market value. Slightly revised infographics on cash flows from operating, investing, and financing. Streamlined sections on analyzing the cash account and noncash accounts. New presentation to aid learning of indirect adjustments to income. Simplified T-accounts to reconstruct cash flows. Simplified reconstruction entries to help compute cash flows. Updated cash flow on total assets analysis using Nike and Under Armour. New Cheat Sheet reinforces chapter content. Added ten new Quick Studies. Added four new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 17 Updated opener—Morgan Stanley and entrepreneurial assignment. Updated data for all analyses of Apple using horizontal, vertical, and ratio analysis. Updated comparative analysis using Google and Samsung. Streamlined section on ratio analysis. Streamlined the “Analysis Reporting” section. Shortened Appendix 17A. New Cheat Sheet reinforces chapter content. Added eight new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 18 NEW opener—MoringaConnect and entrepreneurial assignment. Added discussion on role of managerial accounting for nonaccounting and nonbusiness majors. Added equation boxes for total manufacturing costs and cost of goods manufactured. New margin exhibit showing product and period cost flows. Added lists of common selling and administrative expenses. Updated and edited several exhibits for clarity. New Cheat Sheet reinforces chapter content. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global

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Analysis.

Chapter 19 NEW opener—HoopSwagg and entrepreneurial assignment. Revised discussions of manufacturing costs and link between job cost sheets and general ledger. Added graphic linking job cost sheets and general ledger accounts. Enhanced exhibit of 4-step overhead process. Added formula for computing applied overhead. New short discussion of cost-plus pricing. Added margin T-accounts and calculations for clarity. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 20 NEW opener—Azucar Ice Cream and entrepreneurial assignment. Revised discussion comparing process and job order costing systems. Added cost flow graphic. New margin graphic illustrating EUP. Revised discussion of weighted-average versus FIFO method of process costing. Revised discussion of using the process cost summary. New graphic on FIFO goods flow. Added margin T-accounts and calculations for clarity. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 21 NEW opener—Ellis Island Tropical Tea and entrepreneurial assignment. Added margin graphs of fixed, variable, and mixed costs. New Excel steps to create a line chart. Moved details of creating scatter plot to Appendix 21A, with Excel steps. Revised discussion of scatter plots. Moved details of creating a CVP chart to Appendix 21C, with Excel steps. New Cheat Sheet reinforces chapter content. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 22 NEW opener—Misfit Juicery and entrepreneurial assignment.

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Added T-accounts and steps to exhibit margins. Added numbered steps to several exhibits. Expanded discussion of cost of goods sold budgeting. New exhibit for calculation of cash paid for interest. Expanded discussion with bulleted list on use of a master budget. New Cheat Sheet reinforces chapter content. Added one new Quick Study. Added one new Exercise. New assignment on CMA exam budgeting coverage. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 23 NEW opener—Away and entrepreneurial assignment. Added graph to flexible budget exhibit. Revised discussion of flexible budget. New exhibit and discussion of computing total cost variance. Edited discussion of direct materials cost variance. Edited discussion of evaluating labor variances. Edited discussion of overhead variance reports. New exhibit for summary of variances. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 24 NEW opener—Jibu and entrepreneurial assignment. Updated Walt Disney ROI example. New Decision Analysis on cash conversion cycle. New Cheat Sheet reinforces chapter content. Added two new Quick Studies. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 25 NEW opener—Solugen and entrepreneurial assignment. Organized decision scenarios into three types: production, capacity, and pricing. Expanded discussion of product pricing. Added other pricing methods: value-based, auction-based, and dynamic. New Decision Analysis on time and materials pricing of services. New Decision Insight on blockchain technology.

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New Cheat Sheet reinforces chapter content. Added four new Quick Studies. Added one new Exercise. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Chapter 26 NEW opener—Fellow Robots and entrepreneurial assignment. New discussion of postaudit of investment decisions. Added example of investment in robotics. New Cheat Sheet reinforces chapter content. Added two new Exercises. Added new analysis assignments: Company Analysis, Comparative Analysis, and Global Analysis.

Appendix A New financial statements for Apple, Google, and Samsung.

Appendix B New Decision Maker on postponed retail pricing. Continued Excel demos for PV and FV of lump sums. Continued Excel demos for PV and FV of annuities.

Appendix C New Cheat Sheet reinforces appendix content.

Appendix D NEW appendix on lean principles and accounting. Describes lean business principles. Measures production efficiency. Illustrates how to account for product costs using lean accounting. New: 13 Discussion Questions, 14 Quick Studies, 14 Exercises, and 3 Problems.

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Acknowledgments John J. Wild, Ken W. Shaw, and McGraw-Hill Education recognize the following instructors for their valuable feedback and involvement in the development of Fundamental Accounting Principles. We are thankful for their suggestions, counsel, and encouragement. Darlene Adkins, University of Tennessee–Martin Peter Aghimien, Indiana University South Bend Janice Akao, Butler Community College Nathan Akins, Chattahoochee Technical College John Alpers, Tennessee Wesleyan University Sekhar Anantharaman, Indiana University of Pennsylvania Karen Andrews, Lewis-Clark State College Chandra D. Arthur, Cuyahoga Community College Steven Ault, Montana State University Victoria Badura, Metropolitan Community College Felicia Baldwin, City College of Chicago Reb Beatty, Anne Arundel Community College Robert Beebe, Morrisville State College George Henry Bernard, Seminole State College of Florida Cynthia Bird, Tidewater Community College, Virginia Beach Pascal Bizarro, Bowling Green State University Amy Bohrer, Tidewater Community College, Virginia Beach John Bosco, North Shore Community College Nicholas Bosco, Suffolk County Community College Jerold K. Braun, Daytona State College Doug Brown, Forsyth Technical Community College Tracy L. Bundy, University of Louisiana at Lafayette Marci Butterfield, University of Utah Ann Capion, Scott Community College Amy Cardillo, Metropolitan State University of Denver Anne Cardozo, Broward College Crystal Carlson-Myer, Indian River State College Julie Chasse, Des Moines Area Community College Patricia Chow, Grossmont College Maria Coclin, Community College of Rhode Island Michael Cohen, Lewis-Clark State College Jerilyn Collins, Herzing University Scott Collins, Penn State University, University Park

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William Conner, Tidewater Community College Erin Cornelsen, University of South Dakota Mariah Dar, John Tyler Community College Nichole Dauenhauer, Lakeland Community College Donna DeMilia, Grand Canyon University Tiffany DeRoy, University of South Alabama Susan Dickey, Motlow State Community College Erin Dischler, Milwaukee Area Technical College–West Allis Holly Dixon, State College of Florida Vicky Dominguez, College of Southern Nevada David Doyon, Southern New Hampshire University Chester Drake, Central Texas College Christopher Eller, Appalachian State University Cynthia Elliott, Southwest Tennessee Community College–Macon Kim Everett, East Carolina University Corinne Frad, Eastern Iowa Community College Krystal Gabel, Southeast Community College Harry Gallatin, Indiana State University Rena Galloway, State Fair Community College Rick Gaumer, University of Wisconsin–Green Bay Tammy Gerszewski, University of North Dakota Pradeep Ghimire, Rappahannock Community College Marc Giullian, Montana State University, Bozeman Nelson Gomez, Miami Dade College–Kendall Robert Goodwin, University of Tampa Steve G. Green, U.S. Air Force Academy Darryl Greene, Muskegon Community College Lisa Hadley, Southwest Tennessee Community College–Macon Penny Hahn, KCTCS Henderson Community College Yoon Han, Bemidji State University Becky Hancock, El Paso Community College Amie Haun, University of Tennessee–Chattanooga Michelle Hays, Kalamazoo Valley Community College Rhonda Henderson, Olive Harvey College Lora Hines, John A. Logan College Rob Hochschild, Ivy Tech Community College of Indiana–South Bend John Hoover, Volunteer State Community College Roberta Humphrey, Southeast Missouri State University Carley Hunzeker, Metro Community College, Elkhorn Kay Jackson, Tarrant County College South

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Elizabeth Jennison, Saddleback College Mary Jepperson, Saint John’s University Vicki Jobst, Benedictine University Odessa Jordan, Calhoun Community College Susan Juckett, Victoria College Amanda Kaari, Central Georgia Technical College Ramadevi Kannan, Owens Community College Jan Klaus, University of North Texas Aaron P. Knape, The University of New Orleans Cedric Knott, Henry Ford Community College Robin Knowles, Texas A&M International University Kimberly Kochanny, Central Piedmont Community College Sergey Komissarov, University of Wisconsin–La Crosse Stephanie Lareau Kroeger, Ocean County College Joseph Krupka, Lander University Tara Laken, Joliet Junior College Suzanne Lay, Colorado Mesa University Brian Lazarus, Baltimore City Community College Kevin Leifer, Long Island University, CW Post Campus Harold Levine, Los Angeles Valley College Yuebing Liu, University of Tampa Philip Lee Little, Coastal Carolina University Delores Loedel, Miracosta College Rebecca Lohmann, Southeast Missouri State University Ming Lu, Santa Monica Community College Annette C. Maddox, Georgia Highlands College Natasha Maddox, KCTCS Maysville Community and Technical College Rich Mandau, Piedmont Technical College Robert Maxwell, College of the Canyons Karen McCarron, Georgia Gwinnett College Michael McDonald, College of Southern Neveda Gwendolyn McFadden-Wade, North Carolina A&T University Allison McLeod, University of North Texas Kate McNeil, Johnson County Community College Jane Medling, Saddleback College Heidi H. Meier, Cleveland State University Tammy Metzke, Milwaukee Area Technical College Jeanine Metzler, Northampton Community College Michelle Meyer, Joliet Junior College Pam Meyer, University of Louisiana at Lafayette

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Deanne Michaelson, Pellissippi State Community College Susan Miller, County College of Morris Carmen Morgan, Oregon Tech Karen Satterfield Mozingo, Pitt Community College Haris Mujahid, South Seattle College Andrea Murowski, Brookdale Community College Jaclynn Myers, Sinclair Community College Micki Nickla, Ivy Tech Community College of Indiana–Gary Dan O’Brien, Madison College–Truax Jamie O’Brien, South Dakota State University Grace Odediran, Union County College Ashley Parker, Grand Canyon University Pamela Parker, NOVA Community College Alexandria Margaret Parrish, John Tyler Community College Reed Peoples, Austin Community College Rachel Pernia, Essex County College Brandis Phillips, North Carolina A&T University Debbie Porter, Tidewater Community College–Virginia Beach M. Jeff Quinlan, Madison Area Technical College James E. Racic, Lakeland Community College Ronald de Ramon, Rockland Community College Robert J. Rankin, Texas A&M University–Commerce Robert Rebman, Benedictine University Jenny Resnick, Santa Monica Community College DeAnn Ricketts, York Technical College Renee Rigoni, Monroe Community College Kevin Rosenberg, Southeastern Community College David Rosser, University of Texas at Arlington Michael J. Rusek, Eastern Gateway Community College Alfredo Salas, El Paso Community College Carolyn Satz, Tidewater Community College–Chesapeake Kathy Saxton, Bryant & Stratton College Wilson Seda, Lehman College–CUNY Perry Sellers, Lonestar College–North Harris James Shimko, Ferris State University Philip Slater, Forsyth Technical Community College Clayton Smith, Columbia College Chicago Patricia Smith, DePaul University Jane Stam, Onondaga Community College Natalie Strouse, Notre Dame College

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Many talented educators and professionals have worked hard to create the materials for this product, and for their efforts, we’re grateful. We extend a special thank you to our contributing and technology supplement authors, who have worked so diligently to support this product.

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efforts.

John J. Wild Ken W. Shaw

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1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 A B C

Brief Contents  Accounting in Business 2

 Analyzing and Recording Transactions 44

 Adjusting Accounts for Financial Statements 84

 Completing the Accounting Cycle 128

 Accounting for Merchandising Operations 166

 Inventories and Cost of Sales 214

 Accounting Information Systems 258

 Cash, Fraud, and Internal Control 290

 Accounting for Receivables 326

 Plant Assets, Natural Resources, and Intangibles 358

 Current Liabilities and Payroll Accounting 396

 Accounting for Partnerships 436

 Accounting for Corporations 464

 Long-Term Liabilities 500

 Investments 536

 Reporting the Statement of Cash Flows 568

 Analysis of Financial Statements 612

 Managerial Accounting Concepts and Principles 650

 Job Order Costing 686

 Process Costing 726

 Cost-Volume-Profit Analysis 772

 Master Budgets and Planning 814

 Flexible Budgets and Standard Costs 864

 Performance Measurement and Responsibility Accounting 912

 Relevant Costing for Managerial Decisions 956

 Capital Budgeting and Investment Analysis 990

 Financial Statement Information A1

 Time Value of Money B

 Activity-Based Costing C

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D CA BR

 Lean Principles and Accounting D-1

 Chart of Accounts CA

 Brief Review BR-1

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Contents Preface iv

1 Accounting in Business 2 Importance of Accounting 3

Users of Accounting Information 4 Opportunities in Accounting 4

Fundamentals of Accounting 6 Ethics—A Key Concept 6 Generally Accepted Accounting Principles 7 Conceptual Framework 7

Business Transactions and Accounting 9 Accounting Equation 10 Transaction Analysis 11 Summary of Transactions 14

Communicating with Users 15 Income Statement 15 Statement of Owner’s Equity 17 Balance Sheet 17 Statement of Cash Flows 17

Decision Analysis—Return on Assets 18 Appendix 1A Return and Risk 21 Appendix 1B Business Activities 22

2 Analyzing and Recording Transactions 44 Basis of Financial Statements 45

Source Documents 45 The “Account” Underlying Financial Statements 45 Ledger and Chart of Accounts 48

Double-Entry Accounting 49 Debits and Credits 49 Double-Entry System 49

Analyzing and Processing Transactions 51 Journalizing and Posting Transactions 51 Processing Transactions—An Example 52 Summarizing Transactions in a Ledger 57

Trial Balance 58

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Preparing a Trial Balance 58 Financial Statements Prepared from Trial Balance 59

Decision Analysis—Debt Ratio 62

3 Adjusting Accounts for Financial Statements 84 Timing and Reporting 85

The Accounting Period 85 Accrual Basis versus Cash Basis 86 Recognizing Revenues and Expenses 86 Framework for Adjustments 87

Deferral of Expense 87 Prepaid Insurance 87 Supplies 88 Other Prepaid Expenses 89 Depreciation 89

Deferral of Revenue 91 Unearned Consulting Revenue 92

Accrued Expense 93 Accrued Salaries Expense 93 Accrued Interest Expense 94 Future Cash Payment of Accrued Expenses 94

Accrued Revenue 95 Accrued Services Revenue 96 Accrued Interest Revenue 96 Future Cash Receipt of Accrued Revenues 96 Links to Financial Statements 97

Trial Balance and Financial Statements 98 Adjusted Trial Balance 98 Preparing Financial Statements 99

Decision Analysis—Profit Margin 101 Appendix 3A Alternative Accounting for Prepayments 104

4 Completing the Accounting Cycle 128 Work Sheet as a Tool 129

Benefits of a Work Sheet (Spreadsheet) 129 Use of a Work Sheet 129 Work Sheet Applications and Analysis 130

Closing Process 133 Temporary and Permanent Accounts 134 Recording Closing Entries 134

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Post-Closing Trial Balance 137 Accounting Cycle 137 Classified Balance Sheet 138

Classification Structure 138 Classification Categories 139

Decision Analysis—Current Ratio 141 Appendix 4A Reversing Entries 143

5 Accounting for Merchandising Operations 166 Merchandising Activities 167

Reporting Income for a Merchandiser 167 Reporting Inventory for a Merchandiser 168 Operating Cycle for a Merchandiser 168 Inventory Systems 168

Accounting for Merchandise Purchases 169 Purchases without Cash Discounts 169 Purchases with Cash Discounts 169 Purchases with Returns and Allowances 171 Purchases and Transportation Costs 172

Accounting for Merchandise Sales 174 Sales without Cash Discounts 174 Sales with Cash Discounts 175 Sales with Returns and Allowances 175

Adjusting and Closing for Merchandisers 177 Adjusting Entries for Merchandisers 177 Preparing Financial Statements 178 Closing Entries for Merchandisers 178 Summary of Merchandising Entries 179

More on Financial Statement Formats 177 Multiple-Step Income Statement 180 Single-Step Income Statement 181 Classified Balance Sheet 182

Decision Analysis—Acid-Test and Gross Margin Ratios 183 Appendix 5A Periodic Inventory System 187 Appendix 5B Adjusting Entries under New Revenue Recognition Rules 191 Appendix 5C Net Method for Inventory 192

6 Inventories and Cost of Sales 214 Inventory Basics 215

Determining Inventory Items 215

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Determining Inventory Costs 216 Internal Controls and Taking a Physical Count 216

Inventory Costing under a Perpetual System 217 Inventory Cost Flow Assumptions 217 Inventory Costing Illustration 218 Specific Identification 218 First-In, First-Out 219 Last-In, First-Out 219 Weighted Average 220 Financial Statement Effects of Costing Methods 221 Tax Effects of Costing Methods 222

Valuing Inventory at LCM and the Effects of Inventory Errors 224 Lower of Cost or Market 224 Financial Statement Effects of Inventory Errors 225

Decision Analysis—Inventory Turnover and Days’ Sales in Inventory 227 Appendix 6A Inventory Costing under a Periodic System 233 Appendix 6B Inventory Estimation Methods 238

7 Accounting Information Systems 258 System Principles 259 System Components 260 Special Journals and Subsidiary Ledgers 261

Basics of Special Journals 261 Subsidiary Ledgers 261

Sales Journal 263 Cash Receipts Journal 265 Purchases Journal 267 Cash Payments (Disbursements) Journal 268

General Journal Transactions 269 Technology-Based Accounting Systems 270

Technology in Accounting 270 Data Processing in Accounting 270 Computer Networks in Accounting 270 Enterprise Resource Planning Software 271 Data Analytics and Data Visualization 271 Cloud Computing 271

Decision Analysis—Days’ Payable Outstanding 271

8 Cash, Fraud, and Internal Control 290 Fraud and Internal Control 291

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Purpose of Internal Control 291 Principles of Internal Control 292 Technology, Fraud, and Internal Control 293 Limitations of Internal Control 293

Control of Cash 294 Cash, Cash Equivalents, and Liquidity 294 Cash Management 295 Control of Cash Receipts 295 Control of Cash Payments 297

Banking Activities as Controls 301 Basic Bank Services 301 Bank Statement 302 Bank Reconciliation 303

Decision Analysis—Days’ Sales Uncollected 306 Appendix 8A Documentation and Verification 308

9 Accounting for Receivables 326 Valuing Accounts Receivable 327 Direct Write-Off Method 330 Allowance Method 331 Estimating Bad Debts 334

Percent of Sales Method 334 Percent of Receivables Method 334 Aging of Receivables Method 335

Notes Receivable 337 Computing Maturity and Interest 338 Recording Notes Receivable 339 Valuing and Settling Notes 339 Disposal of Receivables 341

Decision Analysis—Accounts Receivable Turnover 341

10 Plant Assets, Natural Resources, and Intangibles 358 SECTION 1—PLANT ASSETS 359 Cost Determination 360

Machinery and Equipment 360 Buildings 360 Land Improvements 360 Land 360 Lump-Sum Purchase 361

Depreciation 361

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Factors in Computing Depreciation 361 Depreciation Methods 362 Partial-Year Depreciation 365 Change in Estimates 366 Reporting Depreciation 366

Additional Expenditures 367 Ordinary Repairs 368 Betterments and Extraordinary Repairs 368

Disposals of Plant Assets 368 Discarding Plant Assets 369 Selling Plant Assets 369

SECTION 2—NATURAL RESOURCES 371 Cost Determination and Depletion 371 Plant Assets Tied into Extracting 372

SECTION 3—INTANGIBLE ASSETS 373 Cost Determination and Amortization 373 Types of Intangibles 373

Decision Analysis—Total Asset Turnover 376 Appendix 10A Exchanging Plant Assets 379

11 Current Liabilities and Payroll Accounting 396 Known Liabilities 397

Characteristics of Liabilities 397 Examples of Known Liabilities 398 Accounts Payable 399 Sales Taxes Payable 399 Unearned Revenues 399 Short-Term Notes Payable 399

Payroll Liabilities 402 Employee Payroll and Deductions 402 Employer Payroll Taxes 403 Internal Control of Payroll 404 Multi-Period Known Liabilities 404

Estimated Liabilities 405 Health and Pension Benefits 405 Vacation Benefits 406 Bonus Plans 406 Warranty Liabilities 406 Multi-Period Estimated Liabilities 407

Contingent Liabilities 408

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Accounting for Contingent Liabilities 408 Applying Rules of Contingent Liabilities 409 Uncertainties That Are Not Contingencies 409

Decision Analysis—Times Interest Earned Ratio 409 Appendix 11A Payroll Reports, Records, and Procedures 412 Appendix 11B Corporate Income Taxes 417

12 Accounting for Partnerships 436 Partnership Formation 437

Characteristics of Partnerships 437 Organizations with Partnership Characteristics 438 Choosing a Business Form 438 Accounting for Partnership Formation 438

Dividing Partnership Income or Loss 439 Partnership Financial Statements 441

Partner Admission 442 Purchase of Partnership Interest 442 Investing Assets in a Partnership 443

Partner Withdrawal 444 No Bonus 444 Bonus to Remaining Partners 445 Bonus to Withdrawing Partner 445 Death of a Partner 445

Liquidation of a Partnership 446 No Capital Deficiency 446 Capital Deficiency 448

Decision Analysis—Partner Return on Equity 449

13 Accounting for Corporations 464 Corporate Form of Organization 465

Corporate Advantages 465 Corporate Disadvantages 465 Corporate Organization and Management 466 Corporate Stockholders 466 Corporate Stock 467

Common Stock 468 Issuing Par Value Stock 468 Issuing No-Par Value Stock 469 Issuing Stated Value Stock 469 Issuing Stock for Noncash Assets 469

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Dividends 471 Cash Dividends 470 Stock Dividends 471 Stock Splits 473 Financial Statement Effects of Dividends and Splits 473

Preferred Stock 474 Issuance of Preferred Stock 474 Dividend Preference of Preferred Stock 475 Reasons for Issuing Preferred Stock 475

Treasury Stock 477 Purchasing Treasury Stock 477 Reissuing Treasury Stock 477

Reporting of Equity 479 Statement of Retained Earnings 479 Statement of Stockholders’ Equity 480

Decision Analysis—Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share 480

14 Long-Term Liabilities 500 Basics of Bonds 501

Bond Financing 501 Bond Issuing 502 Bond Trading 502

Par Bonds 502 Discount Bonds 503

Bond Discount or Premium 503 Issuing Bonds at a Discount 504

Premium Bonds 506 Issuing Bonds at a Premium 506 Bond Retirement 508

Long-Term Notes Payable 510 Installment Notes 510 Mortgage Notes and Bonds 511

Decision Analysis—Debt Features and the Debt-to-Equity Ratio 512 Appendix 14A Bond Pricing 515 Appendix 14B Effective Interest Amortization 517 Appendix 14C Leases and Pensions 518

15 Investments 536 Basics of Investments 537

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Purposes and Types of Investments 537 Classification and Reporting 538

Debt Investments 538 Debt Investments—Basics 538

Debt Investments—Trading 539 Debt Investments—Held-to-Maturity 540 Debt Investments—Available-for-Sale 541 Equity Investments 543 Equity Investments—Insignificant Influence, Under 20% 543 Equity Investments—Significant Influence, 20% to 50% 545 Equity Investments—Controlling Influence, More Than 50% 547 Accounting Summary for Debt and Equity Investments 548 Decision Analysis—Components of Return on Total Assets 549

16 Reporting the Statement of Cash Flows 568 Basics of Cash Flow Reporting 569

Purpose of the Statement of Cash Flows 569 Importance of Cash Flows 569 Measurement of Cash Flows 569 Classification of Cash Flows 570 Noncash Investing and Financing 571 Format of the Statement of Cash Flows 571 Preparing the Statement of Cash Flows 572

Cash Flows from Operating 573 Indirect and Direct Methods of Reporting 573 Applying the Indirect Method 573 Summary of Adjustments for Indirect Method 576

Cash Flows from Investing 577 Three-Step Analysis 577 Analyzing Noncurrent Assets 577

Cash Flows from Financing 579 Three-Step Analysis 579 Analyzing Noncurrent Liabilities 579 Analyzing Equity 580 Proving Cash Balances 580

Summary Using T-Accounts 582 Decision Analysis—Cash Flow Analysis 583 Appendix 16A Spreadsheet Preparation of the Statement of Cash Flows 586 Appendix 16B Direct Method of Reporting Operating Cash Flows 588

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17 Analysis of Financial Statements 612 Basics of Analysis 613

Purpose of Analysis 613 Building Blocks of Analysis 613 Information for Analysis 614 Standards for Comparisons 614 Tools of Analysis 614

Horizontal Analysis 614 Comparative Statements 614 Trend Analysis 617

Vertical Analysis 618 Common-Size Statements 618 Common-Size Graphics 620

Ratio Analysis 622 Liquidity and Efficiency 622 Solvency 624 Profitability 625 Market Prospects 626 Summary of Ratios 627

Decision Analysis—Analysis Reporting 628 Appendix 17A Sustainable Income 631

18 Managerial Accounting Concepts and Principles 650 Managerial Accounting Basics 651

Purpose of Managerial Accounting 651 Nature of Managerial Accounting 652 Fraud and Ethics in Managerial Accounting 653 Career Paths 654

Managerial Cost Concepts 655 Types of Cost Classifications 655 Identification of Cost Classifications 657 Cost Concepts for Service Companies 657

Managerial Reporting 658 Manufacturing Costs 658 Nonmanufacturing Costs 658 Prime and Conversion Costs 659 Costs and the Balance Sheet 659 Costs and the Income Statement 659

Cost Flows and Cost of Goods Manufactured 662

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Flow of Manufacturing Activities 662 Schedule of Cost of Goods Manufactured 663 Trends in Managerial Accounting 666

Decision Analysis—Raw Materials Inventory Turnover and Days’ Sales in Raw Materials Inventory 668

19 Job Order Costing 686 Job Order Costing 687

Cost Accounting System 687 Job Order Production 687 Job Order vs. Process Operations 688 Production Activities in Job Order Costing 688 Cost Flows 689 Job Cost Sheet 689

Materials and Labor Cost 690 Materials Cost Flows and Documents 690 Labor Cost Flows and Documents 693

Overhead Cost 694 Set Predetermined Overhead Rate 695 Apply Estimated Overhead 695 Record Actual Overhead 697 Summary of Cost Flows 698 Using Job Cost Sheets for Managerial Decisions 699 Schedule of Cost of Goods Manufactured 700

Adjusting Overhead 701 Factory Overhead Account 701 Adjust Underapplied or Overapplied Overhead 701 Job Order Costing of Services 702

Decision Analysis—Pricing for Services 703

20 Process Costing 726 Process Operations 727

Organization of Process Operations 727 Comparing Process and Job Order Costing Systems 728 Equivalent Units of Production 729

Process Costing Illustration 730 Overview of GenX Company’s Process Operation 730 Pre-Step: Collect Production and Cost Data 731 Step 1: Determine Physical Flow of Units 732 Step 2: Compute Equivalent Units of Production 732 Step 3: Compute Cost per Equivalent Unit 733

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Step 4: Assign and Reconcile Costs 733 Process Cost Summary 735

Accounting for Process Costing 736 Accounting for Materials Costs 737 Accounting for Labor Costs 738 Accounting for Factory Overhead 739 Accounting for Transfers 740 Trends in Process Operations 742

Decision Analysis—Hybrid Costing System 743 Appendix 20A FIFO Method of Process Costing 747

21 Cost-Volume-Profit Analysis 772 Identifying Cost Behavior 773

Fixed Costs 774 Variable Costs 774 Graphing Fixed and Variable Costs against Volume 774 Mixed Costs 774 Step-wise Costs 775 Curvilinear Costs 776

Measuring Cost Behavior 777 Scatter Diagram 777 High-Low Method 778 Regression 778 Comparing Cost Estimation Methods 778

Contribution Margin and Break-Even Analysis 779 Contribution Margin and Its Measures 779 Break-Even Point 780 Cost-Volume-Profit Chart 782 Changes in Estimates 782

Applying Cost-Volume-Profit Analysis 783 Margin of Safety 783 Computing Income from Sales and Costs 784 Computing Sales for a Target Income 785 Evaluating Strategies 786 Sales Mix and Break-Even 787 Assumptions in Cost-Volume-Profit Analysis 789

Decision Analysis—Degree of Operating Leverage 790 Appendix 21A Using Excel for Cost Estimation 792 Appendix 21B Variable Costing and Performance Reporting 793

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Appendix 21C Preparing a CVP Chart 796

22 Master Budgets and Planning 814 Budget Process and Administration 815

Budgeting Process 815 Benefits of Budgeting 816 Budgeting and Human Behavior 816 Budget Reporting and Timing 817 Master Budget Components 817

Operating Budgets 818 Sales Budget 818 Production Budget 818 Direct Materials Budget 820 Direct Labor Budget 821 Factory Overhead Budget 822 Selling Expense Budget 823 General and Administrative Expense Budget 824

Investing and Financing Budgets 825 Capital Expenditures Budget 825 Cash Budget 825

Budgeted Financial Statements 829 Budgeted Income Statement 829 Budgeted Balance Sheet 830 Using the Master Budget 830 Budgeting for Service Companies 830

Decision Analysis—Activity-Based Budgeting 831 Appendix 22A Merchandise Purchases Budget 839

23 Flexible Budgets and Standard Costs 864 Fixed and Flexible Budgets 865

Fixed Budget Reports 866 Budget Reports for Evaluation 867 Flexible Budget Reports 867

Standard Costing 871 Standard Costs 871 Setting Standard Costs 871 Cost Variance Analysis 872

Materials and Labor Variances 874 Materials Variances 874 Labor Variances 876

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Overhead Standards and Variances 877 Flexible Overhead Budgets 877 Standard Overhead Rate 877 Computing Overhead Cost Variances 879 Standard Costing—Management Considerations 882

Decision Analysis—Sales Variances 883 Appendix 23A Expanded Overhead Variances and Standard Cost Accounting System 888

24 Performance Measurement and Responsibility Accounting 912 Responsibility Accounting 913

Performance Evaluation 913 Controllable versus Uncontrollable Costs 914 Responsibility Accounting for Cost Centers 914

Profit Centers 916 Direct and Indirect Expenses 916 Expense Allocations 917 Departmental Income Statements 918 Departmental Contribution to Overhead 921

Investment Centers 922 Return-on-Investment and Residual Income 922 Investment Center Profit Margin and Investment Turnover 924

Nonfinancial Performance Evaluation Measures 925 Balanced Scorecard 925 Transfer Pricing 927

Decision Analysis—Cash Conversion Cycle 928 Appendix 24A Cost Allocations 931 Appendix 24B Transfer Pricing 933 Appendix 24C Joint Costs and Their Allocation 934

25 Relevant Costing for Managerial Decisions 956 Decisions and Information 957

Decision Making 957 Relevant Costs and Benefits 958

Production Decisions 958 Make or Buy 959 Sell or Process Further 960 Sales Mix Selection When Resources Are Constrained 961

Capacity Decisions 963 Segment Elimination 963

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Appendix A

Appendix B Appendix C Appendix D Index Chart of Accounts Brief Review

Keep or Replace Equipment 964 Pricing Decisions 965

Normal Pricing 965 Special Offers 967

Decision Analysis—Time and Materials Pricing 969

26 Capital Budgeting and Investment Analysis 990 Capital Budgeting 991

Capital Budgeting Process 991 Capital Investment Cash Flows 992

Methods Not Using Time Value of Money 992 Payback Period 992 Accounting Rate of Return 995

Methods Using Time Value of Money 996 Net Present Value 996 Internal Rate of Return 1000 Comparison of Capital Budgeting Methods 1002 Postaudit 1002

Decision Analysis—Break-Even Time 1004 Appendix 26A Using Excel to Compute Net Present Value and Internal Rate of Return 1006

 Financial Statement Information A-1  Apple A-2  Google A-10  Samsung A-14  Time Value of Money B  Activity-Based Costing C  Lean Principles and Accounting D-1  IND-1

 CA  Managerial Analyses and Reports BR-1  Financial Reports and Tables BR-2  Selected Transactions and Relations BR-3  Fundamentals and Analyses BR-4

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Education and ©Dizzle52/Getty Images

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C1 C2

C3 C4

Page 2

1 Accounting in Business

Chapter Preview is organized by “blocks” of key content and learning objectives followed by Need-To-Know (NTK) guided video examples

Chapter Preview

ACCOUNTING USES

Purpose of accounting Accounting information users Opportunities in accounting

NTK 1-1

ETHICS AND ACCOUNTING

Ethics Generally accepted accounting principles Conceptual framework

NTK 1-2

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A1

P1

P2

A2

C1 C2 C3 C4

C5

A1 A2 A3

P1

TRANSACTION ANALYSIS

Accounting equation and its components Expanded accounting equation Transaction analysis—Illustrated

NTK 1-3 , 1-4

FINANCIAL STATEMENTS

Income statement Statement of owner’s equity Balance sheet Statement of cash flows Financial analysis

NTK 1-5

Learning Objectives are classified as conceptual, analytical, or procedural

Learning Objectives

CONCEPTUAL

Explain the purpose and importance of accounting. Identify users and uses of, and opportunities in, accounting. Explain why ethics are crucial to accounting. Explain generally accepted accounting principles and define and apply several accounting principles. Appendix 1B—Identify and describe the three major activities of organizations.

ANALYTICAL

Define and interpret the accounting equation and each of its components. Compute and interpret return on assets. Appendix 1A—Explain the relation between return and risk.

PROCEDURAL

Analyze business transactions using the accounting equation.

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P2

Page 3

Identify and prepare basic financial statements and explain how they interrelate.

Big Apple

“We ran the business . . . with just a few hundred bucks” —STEVE WOZNIAK CUPERTINO, CA—“When I designed the Apple stuff,” says Steve Wozniak, “I never thought in my life I would have enough money to fly to Hawaii or make a down payment on a house.” But some dreams do come true. Woz, along with Steve Jobs and Ron Wayne, founded Apple (Apple.com) when Woz was 25 and Jobs was 21.

©Miguel Medina/AFP/Getty Images

The young entrepreneurs faced challenges, including how to read and interpret accounting data. They also needed to finance the company, which they did by selling Woz’s HP calculator and Jobs’s Volkswagen van. The $1,300 raised helped them purchase the equipment Woz used to build the first Apple computer.

In setting up their company, the owners chose between a partnership and a corporation. They decided on a partnership that included Ron as a third partner with 10% ownership. Days later, Ron withdrew when he considered the unlimited liability of a partnership. He sold his 10% share to Woz and Jobs for $800. Within nine months, Woz and Jobs converted Apple to a corporation.

As Apple grew, Woz and Jobs had to learn more accounting, along with details of preparing and interpreting financial statements. Important questions involving transaction analysis and financial reporting arose, and the owners took care to do things right. “Everything we did,” asserts Woz, “we were setting the tone for the world.”

Woz and Jobs focused their accounting system to provide information for Apple’s business decisions. Today, Woz believes that Apple is key to the language of technology, just as accounting is the language of business. In retrospect, Woz says, “Every dream I have ever had in life has come true ten times over.”

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http://Apple.com
Page 4

Sources: Apple website, January 2019; Woz.org, January 2019; Apple 2016 Sustainability Report, April 2016; Greenbiz, October 2014; iWoz: From Computer Geek to Cult Icon, W.W. Norton & Co., 2006; Founders at Work, Apress, 2007

Decision Feature launches each chapter showing the relevance of accounting for a real entrepreneur; Entrepreneurial Decision assignment returns to this feature with a mini- case

IMPORTANCE OF ACCOUNTING

C1_______ Explain the purpose and importance of accounting.

Why is accounting so popular on campus? Why are there so many openings for accounting jobs? Why is accounting so important to companies? The answer is that we live in an information age in which accounting information impacts us all.

Accounting is an information and measurement system that identifies, records, and communicates an organization’s business activities. Exhibit 1.1 shows these accounting functions.

EXHIBIT 1.1 Accounting Functions

Our most common contact with accounting is through credit checks, checking accounts, tax forms, and payroll. These experiences focus on recordkeeping, or bookkeeping, which is the recording of transactions and events. This is just one part of accounting. Accounting also includes analysis and interpretation of information. Point: Technology is only as useful as the accounting data available, and users’ decisions are only as good as their understanding of accounting.

Technology plays a major role in accounting. Technology reduces the time, effort, and cost of recordkeeping while improving accuracy. As technology makes more information available, the demand for accounting knowledge increases. Consulting, planning, and other financial services are closely linked to accounting.

Users of Accounting Information

C2_______

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Identify users and uses of, and opportunities in, accounting.

Accounting is called the language of business because it communicates data that help people make better decisions. People using accounting information are divided into two groups: external users and internal users. Financial accounting focuses on the needs of external users, and managerial accounting focuses on the needs of internal users.

External Users External users of accounting information do not directly run the organization and have limited access to its accounting information. These users get accounting information from general-purpose financial statements. Following is a partial list of external users and decisions they make with accounting information.

Lenders (creditors) loan money or other resources to an organization. Banks, savings and loans, and mortgage companies are lenders. Lenders use information to assess if an organization will repay its loans. Shareholders (investors) are the owners of a corporation. They use accounting reports to decide whether to buy, hold, or sell stock. Boards of directors oversee organizations. Directors use accounting information to evaluate the performance of executive management. External (independent) auditors examine financial statements to verify that they are prepared according to generally accepted accounting principles. Nonmanagerial and nonexecutive employees and labor unions use external information to bargain for better wages. Regulators have legal authority over certain activities of organizations. For example, the Internal Revenue Service (IRS) requires accounting reports for computing taxes. Voters and government officials use information to evaluate government performance. Contributors to nonprofits use information to evaluate the use and impact of donations. Suppliers use information to analyze a customer before extending credit. Customers use financial reports to assess the stability of potential suppliers.

Internal Users Internal users of accounting information directly manage the organization. Internal reports are designed for the unique needs of managerial or executive employees, such as the chief executive officer (CEO). Following is a partial list of internal users and decisions they make with accounting information.

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Purchasing managers need to know what, when, and how much to purchase. Human resource managers need information about employees’ payroll, benefits, and performance. Production managers use information to monitor costs and ensure quality. Distribution managers need reports for timely and accurate delivery of products and services. Marketing managers use reports to target consumers, set prices, and monitor consumer needs. Service managers use reports to provide better service to customers. Research and development managers use information on projected costs and revenues of innovations.

Opportunities in Accounting Accounting has four areas of opportunities: financial, managerial, taxation, and accounting- related. Exhibit 1.2 lists selected opportunities in each area.

EXHIBIT 1.2 Accounting Opportunities

Point: The largest accounting firms are EY, KPMG, PwC, and Deloitte. Point: Higher education yields higher pay:

EXHIBIT 1.3 Accounting Jobs by Area

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Exhibit 1.3 shows that the majority of opportunities are in private accounting, which are employees working for businesses. Public accounting involves accounting services such as auditing and taxation. Opportunities also exist in government and not-for-profit agencies, including business regulation and law enforcement.

Accounting specialists are highly regarded, and their professional standing is often denoted by a certificate. Certified public accountants (CPAs) must meet education and experience requirements, pass an exam, and be ethical. Many accounting specialists hold certificates in addition to or instead of the CPA. Two of the most common are the certificate in management accounting (CMA) and the certified internal auditor (CIA). Employers also look for specialists with designations such as certified bookkeeper (CB), certified payroll professional (CPP), certified fraud examiner (CFE), and certified forensic accountant (CrFA).

Accounting specialists are in demand. Exhibit 1.4 reports average annual salaries for several accounting positions. Salaries vary based on location, company size, and other factors.

EXHIBIT 1.4 Accounting Salaries

NEED-TO-KNOWs highlight key procedures and concepts in learning accounting

NEED-TO-KNOW 1-1

Accounting Users C1 C2

Identify the following users of accounting information as either an (a) external or (b) internal user.

1. _____ Regulator

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2. _____ CEO 3. _____ Shareholder 4. _____ Marketing manager 5. _____ Executive employee 6. _____ External auditor 7. _____ Production manager 8. _____ Nonexecutive employee 9. _____ Bank lender

Solution

1. a 2. b 3. a 4. b 5. b 6. a 7. b 8. a 9. a.

Do More: QS 1-1, QS 1-2, E 1-1, E 1-2, E 1-3

FUNDAMENTALS OF ACCOUNTING

Ethics—A Key Concept

C3_______ Explain why ethics are crucial to accounting.

For information to be useful, it must be trusted. This demands ethics in accounting. Ethics are beliefs that separate right from wrong. They are accepted standards of good and bad behavior. Point: A Code of Conduct is available at AICPA.org.

Accountants face ethical choices as they prepare financial reports. These choices can affect the salaries and bonuses paid to workers. They even can affect the success of products and services. Misleading information can lead to a bad decision that harms workers and the business. There is an old saying: Good ethics are good business. Exhibit 1.5 gives a three- step process for making ethical decisions.

EXHIBIT 1.5 Ethical Decision Making

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Fraud Triangle: Ethics under Attack The fraud triangle shows that three factors push a person to commit fraud.

Opportunity. A person must be able to commit fraud with a low risk of getting caught. Pressure, or incentive. A person must feel pressure or have incentive to commit fraud. Rationalization, or attitude. A person justifies fraud or does not see its criminal nature.

The key to stopping fraud is to focus on prevention. It is less expensive and more effective to prevent fraud from happening than it is to detect it.

To prevent fraud, companies set up internal controls. Internal controls are procedures to protect assets, ensure reliable accounting, promote efficiency, and uphold company policies. Examples are good records, physical controls (locks), and independent reviews.

Enforcing Ethics In response to major accounting scandals, like those at Enron and WorldCom, Congress passed the Sarbanes-Oxley Act, also called SOX, to help stop financial abuses. SOX requires documentation and verification of internal controls and emphasizes effective internal controls. Management must issue a report stating that internal controls are effective. Auditors verify the effectiveness of internal controls. Ignoring SOX can lead to penalties and criminal prosecution of executives. CEOs and CFOs who knowingly sign off on bogus accounting reports risk millions of dollars in fines and years in prison. Point: An audit examines whether financial statements are prepared using GAAP. Point: SOX requires a business that sells stock to disclose a code of ethics for its executives.

Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank, has two important provisions.

Clawback Mandates recovery (clawback) of excessive pay. Whistleblower SEC pays whistleblowers 10% to 30% of sanctions exceeding $1 million.

Ethical Risk boxes highlight ethical issues from practice

Ethical Risk

Ethics Pay The $100 million mark in total payments made by the SEC to whistleblowers was recently surpassed. Since the SEC began awarding whistleblowers a percentage of money from sanctions, over 14,000 tips have been reported. Many of the tips come from accountants. ■

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Generally Accepted Accounting Principles

C4_______ Explain generally accepted accounting principles and define and apply several accounting principles.

Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). GAAP wants information to have relevance and faithful representation. Relevant information affects decisions of users. Faithful representation means information accurately reflects the business results. Point: CPAs who audit financial statements must disclose if they do not comply with GAAP.

The Financial Accounting Standards Board (FASB) is given the task of setting GAAP from the Securities and Exchange Commission (SEC). The SEC is a U.S. government agency that oversees proper use of GAAP by companies that sell stock and debt to the public.

International Standards Our global economy demands comparability in accounting reports. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. These standards are similar to, but sometimes different from, U.S. GAAP. The FASB and IASB are working to reduce differences between U.S. GAAP and IFRS.

Conceptual Framework The FASB conceptual framework in Exhibit 1.6 consists of the following.

Objectives—to provide information useful to investors, creditors, and others. Qualitative characteristics—to require information that has relevance and faithful representation. Elements—to define items in financial statements. Recognition and measurement—to set criteria for an item to be recognized as an element; and how to measure it.

EXHIBIT 1.6 Conceptual Framework

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Principles, Assumptions, and Constraint There are two types of accounting principles (and assumptions). General principles are the assumptions, concepts, and guidelines for preparing financial statements; these are shown in purple font in Exhibit 1.7, along with key assumptions in red font. Specific principles are detailed rules used in reporting business transactions and events; they are described as we encounter them.

EXHIBIT 1.7 Building Blocks for GAAP

Accounting Principles There are four general principles.

Measurement principle (cost principle) Accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured by the cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. Information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence. Later chapters cover adjustments to market and introduce fair value. Point: A company pays $500 for equipment. The cost principle requires it be recorded at $500. It makes no difference if the owner thinks this equipment is worth $700.

Revenue recognition principle Revenue is recognized (1) when goods or services are provided to customers and (2) at the amount expected to be received from the customer. Revenue (sales) is the amount received from selling products and services.

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Page 8 The amount received is usually in cash, but it also can be a customer’s promise to pay at a future date, called credit sales. (To recognize means to record it.) Example: A lawn service bills a customer $800 on June 1 for two months of mowing (June and July). The customer pays the bill on July 1. When is revenue recorded? Answer: It is recorded over time as it is earned; record $400 revenue for June and $400 for July.

Expense recognition principle (matching principle) A company records the expenses it incurred to generate the revenue reported. An example is rent costs of office space. Example: Credit cards are used to pay $200 in gas for a lawn service during June and July. The cards are paid in August. When is expense recorded? Answer: If revenue is earned over time, record $100 expense in June and $100 in July.

Full disclosure principle A company reports the details behind financial statements that would impact users’ decisions. Those disclosures are often in footnotes to the statements.

Decision Insight

Measurement and Recognition Revenues for the Seattle Seahawks, Atlanta Falcons, Green Bay Packers, and other professional football teams include ticket sales, television broadcasts, concessions, and advertising. Revenues from ticket sales are earned when the NFL team plays each game. Advance ticket sales are not revenues; instead, they are a liability until the NFL team plays the game for which the ticket was sold. At that point, the liability is removed and revenues are reported. ■

©Shane Roper/CSM/REX/Shutterstock

Accounting Assumptions There are four accounting assumptions.

Going-concern assumption Accounting information presumes that the business will continue operating instead of being closed or sold. This means, for example, that property is reported at cost instead of liquidation value. Monetary unit assumption Transactions and events are expressed in monetary, or money, units. Examples of monetary units are the U.S. dollar and the Mexican peso. Time period assumption The life of a company can be divided into time periods, such as months and years, and useful reports can be prepared for those periods. Business entity assumption A business is accounted for separately from other business entities and its owner. Exhibit 1.8 describes four common business entities.

EXHIBIT 1.8 Attributes of Businesses

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*When a corporation issues only one class of stock, it is called common stock (or capital stock).

Accounting Constraint The cost-benefit constraint, or cost constraint, says that information disclosed by an entity must have benefits to the user that are greater than the costs of providing it. Materiality, or the ability of information to influence decisions, is also sometimes mentioned as a constraint. Conservatism and industry practices are sometimes listed as well. Point: Proprietorships, partnerships, and LLCs are managed by their owners. In a corporation, the owners (shareholders) elect a board of directors who hire managers to run the business.

Decision Ethics boxes are role-playing exercises that stress ethics in accounting

Decision Ethics

Entrepreneur You and a friend develop a new design for ice skates that improves speed. You plan to form a business to manufacture and sell the skates. You and your friend want to minimize taxes, but your big concern is potential lawsuits from customers who might be injured on these skates. What form of organization do you set up? ■ Answer: You should probably form an LLC. An LLC helps protect personal property from lawsuits directed at the business. Also, an LLC is not subject to an additional business income tax. You also must examine the ethical and social aspects of starting a business where injuries are expected.

Point: Double taxation means that (1) the corporation income is taxed and (2) any dividends to owners are taxed as part of the owners’ personal income.

NEED-TO-KNOW 1-2

Accounting Guidance C3 C4

Part 1: Identify each of the following terms/phrases as either an accounting (a) principle, (b) assumption, or (c) constraint.

1. ______ Cost-benefit 2. ______ Measurement

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3. ______ Business entity 4. ______ Going-concern 5. ______ Full disclosure 6. ______ Time period 7. ______ Expense recognition 8. ______ Revenue recognition

Solution

1. c 2. a 3. b 4. b 5. a 6. b 7. a 8. a Part 2: Complete the following table with either a yes or a no regarding the attributes of a partnership, corporation, and LLC.

Solution

a. no b. no c. no d. no e. yes f. yes g. yes h. yes i. no j. yes k. yes l. yes

Do More: QS 1-3, QS 1-4, QS 1-5, QS 1-6, E 1-4, E 1-5, E 1-6, E 1-7

BUSINESS TRANSACTIONS AND ACCOUNTING

A1_______ Define and interpret the accounting equation and each of its components.

Accounting shows two basic aspects of a company: what it owns and what it owes. Assets are resources a company owns or controls. The claims on a company’s assets—what it owes— are separated into owner (equity) and nonowner (liability) claims. Together, liabilities and equity are the source of funds to acquire assets.

Assets Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. Assets include cash, supplies, equipment, land, and accounts receivable. A receivable is an asset that promises a future inflow of resources. A company that provides a service or product on credit has an account receivable from that customer. Point: “On credit” and “on account” mean cash is paid at a future date.

Liabilities Liabilities are creditors’ claims on assets. These claims are obligations to provide assets, products, or services to others. A payable is a liability that promises a future

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outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes (loans) payable to banks, and taxes payable.

Equity Equity is the owner’s claim on assets and is equal to assets minus liabilities. Equity is also called net assets or residual equity.

Accounting Equation The relation of assets, liabilities, and equity is shown in the following accounting equation. The accounting equation applies to all transactions and events, to all companies and organizations, and to all points in time.

We can break down equity to get the expanded accounting equation.

Point: This equation can be rearranged. Example: Assets − Liabilities = Equity

We see that equity increases from owner investments and from revenues. It decreases from withdrawals and from expenses. Equity consists of four parts.

Decision Insight

Big Data The SEC keeps an online database called EDGAR (sec.gov/edgar) that has accounting information for thousands of companies, such as Columbia Sportswear, that issue stock to the public. The annual report filing for most publicly traded U.S. companies is known as Form 10-K, and the quarterly filing is Form 10-Q. Information services such as Finance.Yahoo.com offers online data and analysis. ■

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http://sec.gov/edgar
http://Finance.Yahoo.com
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©Greg Epperson/Shutterstock

NEED-TO-KNOW 1-3

Accounting Equation A1

Part 1: Use the accounting equation to compute the missing financial statement amounts.

Solution

a. $120 b. $400 Part 2: Use the expanded accounting equation to compute the missing financial statement amounts.

Solution

a. $65 b. $10

Do More: QS 1-7, QS 1-8, E 1-8, E 1-9

Transaction Analysis

P1_______ Analyze business transactions using the accounting equation.

Business activities are described in terms of transactions and events. External transactions are exchanges of value between two entities, which cause changes in the accounting equation. An example is the sale of the AppleCare Protection Plan by Apple. Internal transactions are exchanges within an entity, which may or may not affect the accounting equation. An

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example is Target’s use of its supplies, which are reported as expenses when used. Events are happenings that affect the accounting equation and are reliably measured. They include business events such as changes in the market value of certain assets and liabilities and natural events such as fires that destroy assets and create losses.

This section uses the accounting equation to analyze 11 transactions and events of FastForward, a start-up consulting (service) business, in its first month of operations. Remember that after each transaction and event, assets always equal liabilities plus equity.

Real company names are in bold magenta

Transaction 1: Investment by Owner On December 1, Chas Taylor forms a consulting business named FastForward and set up as a proprietorship. FastForward evaluates the performance of footwear and accessories. Taylor owns and manages the business, which will publish online reviews and consult with clubs, athletes, and others who purchase Nike and Adidas products.

Taylor invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, cash (an asset) and owner’s equity each equals $30,000. Equity is increased by the owner’s investment, which is included in the column titled C. Taylor, Capital. The effect of this transaction on FastForward is shown in the accounting equation as follows (we label the equity entries).

Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of Nike and Adidas footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It simply changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of footwear are assets because of the expected future benefits from the test results of their performance.

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Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to acquire equipment for testing footwear. Like Transaction 2, Transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected future benefits from testing footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.

Transaction 4: Purchase Supplies on Credit Taylor decides more supplies of footwear and accessories are needed. These additional supplies cost $7,100, but FastForward has only $1,500 in cash. Taylor arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount.

Example: If FastForward pays $500 cash in Transaction 4, how does this partial payment affect the liability to CalTech? Answer: The liability to CalTech is reduced to $6,600 and the cash balance is reduced to $1,000.

Transaction 5: Provide Services for Cash FastForward plans to earn revenues by selling online ad space and consulting with clients about footwear and accessories. It earns net income only if its revenues are greater than its expenses. In its first job, FastForward provides consulting services and immediately collects $4,200 cash. The accounting equation reflects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is

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shown in the far right column under Revenues because the cash received is earned by providing consulting services.

Point: Revenue recognition principle requires that revenue is recognized when work is performed.

Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 to rent its facilities. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is shown in the following accounting equation as Transaction 6. FastForward also pays the biweekly $700 salary of the company’s only employee. This is shown in the accounting equation as Transaction 7. Both Transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, not assets, because their benefits are used in December (they have no future benefits after December). The accounting equation shows that both transactions reduce cash and equity. The far right column shows these decreases as Expenses.

Point: Expense recognition principle requires that expenses are recognized when the revenue they help generate is recorded.

Transaction 8: Provide Services and Facilities for Credit FastForward provides consulting services of $1,600 and rents its test facilities for an additional $300 to Adidas on credit. Adidas is billed for the $1,900 total. This transaction creates a new asset, called accounts receivable, from Adidas. Accounts receivable is increased instead of cash because the payment has not yet been received. Equity is increased from the two revenue components shown in the Revenues column of the accounting equation.

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Point: Transaction 8, like 5, records revenue when work is performed, not necessarily when cash is received.

Transaction 9: Receipt of Cash from Accounts Receivable The client in Transaction 8 (Adidas) pays $1,900 to FastForward 10 days after it is billed for consulting services. This Transaction 9 does not change the total amount of assets and does not affect liabilities or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward performed the services in Transaction 8, not when the cash is collected.

Point: Transaction 9 involved no added client work, so no added revenue is recorded. Point: Receipt of cash is not always a revenue.

Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (Transaction 4), leaving $6,200 unpaid. This transaction decreases FastForward’s cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an expense even though cash flows out of FastForward (instead the expense is recorded when FastForward uses these supplies).

Transaction 11: Withdrawal of Cash by Owner The owner of FastForward withdraws $200 cash for personal use. Withdrawals (decreases in equity) are not reported as expenses because they do not help earn revenue. Because withdrawals are not expenses, they are not used in computing net income.

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Summary of Transactions Exhibit 1.9 shows the effects of these 11 transactions of FastForward using the accounting equation. Assets equal liabilities plus equity after each transaction.

EXHIBIT 1.9 Summary of Transactions Using the Accounting Equation

NEED-TO-KNOW 1-4

Transaction Analysis P1

Assume Tata Company began operations on January 1 and completed the following transactions during its first month of operations. Arrange the following asset, liability, and equity titles in a table like Exhibit 1.9: Cash; Accounts Receivable; Equipment; Accounts Payable; J. Tata, Capital; J. Tata, Withdrawals; Revenues; and Expenses.

Solution

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Do More: QS 1-10, QS 1-11, E 1-10, E 1-11, E 1-13

COMMUNICATING WITH USERS

P2_______ Identify and prepare basic financial statements and explain how they interrelate.

Financial statements are prepared in the order below using the 11 transactions of FastForward. (These statements are unadjusted—we explain this in Chapters 2 and 3.) The four financial statements and their purposes follow.

Income Statement FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from Transactions 5 and 8 and rental revenue of $300 from Transaction 8. Expenses are reported after revenues. Rent and salary expenses are from Transactions 6 and 7. Expenses are the costs to generate the revenues reported. Net income occurs when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Net income (or loss) is

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Page 16 shown at the bottom of the statement and is the amount reported in December. Owner’s investments and withdrawals are not part of income.

Key Terms are in bold and defined again in the glossary

Point: Net income is sometimes called earnings or profit.

EXHIBIT 1.10 Financial Statements and Their Links

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Point: A statement’s heading identifies the company, the statement title, and the date or time period. Point: Arrow lines show how the statements are linked. ➀ Net income is used to compute equity. ➁ Owner capital is used to prepare the balance sheet. ➂ Cash from the balance sheet is used to reconcile the statement of cash flows.

Point: The income statement, the statement of owner’s equity, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

Point: A single ruled line means an addition or subtraction. Final totals are double underlined. Negative amounts may or may not be in parentheses.

Statement of Owner’s Equity

©Pavel1964/Shutterstock

The statement of owner’s equity reports how equity changes over the reporting period. This statement shows beginning capital, events that increase it (owner investments and net income), and events that decrease it (withdrawals and net loss). Ending capital is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of owner’s equity is the second report in Exhibit 1.10. The beginning balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports a beginning balance equal to the prior period’s ending balance (such as from November 30). FastForward’s statement shows the $4,400 of net income for the period, which links the income statement to the statement of owner’s equity (see line ➀). The statement also reports the $200 cash withdrawal and FastForward’s end-of- period capital balance.

Balance Sheet FastForward’s balance sheet is the third report in Exhibit 1.10. This statement shows FastForward’s financial position at the end of business day on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity balance is $34,200. Line ➁ shows the link between the ending balance of the statement of owner’s equity and the equity balance on the balance sheet. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Both are acceptable.) As always, the accounting equation balances: Assets of $40,400 = Liabilities of $6,200 + Equity of $34,200.

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Statement of Cash Flows FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the $5,100 cash paid for supplies, rent, and employee salaries. Outflows are in parentheses to denote subtraction. Net cash provided by operating activities for December is $1,000. The second section reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include long-term borrowing and repaying of cash from lenders and the cash investments from, and withdrawals by, the owner. FastForward reports $30,000 from the owner’s initial investment and a $200 cash withdrawal. The net cash effect of all financing transactions is a $29,800 cash inflow. The final part of the statement shows an increased cash balance of $4,800. The ending balance is also $4,800 as it started with no cash—see line ➂. Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

NEED-TO-KNOW 1-5

Financial Statements P2

Prepare the (a) income statement, (b) statement of owner’s equity, and (c) balance sheet for Apple using the following condensed data from its fiscal year ended September 30, 2017 ($ in millions).

Solution ($ in millions)

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Do More: QS 1-12, QS 1-13, QS 1-14, E 1-15, E 1-16, E 1-17

Decision Analysis (a section at the end of each chapter) covers ratios for decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 17

Decision Analysis Return on Assets

A2_______ Compute and interpret return on assets.

We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 17 has a ratio listing with definitions and groupings by area. When analyzing ratios, we use a company’s prior-year ratios and competitor ratios to identify good, bad, or average performance.

This chapter presents a profitability measure: return on assets. Return on assets is

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useful in evaluating management, analyzing and forecasting profits, and planning activities. Return on assets (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

EXHIBIT 1.11 Return on Assets

Net income is from the annual income statement, and average total assets is computed by adding the beginning and ending amounts for that same period and dividing by 2. Nike reports total net income of $4,240 million for the current year. At the beginning of the current year its total assets are $21,396 million, and at the end of the current year they total $23,259 million. Nike’s return on assets for the current year is:

Is a 19.0% return on assets good or bad for Nike? To help answer this question, we compare (benchmark) Nike’s return with its prior performance and the return of its competitor, Under Armour. Nike shows a stable pattern of good returns that reflects effective use of assets. Nike has outperformed Under Armour in each of the last three years. Its management performed well based on Nike’s return on assets.

EXHIBIT 1.12 Nike and Under Armour Returns

Decision Analysis ends with a role-playing scenario to show the usefulness of ratios

Decision Maker

Business Owner You own a winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 14% return on its assets. The industry return for competitors of this manufacturer is 9%. Do you purchase this manufacturer? ■ Answer: The 14% return on assets for the manufacturer exceeds the 9% industry return. This is positive for a potential purchase. Also, this purchase is an opportunity to spread your risk over two businesses. Still, you should hesitate to purchase a business whose 14% return is lower than your current 21% return. You might better direct efforts to increase investment in your resort if it can earn more than the 14% alternative.

Comprehensive Need-to-Know is a review of key chapter content; the Planning the Solution section offers strategies in solving it

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NEED-TO-KNOW 1-6 COMPREHENSIVE

Transaction Analysis, Statement Preparation, and Return on Assets

After several months of planning, Jasmine Worthy started a haircutting business called Expressions. The following events occurred during its first month of business.

Required

1. Arrange the following asset, liability, and equity titles in a table similar to the one in Exhibit 1.9: Cash; Accounts Receivable; Furniture; Store Equipment; Accounts Payable; J. Worthy, Capital; J. Worthy, Withdrawals; Revenues; and Expenses. Show the effects of each transaction using the accounting equation.

2. Prepare an income statement for August. 3. Prepare a statement of owner’s equity for August. 4. Prepare a balance sheet as of August 31. 5. Prepare a statement of cash flows for August. 6. Determine the return on assets ratio for August.

PLANNING THE SOLUTION

Set up a table like Exhibit 1.9 with the appropriate columns for accounts. Analyze each transaction and show its effects as increases or decreases in the appropriate columns. Be sure the accounting equation remains in balance after each transaction. Prepare the income statement, and identify revenues and expenses. List those items on the statement, compute the difference, and label the result as net income or net loss. Use information in the Equity columns to prepare the statement of owner’s equity. Use information in the last row of the transactions table to prepare the balance sheet. Prepare the statement of cash flows; include all events listed in the Cash column of the transactions table. Classify each cash flow as operating, investing, or financing.

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Page 20 Calculate return on assets by dividing net income by average assets.

SOLUTION

1.

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1A

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*Uses the initial $18,000 investment as the beginning balance for the start-up period only.

APPENDIX

Return and Risk A3_______ Explain the relation between return and risk.

This appendix covers return and risk analysis. Net income is often linked to return. Return on assets (ROA) is stated in ratio

form as income divided by assets invested. For example, banks report return from a savings account in the form of an interest return such as 2%. We also could invest in a company’s stock, or even start our own business. How do we decide among these options? The answer depends on our trade-off between return and risk.

Risk is the uncertainty about the return we will earn. All business investments involve risk, but some investments involve more risk than others. The lower the risk of an investment, the lower is our expected return. The reason that savings accounts pay such a low return is the low risk of not being repaid with interest (the government guarantees most savings accounts). If we buy a share of eBay or any other company, we might get a large return. However, we have no guarantee of any return; there is even the risk of loss.

Exhibit 1A.1 shows recent returns for 10-year bonds with different risks. Bonds are written promises by organizations to repay amounts loaned with interest. U.S. Treasury bonds have a low expected return, but they also have low risk because they are backed by the U.S. government. High-risk corporate bonds have a much larger potential return but have much higher risk.

EXHIBIT 1A.1 Average Returns for Bonds with Different Risks

The trade-off between return and risk is a normal part of business. Higher risk implies higher, but riskier, expected returns. To help us make better decisions, we use accounting information to assess both return and risk.

APPENDIX

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1BBusiness Activities C5_______ Identify and describe the three major activities of organizations.

This appendix explains how the accounting equation is linked to business activities. There are three major types of business activities: financing, investing, and operating. Each of these requires planning. Planning is defining an organization’s ideas, goals, and actions. Point: Investing (assets) and financing (liabilities plus equity) totals are always equal.

Financing Financing activities provide the resources organizations use to pay for assets such as land, buildings, and equipment. The two sources of financing are owner and nonowner. Owner financing refers to resources contributed by the owner along with any income the owner leaves in the organization. Nonowner (or creditor) financing refers to resources loaned by creditors (lenders).

Investing Investing activities are the acquiring and disposing of assets that an organization uses to buy and sell its products or services. Some organizations require land and factories to operate. Others need only an office. Invested amounts are referred to as assets. Creditor and owner financing hold claims on assets. Creditors’ claims are called liabilities, and the owner’s claim is called equity. This yields the accounting equation: Assets = Liabilities + Equity.

Operating Operating activities involve using resources to research, develop, purchase, produce, distribute, and market products and services. Sales and revenues are the inflow of assets from selling products and services. Costs and expenses are the outflow of assets to support operating activities. Exhibit 1B.1 summarizes business activities. Planning is part of each activity and gives them meaning and focus. Investing (assets) and financing (liabilities and equity) are opposite each other because they always are equal. Operating activities are below to show that they are the result of investing and financing.

EXHIBIT 1B.1 Activities of Organizations

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Summary: Cheat Sheet

ACCOUNTING USES

External users: Do not directly run the organization and have limited access to its accounting information. Examples are lenders, shareholders, boards of directors, external auditors, nonexecutive employees, labor unions, regulators, voters, donors, suppliers, and customers. Internal users: Directly manage organization operations. Examples are the CEO and other executives, research and development managers, purchasing managers, production managers, and other managerial-level employees. Private accounting: Accounting employees working for businesses. Public accounting: Offering audit, tax, and accounting services to others.

ETHICS AND ACCOUNTING

Fraud triangle: Factors that push a person to commit fraud. Opportunity: Must be able to commit fraud with a low risk of getting caught. Pressure, or incentive: Must feel pressure or have incentive to commit fraud. Rationalization, or attitude: Justifies fraud or does not see its criminal nature.

Common business entities:

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SYSTEM OF ACCOUNTS

Assets: Resources a company owns or controls that are expected to yield future benefits. Liabilities: Creditors’ claims on assets. These are obligations to provide assets, products, or services to others. Equity: Owner’s claim on assets. It consists of:

TRANSACTION ANALYSIS

Accounting equation: Applies to all transactions and events, to all companies and organizations, and to all points in time.

Summary of transactions:

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Transaction 1: Investment by owner Transaction 2: Purchase supplies for cash Transaction 3: Purchase equipment for cash Transaction 4: Purchase supplies on credit Transaction 5: Provide services for cash Transactions 6 and 7: Payment of expenses in cash Transaction 8: Provide services and facilities for credit Transaction 9: Receipt of cash from accounts receivable Transaction 10: Payment of accounts payable Transaction 11: Withdrawal of cash by owner

FINANCIAL STATEMENTS

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A list of key terms concludes each chapter (a complete glossary is also available)

Key Terms

Accounting 3 Accounting equation 10 Assets 9 Audit 6 Auditors 6 Balance sheet 15 Bookkeeping 3 Business entity assumption 8 Common stock 8 Conceptual framework 7 Corporation 8 Cost-benefit constraint 8 Cost constraint 8 Cost principle 7 Dodd-Frank Wall Street Reform and Consumer Protection Act 6 Double taxation 9 Equity 9 Ethics 6 Events 11 Expanded accounting equation 10 Expense recognition principle 8 Expenses 10 External transactions 11 External users 4 Financial accounting 4 Financial Accounting Standards Board (FASB) 7 Full disclosure principle 8 Generally accepted accounting principles (GAAP) 7 Going-concern assumption 8 Income statement 15 Internal controls 6 Internal transactions 11 Internal users 4 International Accounting Standards Board (IASB) 7 International Financial Reporting Standards (IFRS) 7 Liabilities 9

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Limited liability company (LLC) 8 Managerial accounting 4 Matching principle 8 Measurement principle 7 Members 8 Monetary unit assumption 8 Net income 15 Net loss 15 Owner, Capital 10 Owner investments 10 Owner, Withdrawals 10 Partnership 8 Proprietorship 8 Recordkeeping 3 Return 21 Return on assets (ROA) 18 Revenue recognition principle 7 Revenues 10 Risk 21 Sarbanes-Oxley Act 6 Securities and Exchange Commission (SEC) 7 Shareholders 8 Shares 8 Sole proprietorship 8 Statement of cash flows 15 Statement of owner’s equity 15 Stock 8 Stockholders 8 Time period assumption 8

Multiple Choice Quiz

1. A building is offered for sale at $500,000 but is currently assessed at $400,000. The purchaser of the building believes the building is worth $475,000, but ultimately purchases the building for $450,000. The purchaser records the building at:

a. $50,000. b. $400,000. c. $450,000. d. $475,000.

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Page 24e. $500,000. 2. On December 30 of the current year, KPMG signs a $150,000

contract to provide accounting services to one of its clients in the next year. KPMG has a December 31 year-end. Which accounting principle or assumption requires KPMG to record the accounting services revenue from this client in the next year and not in the current year?

a. Business entity assumption b. Revenue recognition principle c. Monetary unit assumption d. Cost principle e. Going-concern assumption

3. If the assets of a company increase by $100,000 during the year and its liabilities increase by $35,000 during the same year, then the change in equity of the company during the year must have been:

a. An increase of $135,000. b. A decrease of $135,000. c. A decrease of $65,000. d. An increase of $65,000. e. An increase of $100,000.

4. Brunswick borrows $50,000 cash from Third National Bank. How does this transaction affect the accounting equation for Brunswick?

a. Assets increase by $50,000; liabilities increase by $50,000; no effect on equity.

b. Assets increase by $50,000; no effect on liabilities; equity increases by $50,000.

c. Assets increase by $50,000; liabilities decrease by $50,000; no effect on equity.

d. No effect on assets; liabilities increase by $50,000; equity increases by $50,000.

e. No effect on assets; liabilities increase by $50,000; equity decreases by $50,000.

5. Geek Squad performs services for a customer and bills the customer for $500. How would Geek Squad record this transaction?

a. Accounts receivable increase by $500; revenues increase by $500. b. Cash increases by $500; revenues increase by $500. c. Accounts receivable increase by $500; revenues decrease by $500. d. Accounts receivable increase by $500; accounts payable increase by

$500. e. Accounts payable increase by $500; revenues increase by $500.

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $450,000 is the actual cost incurred. 2. b; revenue is recorded when services are provided.

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3. d;

Change in equity = $100,000 – $35,000 = $65,000 4. a 5. a

A(B) Superscript letter A (B) denotes assignments based on Appendix 1A (1B).

Icon denotes assignments that involve decision making.

Discussion Questions

1. What is the purpose of accounting in society? 2. Technology is increasingly used to process accounting data. Why then must

we study and understand accounting? 3. Identify four kinds of external users and describe how they use accounting

information. 4. What are at least three questions business owners and managers might be

able to answer by looking at accounting information? 5. Identify three actual businesses that offer services and three actual businesses

that offer products. 6. Describe the internal role of accounting for organizations. 7. Identify three types of services typically offered by accounting professionals. 8. What type of accounting information might be useful to the marketing

managers of a business? 9. Why is accounting described as a service activity?

10. What are some accounting-related professions? 11. How do ethics rules affect auditors’ choice of clients? 12. What work do tax accounting professionals perform in addition to preparing

tax returns? 13. What does the concept of objectivity imply for information reported in

financial statements? 14. A business reports its own office stationery on the balance sheet at its $400

cost, although it cannot be sold for more than $10 as scrap paper. Which accounting principle and/or assumption justifies this treatment?

15. Why is the revenue recognition principle needed? What does it demand? 16. Describe the four basic forms of business organization and their key

attributes. 17. Define (a) assets, (b) liabilities, (c) equity, and (d) net assets. 18. What events or transactions change equity?

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19. Identify the two main categories of accounting principles. 20. What do accountants mean by the term revenue? 21. Define net income and explain its computation. 22. Identify the four basic financial statements of a business. 23. What information is reported in an income statement? 24. Give two examples of expenses a business might incur. 25. What is the purpose of the statement of owner’s equity? 26. What information is reported in a balance sheet? 27. The statement of cash flows reports on what major activities? 28. Define and explain return on assets.

29. A Define return and risk. Discuss the trade-off between them.

30. B Describe the three major business activities in organizations. 31. B Explain why investing (assets) and financing (liabilities and equity) totals

are always equal. 32. Refer to the financial statements of Google in Appendix A near

the end of the text. To what level of significance are dollar amounts rounded? What time period does its income statement cover?

33. Access the SEC EDGAR database (SEC.gov) and retrieve Apple’s 2017 10-K (filed November 3, 2017). Identify its auditor. What responsibility does its independent auditor claim regarding Apple’s financial statements?

Quick Study exercises offer a brief check of key points

Connect reproduces assignments online, in static or algorithmic mode, which allows instructors to monitor, promote, and assess student learning. It can be used for practice, homework, or exams

QUICK STUDY

QS 1-1 Understanding accounting C1 Choose the term or phrase below that best completes each statement.

a. Accounting b. Identifying c. Recording d. Communicating e. Governmental f. Technology

g. Language of business h. Recordkeeping (bookkeeping)

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http://www.SEC.gov
1. _____

2. _____ 3. _____

_____ a. _____ b. _____ c. _____ d. _____ e. _____ f. _____ g. _____ h. _____ i. _____ j. _____ k. _____ l.

_____ 1. _____ 2. _____ 3.

_____ 4. _____ 5. _____ 6.

reduces the time, effort, and cost of recordkeeping while improving clerical accuracy.

requires that we input, measure, and log transactions and events. is the recording of transactions and events, either manually or

electronically.

QS 1-2 Identifying accounting users C2 Identify the following users as either external users (E) or internal users (I).

Customers Suppliers External auditors Business press Managers District attorney Shareholders Lenders

Controllers FBI and IRS Consumer group Directors

QS 1-3 Identifying ethical risks C3 The fraud triangle asserts that the following three factors must exist for a person to commit fraud.

A. Opportunity B. Pressure C. Rationalization

Identify the fraud risk factor (A, B, or C) in each of the following situations.

The business has no cameras or security devices at its warehouse. Managers are expected to grow business or be fired. A worker sees other employees regularly take inventory for personal

use. No one matches the cash in the register to receipts when shifts end. Officers are told to show rising income or risk layoffs. A worker feels that fellow employees are not honest.

This icon highlights ethics-related assignments

QS 1-4 Identifying principles, assumptions, and constraints C4

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_____ 1. _____ 2. _____ 3. _____ 4.

_____ 1.

_____ 2.

_____ 3.

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Identify each of the following terms or phrases as an accounting (a) principle, (b) assumption, or (c) constraint.

Full disclosure Time period Going-concern Revenue recognition

QS 1-5 Identifying attributes of businesses C4 Complete the following table with either a yes or no regarding the attributes of a proprietorship, partnership, corporation, and limited liability company (LLC).

QS 1-6 Identifying accounting principles and assumptions C4 Identify the letter for the principle or assumption from A through F in the blank space next to each numbered situation that it best explains or justifies.

A. General accounting principle B. Measurement (cost) principle C. Business entity assumption D. Revenue recognition principle E. Expense recognition (matching) principle F. Going-concern assumption

In December of this year, Chavez Landscaping received a customer’s order and cash prepayment to install sod at a house that would not be ready for installation until March of next year. Chavez should record the revenue from the customer order in March of next year, not in December of this year.

If $51,000 cash is paid to buy land, the land is reported on the buyer’s balance sheet at $51,000.

Mike Derr owns both Sailing Passions and Dockside Digs. In preparing financial statements for Dockside Digs, Mike makes sure that the expense transactions of Sailing Passions are kept separate from Dockside Digs’s transactions and financial statements.

QS 1-7 Applying the accounting equation A1

a. Total assets of Charter Company equal $700,000 and its equity is $420,000. What is the amount of its liabilities?

b. Total assets of Martin Marine equal $500,000 and its liabilities and equity amounts are equal to each other. What is the amount of its liabilities? What is the amount of its equity?

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This icon highlights assignments that enhance decision-making skills

QS 1-8 Applying the accounting equation A1

1. Use the accounting equation to compute the missing financial statement amounts (a), (b), and (c).

2. Use the expanded accounting equation to compute the missing financial statement amounts (a) and (b).

QS 1-9 Identifying and computing assets, liabilities, and equity A1

Use Google’s December 31, 2017, financial statements, in Appendix A near the end of the text, to answer the following.

a. Identify the amounts (in $ millions) of its 2017 (1) assets, (2) liabilities, and (3) equity.

b. Using amounts from part a, verify that Assets = Liabilities + Equity.

QS 1-10 Identifying effects of transactions using accounting equation— Revenues and Expenses P1 Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation (identify each revenue and expense type, such as commissions revenue or rent expense).

a. The company completed consulting work for a client and immediately collected $5,500 cash earned.

b. The company completed commission work for a client and sent a bill for $4,000 to be received within 30 days.

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_____ a. _____ b. _____ c. _____ d. _____ e. _____ f. _____ g. _____ h.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6.

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c. The company paid an assistant $1,400 cash as wages for the period. d. The company collected $1,000 cash as a partial payment for the amount owed

by the client in transaction b. e. The company paid $700 cash for this period’s cleaning services.

QS 1-11 Identifying effects of transactions using accounting equation—Assets and Liabilities P1 Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of each transaction on individual items of the accounting equation.

a. The owner (Alex Carr) invested $15,000 cash in the company. b. The company purchased supplies for $500 cash. c. The owner (Alex Carr) invested $10,000 of equipment in the company. d. The company purchased $200 of additional supplies on credit. e. The company purchased land for $9,000 cash.

QS 1-12 Identifying items with financial statements P2 Indicate in which financial statement each item would most likely appear: income statement (I), balance sheet (B), or statement of cash flows (CF).

Assets Cash from operating activities Equipment Expenses Liabilities Net decrease (or increase) in cash Revenues Total liabilities and equity

QS 1-13 Identifying income and equity accounts P2 Classify each of the following items as revenues (R), expenses (EX), or withdrawals (W).

Cost of sales Service revenue Wages expense Owner withdrawal Rent expense Rental revenue

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_____ 7. _____ 8.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6.

_____ 1.

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Insurance expense Consulting revenue

QS 1-14 Identifying assets, liabilities, and equity P2 Classify each of the following items as assets (A), liabilities (L), or equity (EQ).

Land Owner, Capital Equipment Accounts payable Accounts receivable Supplies

QS 1-15 Preparing an income statement P2 On December 31, Hawkin’s records show the following accounts. Use this information to prepare a December income statement for Hawkin.

QS 1-16 Computing and interpreting return on assets A2 In a recent year’s financial statements, Home Depot reported the following results. Compute and interpret Home Depot’s return on assets (assume competitors average an 11.0% return on assets).

QS 1-17 Identifying and computing assets, liabilities, and equity A1

Use Samsung’s December 31, 2017, financial statements in Appendix A near the end of the text to answer the following.

a. Identify the amounts (in millions of Korean won) of Samsung’s 2017 (1) assets, (2) liabilities, and (3) equity.

b. Using amounts from part a, verify that Assets = Liabilities + Equity.

EXERCISES

Exercise 1-1 Classifying activities reflected in the accounting system C1 Classify the following activities as part of the identifying (I), recording (R), or communicating (C) aspects of accounting.

Analyzing and interpreting reports.

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_____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ 1. _____ 2. _____ 3.

Presenting financial information. Keeping a log of service costs. Measuring the costs of a product. Preparing financial statements. Acquiring knowledge of revenue transactions. Observing transactions and events. Registering cash sales of products sold.

Exercise 1-2 Identifying accounting users and uses C2 Part A. Identify the following questions as most likely to be asked by an internal (I) or an external (E) user of accounting information.

Which inventory items are out of stock? Should we make a five-year loan to that business? What are the costs of our product’s ingredients? Should we buy, hold, or sell a company’s stock? Should we spend additional money for redesign of our product? Which firm reports the highest sales and income? What are the costs of our service to customers?

Part B. Identify the following users as either an internal (I) or an external (E) user.

Research and development executive Human resources executive Politician Shareholder Distribution manager Creditor Production supervisor Purchasing manager

Exercise 1-3 Describing accounting responsibilities C2 Many accounting professionals work in one of the following three areas.

A. Financial accounting B. Managerial accounting C. Tax accounting

Identify the area of accounting that is most involved in each of the following responsibilities.

Internal auditing External auditing Cost accounting

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_____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ 1. _____ 2.

_____ 3. _____ 4. _____ 5.

_____ 1. _____ 2.

_____ 3. Page 29

Budgeting Enforcing tax laws Planning transactions to minimize taxes Preparing external financial statements Analyzing external financial reports

Exercise 1-4 Learning the language of business C1 C2 C3 Match each of the numbered descriptions 1 through 5 with the term or phrase it best reflects. Indicate your answer by writing the letter A through H for the term or phrase in the blank provided.

A. Audit B. GAAP C. Ethics D. FASB E. SEC F. Public accountants G. Net income H. IASB

An assessment of whether financial statements follow GAAP. Amount a business earns in excess of all expenses and costs

associated with its sales and revenues. A group that sets accounting principles in the United States. Accounting professionals who provide services to many clients. Principles that determine whether an action is right or wrong.

Exercise 1-5 Identifying ethical terminology C3 Match each of the numbered descriptions 1 through 7 with the term or phrase it best reflects. Indicate your answer by writing the letter A through G for the term or phrase in the blank provided.

A. Ethics B. Fraud triangle C. Prevention D. Internal controls E. Sarbanes-Oxley Act F. Audit G. Dodd-Frank Act

Requires the SEC to pay whistleblowers. Examines whether financial statements are prepared using GAAP; it

does not ensure absolute accuracy of the statements. Requires documentation and verification of internal

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_____ 4.

_____ 5. _____ 6.

_____ 7.

_____ a.

_____ b.

_____ c.

_____ d.

_____ e.

_____ f.

_____ g. _____ h.

_____ 1.

controls and increases emphasis on internal control effectiveness. Procedures set up to protect company property and equipment,

ensure reliable accounting, promote efficiency, and encourage adherence to policies.

A less expensive and more effective means to stop fraud. Three factors push a person to commit fraud: opportunity, pressure,

and rationalization. Beliefs that distinguish right from wrong.

Exercise 1-6 Distinguishing business organizations C4 The following describe several different business organizations. Determine whether each description best refers to a sole proprietorship (SP), partnership (P), corporation (C), or limited liability company (LLC).

Micah and Nancy own Financial Services, which pays a business income tax. Micah and Nancy do not have personal responsibility for the debts of Financial Services.

Riley and Kay own Speedy Packages, a courier service. Both are personally liable for the debts of the business.

IBC Services does not have separate legal existence apart from the one person who owns it.

Trent Company is owned by Trent Malone, who is personally liable for the company’s debts.

Ownership of Zander Company is divided into 1,000 shares of stock. The company pays a business income tax.

Physio Products does not pay income taxes and has one owner. The owner has unlimited liability for business debt.

AJ Company pays a business income tax and has two owners. Jeffy Auto is a separate legal entity from its owner, but it does not

pay a business income tax.

Exercise 1-7 Identifying accounting principles and assumptions C4 Enter the letter A through H for the principle or assumption in the blank space next to each numbered description that it best reflects.

A. General accounting principle B. Measurement (cost) principle C. Business entity assumption D. Revenue recognition principle E. Specific accounting principle F. Expense recognition (matching) principle G. Going-concern assumption H. Full disclosure principle

A company reports details behind financial statements that would

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_____ 2.

_____ 3.

_____ 4.

_____ 5. _____ 6. _____ 7. _____ 8.

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impact users’ decisions. Financial statements reflect the assumption that the business

continues operating. A company records the expenses incurred to generate the revenues

reported. Concepts, assumptions, and guidelines for preparing financial

statements. Each business is accounted for separately from its owner or owners. Revenue is recorded when products and services are delivered. Detailed rules used in reporting events and transactions. Information is based on actual costs incurred in transactions.

Exercise 1-8 Using the accounting equation A1 Determine the missing amount from each of the separate situations a, b, and c below.

Exercise 1-9 Using the accounting equation A1 Answer the following questions. Hint: Use the accounting equation.

a. At the beginning of the year, Addison Company’s assets are $300,000 and its equity is $100,000. During the year, assets increase $80,000 and liabilities increase $50,000. What is the equity at year-end?

b. Office Store has assets equal to $123,000 and liabilities equal to $47,000 at year-end. What is the equity for Office Store at year-end?

c. At the beginning of the year, Quaker Company’s liabilities equal $70,000. During the year, assets increase by $60,000, and at year-end assets equal $190,000. Liabilities decrease $5,000 during the year. What are the beginning and ending amounts of equity?

Check (c) Beg. equity, $60,000

Exercise 1-10 Analysis using the accounting equation P1 Zen began a new consulting firm on January 5. Following is a financial summary, including balances, for each of the company’s first five transactions (using the accounting equation form).

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Identify the explanation from a through j below that best describes each transaction 1 through 5 above and enter it in the blank space in front of each numbered transaction.

a. The company purchased office furniture for $8,000 cash. b. The company received $40,000 cash from a bank loan. c. The owner invested $1,000 cash in the business. d. The owner invested $40,000 cash in the business. e. The company purchased office supplies for $3,000 by paying $2,000 cash and

putting $1,000 on credit. f. The company billed a customer $6,000 for services provided.

g. The company purchased office furniture worth $8,000 on credit. h. The company provided services for $1,000 cash. i. The company sold office supplies for $3,000 and received $2,000 cash and

$1,000 on credit. j. The company provided services for $6,000 cash.

Exercise 1-11 Identifying effects of transactions on the accounting equation P1 The following table shows the effects of transactions 1 through 5 on the assets, liabilities, and equity of Mulan’s Boutique.

Identify the explanation from a through j below that best describes each transaction 1 through 5 and enter it in the blank space in front of each numbered transaction.

a. The company purchased $1,000 of office supplies on credit. b. The company collected $1,900 cash from an account receivable. c. The company sold land for $4,000 cash. d. The owner withdrew $1,000 cash from the business.

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_____ a. _____ b. _____ c. _____ d. _____ e. _____ f.

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e. The company purchased office supplies for $1,000 cash. f. The company purchased land for $4,000 cash.

g. The company billed a client $1,900 for services provided. h. The company paid $1,000 cash toward an account payable. i. The owner invested $1,900 cash in the business. j. The company sold office supplies for $1,900 on credit.

Exercise 1-12 Identifying effects of transactions on the accounting equation P1 For each transaction a through f, identify its impact on the accounting equation (select from 1 through 5 below).

The company pays cash toward an account payable. The company purchases equipment on credit. The owner invests cash in the business. The owner withdraws cash from the business. The company purchases supplies for cash. The company provides services for cash.

1. Decreases an asset and decreases equity. 2. Increases an asset and increases a liability. 3. Decreases an asset and decreases a liability. 4. Increases an asset and decreases an asset. 5. Increases an asset and increases equity.

Exercise 1-13 Identifying effects of transactions using the accounting equation P1 Ming Chen began a professional practice on June 1 and plans to prepare financial statements at the end of each month. During June, Ming Chen (the owner) completed these transactions.

a. Owner invested $60,000 cash in the company along with equipment that had a $15,000 market value.

b. The company paid $1,500 cash for rent of office space for the month. c. The company purchased $10,000 of additional equipment on credit (payment

due within 30 days). d. The company completed work for a client and immediately collected the

$2,500 cash earned. e. The company completed work for a client and sent a bill for $8,000 to be

received within 30 days. f. The company purchased additional equipment for $6,000 cash.

g. The company paid an assistant $3,000 cash as wages for the month. h. The company collected $5,000 cash as a partial payment for the amount owed

by the client in transaction e.

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i. The company paid $10,000 cash to settle the liability created in transaction c. j. Owner withdrew $1,000 cash from the company for personal use.

Required Create the following table similar to the one in Exhibit 1.9.

Then use additions and subtractions to show the dollar effects of the transactions on individual items of the accounting equation. Show new balances after each transaction. Check Ending balances: Cash, $46,000; Expenses, $4,500

Exercise 1-14 Analyzing return on assets A2 Swiss Group reports net income of $40,000 for 2019. At the beginning of 2019, Swiss Group had $200,000 in assets. By the end of 2019, assets had grown to $300,000. What is Swiss Group’s 2019 return on assets? How would you assess its performance if competitors average an 11% return on assets?

Exercise 1-15 Preparing an income statement P2 On October 1, Ebony Ernst organized Ernst Consulting; on October 3, the owner contributed $84,000 in assets to launch the business. On October 31, the company’s records show the following items and amounts. Use this information to prepare an October income statement for the business.

Check Net income, $2,110

Exercise 1-16 Preparing a statement of owner’s equity P2 Use the information in Exercise 1-15 to prepare an October statement of owner’s equity for Ernst Consulting.

Exercise 1-17 Preparing a balance sheet P2 Use the information in Exercise 1-15 to prepare an October 31 balance sheet for Ernst Consulting. Hint: The solution to Exercise 1-16 can help.

Exercise 1-18 Preparing a statement of cash flows P2 Use the information in Exercise 1-15 to prepare an October 31 statement of cash flows for Ernst Consulting. Assume the following additional information.

a. The owner’s initial investment consists of $38,000 cash and $46,000 in land. b. The company’s $18,000 equipment purchase is paid in cash.

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_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

_____ a. _____ b. _____ c. _____ d. _____ e.

c. The accounts payable balance of $8,500 consists of the $3,250 office supplies purchase and $5,250 in employee salaries yet to be paid.

d. The company’s rent, telephone, and miscellaneous expenses are paid in cash. e. No cash has been collected on the $14,000 consulting fees earned.

Check Net increase in cash, $11,360

Exercise 1-19 Identifying sections of the statement of cash flows P2 Indicate the section (O, I, or F) where transactions 1 through 8 would appear on the statement of cash flows.

O. Cash flows from operating activity F. Cash flows from financing activity I. Cash flows from investing activity

Cash purchase of equipment Cash withdrawal by owner Cash paid for advertising Cash paid for wages Cash paid on account payable to supplier Cash received from clients Cash paid for rent Cash investment by owner

Exercise 1-20 Preparing an income statement for a company P2 Ford Motor Company, one of the world’s largest automakers, reports the following income statement accounts for the year ended December 31 ($ in millions). Use this information to prepare Ford’s income statement for the year ended December 31.

Exercise 1-21B Identifying business activities C5 Match each transaction a through e to one of the following activities of an organization: financing activity (F), investing activity (I), or operating activity (O).

An owner contributes cash to the business. An organization borrows money from a bank. An organization advertises a new product. An organization sells some of its land. An organization purchases equipment.

Exercise 1-22 Preparing an income statement for a company P2 BMW Group, one of Europe’s largest manufacturers, reports the following income statement accounts for the year ended December 31 (euros in millions). Use this

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information to prepare BMW’s income statement for the year ended December 31.

Exercise 1-23 Using the accounting equation A1

Answer the following questions. Hint: Use the accounting equation.

a. On January 1, Lumia Company’s liabilities are $60,000 and its equity is $40,000. On January 3, Lumia purchases and installs solar panel assets costing $10,000. For the panels, Lumia pays $4,000 cash and promises to pay the remaining $6,000 in six months. What is the total of Lumia’s assets after the solar panel purchase?

b. On March 1, ABX Company’s assets are $100,000 and its liabilities are $30,000. On March 5, ABX is fined $15,000 for failing emission standards. ABX immediately pays the fine in cash. After the fine is paid, what is the amount of equity for ABX?

c. On August 1, Lola Company’s assets are $30,000 and its liabilities are $10,000. On August 4, Lola issues a sustainability report following SASB guidelines. Investors react positively to this report. On August 5, a new investor contributes $3,000 cash and $7,000 in equipment in exchange for Lola stock. After the investment, what is the amount of equity for Lola?

This icon highlights sustainability-related assignments

PROBLEM SET A

Problem Set B, located at the end of Problem Set A, is provided for each problem to reinforce the learning process

Problem 1-1A Identifying effects of transactions on financial statements A1 P1 Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with dollar amounts. The first transaction is completed as an example.

Required

a. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

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Problem 1-2A Computing missing information using accounting knowledge A1 P1 The following financial statement information is from five separate companies.

Required

1. Answer the following questions about Company A. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019?

Check (1b) $41,500

2. Answer the following questions about Company B. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is net income for year 2019?

(2c) $1,600

3. Compute the amount of assets for Company C on December 31, 2019. (3) $55,875

4. Compute the amount of owner investments for Company D during year 2019. 5. Compute the amount of liabilities for Company E on December 31, 2018.

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Problem 1-3A Preparing an income statement P2 As of December 31, 2019, Armani Company’s financial records show the following items and amounts.

Required Prepare the 2019 year-end income statement for Armani Company. Check Net income, $15,000

Problem 1-4A Preparing a statement of owner’s equity P2 Use the information in Problem 1-3A to prepare a year-end statement of owner’s equity for Armani Company. Note: The owner invested a total of $1,000 cash during the year.

Problem 1-5A Preparing a balance sheet P2 Use the information in Problem 1-3A to prepare a year-end balance sheet for Armani Company.

Problem 1-6A Preparing a statement of cash flows P2 Following is selected financial information of Kia Company for the year ended December 31, 2019.

Required Prepare the 2019 year-end statement of cash flows for Kia Company. Check Cash balance, Dec. 31, 2019, $3,500

Problem 1-7A Analyzing transactions and preparing financial statements P1 P2 Gabi Gram started The Gram Co., a new business that began operations on May 1. The Gram Co. completed the following transactions during its first month of operations.

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1. Create the following table similar to the one in Exhibit 1.9.

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance. Check (1) Ending balances: Cash, $42,780; Expenses, $5,030

2. Prepare the income statement and the statement of owner’s equity for the month of May, and the balance sheet as of May 31. (2) Net income, $6,070; Total assets, $44,750

3. Prepare the statement of cash flows for the month of May.

Problem 1-8A Analyzing effects of transactions P1 A1 Lita Lopez started Biz Consulting, a new business, and completed the following transactions during its first year of operations.

a. Lita Lopez invested $70,000 cash and office equipment valued at $10,000 in the company.

b. The company purchased an office suite for $40,000 cash. c. The company purchased office equipment for $15,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office

equipment on credit. e. The company paid a local newspaper $500 cash for printing an announcement

of the office’s opening. f. The company completed a financial plan for a client and billed that client

$2,800 for the service. g. The company designed a financial plan for another client and immediately

collected a $4,000 cash fee.

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h. Lita Lopez withdrew $3,275 cash from the company for personal use. i. The company received $1,800 cash as partial payment from the client

described in transaction f. j. The company made a partial payment of $700 cash on the equipment

purchased in transaction d. k. The company paid $1,800 cash for the office secretary’s wages for this

period.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $14,525; Expenses, $2,300; Accounts Payable, $2,200

2. Determine the company’s net income. (2) Net income, $4,500

Problem 1-9A Analyzing transactions and preparing financial statements C4 P1 P2 Sanyu Sony started a new business and completed these transactions during December.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $59,180; Accounts Payable, $8,550

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2. Prepare the income statement and the statement of owner’s equity for the current month, and the balance sheet as of the end of the month. (2) Net income, $4,160; Total assets, $76,760

3. Prepare the statement of cash flows for the current month.

Analysis Component

4. Assume that the owner investment transaction on December 1 was $49,000 cash instead of $65,000 and that Sony Electric obtained another $16,000 in cash by borrowing it from a bank. Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

Problem 1-10A Determining expenses, liabilities, equity, and return on assets A1 A2 Kyzera manufactures, markets, and sells cellular telephones. The average total assets for Kyzera is $250,000. In its most recent year, Kyzera reported net income of $65,000 on revenues of $475,000.

Required

1. What is Kyzera’s return on assets? 2. Does return on assets seem satisfactory for Kyzera given that its competitors

average a 12% return on assets? 3. What are total expenses for Kyzera in its most recent year?

Check (3) $410,000

4. What is the average total amount of liabilities plus equity for Kyzera? (4) $250,000

Problem 1-11A Computing and interpreting return on assets A2 Coca-Cola and PepsiCo both produce and market beverages that are direct competitors. Key financial figures for these businesses for a recent year follow.

Required

1. Compute return on assets for (a) Coca-Cola and (b) PepsiCo. Check (1a) 11.3%; (1b) 9.2%

2. Which company is more successful in its total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets

invested?

Analysis Component

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_____ a. _____ b. _____ c. _____ d.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

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4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information provided.)

Problem 1-12AA Identifying risk and return A3 All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” is most risky and “4” is least risky.

Lowest-risk corporate bond Medium-risk corporate bond Company stock in a start-up U.S. government Treasury bond

Problem 1-13AB Describing business activities C5 A start-up company often engages in the following transactions during its first year of operations. Classify those transactions in one of the three major categories of an organization’s business activities.

F. Financing I. Investing O. Operating

Owner investing in business Purchasing a building Purchasing land Borrowing cash from a bank Purchasing equipment Selling and distributing products Paying for advertising Paying employee wages

Problem 1-14AB Describing business activities C5 An organization undertakes various activities in pursuit of business success. Identify an organization’s three major business activities, and describe each activity.

PROBLEM SET B

Problem 1-1B Identifying effects of transactions on financial statements A1 P1 Identify how each of the following separate transactions 1 through 10 affects financial statements. For increases, place a “+” and the dollar amount in the column or columns. For decreases, place a “−” and the dollar amount in the column or columns. Some cells may contain both an increase (+) and a decrease (−) along with

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dollar amounts. The first transaction is completed as an example.

Required

a. For the balance sheet, identify how each transaction affects total assets, total liabilities, and total equity. For the income statement, identify how each transaction affects net income.

b. For the statement of cash flows, identify how each transaction affects cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

Problem 1-2B Computing missing information using accounting knowledge A1 P1 The following financial statement information is from five separate companies.

Required

1. Answer the following questions about Company V. a. What is the amount of equity on December 31, 2018? b. What is the amount of equity on December 31, 2019? c. What is the net income or loss for the year 2019?

Check (1b) $23,000

2. Answer the following questions about Company W. a. What is the amount of equity on December 31, 2018?

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b. What is the amount of equity on December 31, 2019? c. What is the amount of liabilities on December 31, 2019?

(2c) $22,000

3. Compute the amount of owner investments for Company X during 2019. 4. Compute the amount of assets for Company Y on December 31, 2019.

(4) $135,100

5. Compute the amount of liabilities for Company Z on December 31, 2018.

Problem 1-3B Preparing an income statement P2 As of December 31, 2019, Audi Company’s financial records show the following items and amounts.

Required Prepare the 2019 year-end income statement for Audi Company. Check Net income, $3,000

Problem 1-4B Preparing a statement of owner’s equity P2 Use the information in Problem 1-3B to prepare a year-end statement of owner’s equity for Audi Company. Hint: The owner invested $200 cash during the year.

Problem 1-5B Preparing a balance sheet P2 Use the information in Problem 1-3B to prepare a year-end balance sheet for Audi Company.

Problem 1-6B Preparing a statement of cash flows P2 Selected financial information of Banji Company for the year ended December 31, 2019, follows.

Required Prepare the 2019 year-end statement of cash flows for Banji Company.

Problem 1-7B Analyzing transactions and preparing financial statements P1 P2 Nina Niko launched a new business, Niko’s Maintenance Co., that began operations on June 1. The following transactions were completed by the company during that first month.

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1. Create the following table similar to the one in Exhibit 1.9.

Enter the effects of each transaction on the accounts of the accounting equation by recording dollar increases and decreases in the appropriate columns. Do not determine new account balances after each transaction. Determine the final total for each account and verify that the equation is in balance. Check (1) Ending balances: Cash, $130,060; Expenses, $9,790

2. Prepare the income statement and the statement of owner’s equity for the month of June, and the balance sheet as of June 30. (2) Net income, $7,135; Total assets, $133,135

3. Prepare the statement of cash flows for the month of June.

Problem 1-8B Analyzing effects of transactions P1 A1 Neva Nadal started a new business, Nadal Computing, and completed the following transactions during its first year of operations.

a. Neva Nadal invested $90,000 cash and office equipment valued at $10,000 in the company.

b. The company purchased an office suite for $50,000 cash. c. The company purchased office equipment for $25,000 cash. d. The company purchased $1,200 of office supplies and $1,700 of office

equipment on credit. e. The company paid a local newspaper $750 cash for printing an announcement

of the office’s opening. f. The company completed a financial plan for a client and billed that client

$2,800 for the service. g. The company designed a financial plan for another client and immediately

collected a $4,000 cash fee.

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h. Neva Nadal withdrew $11,500 cash from the company for personal use. i. The company received $1,800 cash from the client described in transaction f. j. The company made a payment of $700 cash on the equipment purchased in

transaction d. k. The company paid $2,500 cash for the office secretary’s wages.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $5,350; Expenses, $3,250; Accounts Payable, $2,200

2. Determine the company’s net income. (2) Net income, $3,550

Problem 1-9B Analyzing transactions and preparing financial statements C4 P1 P2 Rivera Roofing Company, owned by Reyna Rivera, began operations in July and completed these transactions during that first month of operations.

Required

1. Create the following table similar to the one in Exhibit 1.9.

Use additions and subtractions within the table to show the dollar effects of each transaction on individual items of the accounting equation. Show new balances after each transaction. Check (1) Ending balances: Cash, $87,545; Accounts Payable, $7,100

2. Prepare the income statement and the statement of owner’s equity for the month of July, and the balance sheet as of July 31. (2) Net income, $18,245; Total assets, $103,545

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3. Prepare the statement of cash flows for the month of July.

Analysis Component

4. Assume that the $5,000 purchase of roofing equipment on July 3 was financed from an owner investment of another $5,000 cash in the business (instead of the purchase conditions described in the transaction above). Compute the dollar effect of this change on the month-end amounts for (a) total assets, (b) total liabilities, and (c) total equity.

Problem 1-10B Determining expenses, liabilities, equity, and return on assets A1 A2 Ski-Doo Company manufactures, markets, and sells snowmobiles and snowmobile equipment and accessories. The average total assets for Ski-Doo is $3,000,000. In its most recent year, Ski-Doo reported net income of $201,000 on revenues of $1,400,000.

Required

1. What is Ski-Doo Company’s return on assets? 2. Does return on assets seem satisfactory for Ski-Doo given that its competitors

average a 9.5% return on assets? 3. What are the total expenses for Ski-Doo Company in its most recent year?

Check (3) $1,199,000

4. What is the average total amount of liabilities plus equity for Ski-Doo Company? (4) $3,000,000

Problem 1-11B Computing and interpreting return on assets A2 AT&T and Verizon produce and market telecommunications products and are competitors. Key financial figures for these businesses for a recent year follow.

Required

1. Compute return on assets for (a) AT&T and (b) Verizon. Check (1a) 1.6%; (1b) 4.5%

2. Which company is more successful in the total amount of sales to consumers? 3. Which company is more successful in returning net income from its assets

invested?

Analysis Component

4. Write a one-paragraph memorandum explaining which company you would invest your money in and why. (Limit your explanation to the information

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_____ a. _____ b. _____ c. _____ d.

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8.

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provided.)

Problem 1-12BA Identifying risk and return A3 All business decisions involve aspects of risk and return. Rank order the following investment activities from 1 through 4, where “1” reflects the highest expected return and “4” the lowest expected return.

Low-risk corporate bond Stock of a successful company Money stored in a fireproof vault U.S. Treasury bond

Problem 1-13BB Describing business activities C5 A start-up company often engages in the following activities during its first year of operations. Classify each of the following activities into one of the three major activities of an organization.

F. Financing I. Investing O. Operating

Providing client services Obtaining a bank loan Purchasing machinery Research for its products Supervising workers Owner investing in business Renting office space Paying utilities expenses

Problem 1-14BB Describing business activities C5 Identify in outline format the three major business activities of an organization. For each of these activities, identify at least two specific transactions or events normally undertaken by the business’s owners or its managers.

Serial Problem starts here and continues throughout the text

SERIAL PROBLEM

Business Solutions C4 P1

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©Alexander Image/Shutterstock

SP 1 On October 1, 2019, Santana Rey launched a computer services company, Business Solutions, that is organized as a proprietorship and provides consulting services, computer system installations, and custom program development.

Required Create a table like the one in Exhibit 1.9 using the following headings for columns: Cash; Accounts Receivable; Computer Supplies; Computer System; Office Equipment; Accounts Payable; S. Rey, Capital; S. Rey, Withdrawals; Revenues; and Expenses. Then use additions and subtractions within the table to show the dollar effects for each of the following October transactions for Business Solutions on the individual items of the accounting equation. Show new balances after each transaction.

Check Ending balances: Cash, $42,772; Revenues, $11,408; Expenses, $3,408

GENERAL LEDGER PROBLEM

Accounting professionals apply many technology tools to aid them in their everyday tasks and decision making. The General Ledger tool in Connect automates several

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of the procedural steps in the accounting cycle so the accounting professional can focus on the impacts of each transaction on the full set of financial statements. Chapter 2 is the first chapter to use this tool in helping students see the advantages of technology and, in particular, the power of the General Ledger tool in accounting practice, including financial analysis and “what-if” scenarios.

Accounting Analysis (AA) is a section aimed to refine company analysis, comparative analysis, and global analysis skills; Accounting Analysis assignments are available in Connect.

Accounting Analysis

COMPANY ANALYSIS A1 A2

AA 1-1 Key financial figures for Apple’s two most recent fiscal years follow.

Required

1. What is the total amount of assets invested in Apple in the current year? 2. What is Apple’s return on assets for the current year? 3. How much are total expenses for Apple for the current year? 4. Is Apple’s current-year return on assets better or worse than competitors’

average of 10% return?

COMPARATIVE ANALYSIS A1 A2

AA 1-2 Key comparative figures ($ millions) for both Apple and Google follow.

Required

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1. What is the total amount of assets invested for the current year in (a) Apple and (b) Google?

2. What is the current-year return on assets for (a) Apple and (b) Google? 3. How much are current-year expenses for (a) Apple and (b) Google? 4. Is the current-year return on assets better than the 10% return of competitors

for (a) Apple and (b) Google? 5. Relying only on return on assets, would we invest in Google or Apple?

Note: Reference to Google throughout the text refers to Alphabet Inc., as Google is a wholly owned subsidiary of Alphabet.

GLOBAL ANALYSIS A1 A2

AA 1-3 Samsung is a leading global manufacturer that competes with Apple and Google. Key financial figures for Samsung follow.

*Figures prepared in accordance with International Financial Reporting Standards as adopted by the Republic of Korea.

Required

1. What is the return on assets for Samsung in the (a) current year and (b) prior year?

2. Does Samsung’s return on assets exhibit a favorable or unfavorable trend? 3. Is Samsung’s current-year return on assets better or worse than that for (a)

Apple and (b) Google?

Beyond the Numbers (BTN) is a special problem section aimed to refine communication, conceptual, analysis, and research skills. It includes many activities helpful in developing an active learning environment.

Beyond the Numbers

ETHICS CHALLENGE C3 C4

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BTN 1-1 Tana Thorne works in a public accounting firm and hopes to eventually be a partner. The management of Allnet Company invites Thorne to prepare a bid to audit Allnet’s financial statements. In discussing the audit fee, Allnet’s management suggests a fee range in which the amount depends on the reported profit of Allnet. The higher its profit, the higher will be the audit fee paid to Thorne’s firm.

Required

1. Identify the parties potentially affected by this audit and the fee plan proposed.

2. What are the ethical factors in this situation? Explain. 3. Would you recommend that Thorne accept this audit fee arrangement? Why

or why not? 4. Describe some ethical considerations guiding your recommendation.

COMMUNICATING IN PRACTICE C2 C4

BTN 1-2 Refer to this chapter’s opening feature about Apple. Assume that the owners, sometime during their first five years of business, desire to expand their computer product services to meet business demand regarding computing services. They eventually decide to meet with their banker to discuss a loan to allow Apple to expand and offer computing services.

Required

1. Prepare a half-page report outlining the information you would request from the owners if you were the loan officer.

2. Indicate whether the information you request and your loan decision are affected by the form of business organization for Apple.

TAKING IT TO THE NET A2

BTN 1-3 Visit the EDGAR database at SEC.gov. Access the Form 10-K report of Rocky Mountain Chocolate Factory (ticker: RMCF) filed on May 23, 2017, covering its 2017 fiscal year.

Required

1. Item 6 of the 10-K report provides comparative financial highlights of RMCF for the years 2013–2017. Describe the revenue trend for RMCF over this five- year period.

2. Has RMCF been profitable (see net income) over this five-year period? Support your answer.

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TEAMWORK IN ACTION C1

BTN 1-4 Teamwork is important in today’s business world. Successful teams schedule convenient meetings, maintain regular communications, and cooperate with and support their members. This assignment aims to establish support/learning teams, initiate discussions, and set meeting times.

Required

1. Form teams and open a team discussion to determine a regular time and place for your team to meet between each scheduled class meeting. Notify your instructor via a memorandum or e-mail message as to when and where your team will hold regularly scheduled meetings.

2. Develop a list of telephone numbers, LinkedIn pages, and/or e-mail addresses of your teammates.

ENTREPRENEURIAL DECISION A1 A2

BTN 1-5 Refer to this chapter’s opening feature about Apple. Assume that the owners decide to open a new company with an innovative mobile app devoted to microblogging for accountants and those learning accounting. This new company will be called AccountApp.

Required

1. AccountApp obtains a $500,000 loan and the two owners contribute $250,000 in total from their own savings in exchange for ownership of the new company.

a. What is the new company’s total amount of liabilities plus equity? b. What is the new company’s total amount of assets?

2. If the new company earns $80,250 in net income in the first year of operation, compute its return on assets (assume average assets equal $750,000). Assess its performance if competitors average a 10% return. Check (2) 10.7%

HITTING THE ROAD C4

BTN 1-6 You are to interview a local business owner. (This can be a friend or relative.) Opening lines of communication with members of the business community can provide personal benefits of business networking. If you do not know the owner, you should call ahead to introduce yourself and explain your position as a student and your assignment requirements. You should request a 30- minute appointment for a face-to-face or phone interview to discuss the form of organization and operations of the business. Be prepared to make a good

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impression.

Required

1. Identify and describe the main operating activities and the form of organization for this business.

2. Determine and explain why the owner(s) chose this particular form of organization.

3. Identify any special advantages and/or disadvantages the owner(s) experiences in operating with this form of business organization.

Design elements: Lightbulb: ©Chuhail/Getty Images; Blue globe: ©nidwlw/Getty Images and ©Dizzle52/Getty Images; Chess piece: ©Andrei Simonenko/Getty Images and ©Dizzle52/Getty Images; Mouse: ©Siede Preis/Getty Images; Global View globe: ©McGraw- Hill Education and ©Dizzle52/Getty Images; Sustainability: ©McGraw-Hill Education and ©Dizzle52/Getty Images

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C1 C2 C3

C4

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2 Analyzing and Recording Transactions

Chapter Preview

SYSTEM OF ACCOUNTS

Using financial statements Source documents Types of accounts General ledger

NTK 2-1

DEBITS AND CREDITS

T-account Debits and credits Normal balance

NTK 2-2

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P1 A1

P2

P3 A2

C1 C2 C3 C4

A1 A2

P1 P2

RECORDING TRANSACTIONS

Journalizing and posting Processing transactions—Examples

NTK 2-3

TRIAL BALANCE

Trial balance preparation and use Error identification

NTK 2-4

FINANCIAL STATEMENTS

Financial statement preparation Debt ratio

NTK 2-5

Learning Objectives

CONCEPTUAL

Explain the steps in processing transactions and the role of source documents. Describe an account and its use in recording transactions. Describe a ledger and a chart of accounts. Define debits and credits and explain double-entry accounting.

ANALYTICAL

Analyze the impact of transactions on accounts and financial statements. Compute the debt ratio and describe its use in analyzing financial condition.

PROCEDURAL

Record transactions in a journal and post entries to a ledger. Prepare and explain the use of a trial balance.

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Prepare financial statements from business transactions.

Have a Fit

“I’m always confident” —JAMES PARK SAN FRANCISCO—James Park and Eric Friedman created a wooden box with a circuit

board inside. James recalls that to fix an antenna, he “literally took a piece of foam and put it on the circuit board.” Their device could be used to track fitness activity, such as steps taken. The device James and Eric built would later be known as a Fitbit (Fitbit.com).

©Daniel Boczarski/Getty Images for Fitbit

As Fitbit grew, the co-founders struggled to track sales and expenses. “It was pretty challenging,” recalls James. “I would just try to use the weekend to see if I could catch up.” James and Eric knew that having reliable accounting data would help “manage the ups and downs of running a company.”

To address this concern, the co-founders took action. They set up recordkeeping processes, transaction analysis, control procedures, and financial statement reporting. “You need to see the data,” insists James.

With accounting data, James says he “can uncover insights that weren’t possible or very practical before . . . and enable the discovery of new insights and trends.”

Eric offers the following advice to aspiring entrepreneurs unsure of how to unlock the potential of accounting data: “Get your hands dirty and do it yourself. You learn more that way.”

Sources: Fitbit website, January 2019; Wareable.com, September 2016; Business Wire, November 2015; Fortune, July 2015; Marketing Land, March 2015; Fast Company, March 2014

BASIS OF FINANCIAL STATEMENTS

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C1_______ Explain the steps in processing transactions and the role of source documents.

Business transactions and events are the starting points of financial statements. The process to go from transactions and events to financial statements includes the following.

Identify each transaction and event from source documents. Analyze each transaction and event using the accounting equation. Record relevant transactions and events in a journal. Post journal information to ledger accounts. Prepare and analyze the trial balance and financial statements.

Source Documents Source documents identify and describe transactions and events entering the accounting system. They can be in hard copy or electronic form. Examples are sales receipts, checks, purchase orders, bills from suppliers, payroll records, and bank statements. For example, cash registers record each sale on a tape or electronic file. This record is a source document for recording sales in the accounting system. Source documents are objective and reliable evidence about transactions and events and their amounts. Point: Accounting records also are called accounting books or the books.

The “Account” Underlying Financial Statements

C2_______ Describe an account and its use in recording transactions.

An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense. The general ledger, or simply ledger, is a record of all accounts used by a company. The ledger is often in electronic form. While most companies’ ledgers have similar accounts, a company often uses one or more unique accounts to match its type of operations. An unclassified balance sheet broadly groups accounts into assets, liabilities, and equity. Exhibit 2.1 shows common asset, liability, and equity accounts.

EXHIBIT 2.1 Accounts Organized by the Accounting Equation

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Asset Accounts Assets are resources owned or controlled by a company. Resources have expected future benefits. Most accounting systems include (at a minimum) separate accounts for the assets described here.

Cash A Cash account shows a company’s cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any funds that a bank accepts for deposit (coins, checks, money orders, and checking account balances).

Accounts Receivable Accounts receivable are held by a seller and are promises of payment from customers to sellers. Accounts receivable are increased by credit sales or sales on account (or on credit). They are decreased by customer payments. We record all increases and decreases in receivables in the Accounts Receivable account. When there are multiple customers, separate records are kept for each, titled Accounts Receivable—‘Customer Name’. Point: Customers and others who owe a company are debtors.

Note Receivable A note receivable, or promissory note, is a written promise of another entity to pay a specific sum of money on a specified future date to the holder of the note; the holder has an asset recorded in a Note (or Notes) Receivable account. Point: A note receivable is different than an account receivable because it comes from a formal contract called a promissory note. A note receivable usually requires interest, whereas an account receivable does not.

Prepaid Accounts Prepaid accounts (or prepaid expenses) are assets from prepayments of future expenses (expenses expected to be incurred in future accounting periods). When the expenses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts are prepaid insurance, prepaid rent, and prepaid services. Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal plans). When financial statements are prepared, (1) all expired and used prepaid accounts are recorded as expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future benefits). Chapter 3 covers prepaid accounts in detail. Point: At the beginning of the term, a prepaid college parking pass is an asset that allows a student to park on campus. Benefits of the parking pass expire as the term progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.

Supplies Accounts Supplies are assets until they are used. When they are used up, their costs are reported as expenses. Unused supplies are recorded in a Supplies asset account. Supplies often are grouped by purpose—for example, office supplies and store supplies. Office supplies include paper and pens. Store supplies include packaging and cleaning

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materials.

Equipment Accounts Equipment is an asset. When equipment is used and wears down, its cost is gradually reported as an expense (called depreciation). Equipment often is grouped by its purpose—for example, office equipment and store equipment. Office equipment includes computers and desks. The Store Equipment account includes counters and cash registers.

Buildings Accounts Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits. When a building is used and wears down, its cost is reported as an expense (called depreciation). When several buildings are owned, separate accounts are sometimes kept for each of them. Point: Some assets are called intangible because they do not have physical existence. Coca-Cola reports billions in intangible assets.

Land The cost of land is recorded in a Land account. The cost of buildings located on the land is separately recorded in building accounts.

Decision Insight

©Rob Kim/Getty Images

Women Entrepreneurs Sara Blakely (in photo), the billionaire entrepreneur/owner of SPANX, has promised to donate half of her wealth to charity. The Center for Women’s Business Research reports the following for women-owned businesses.

They total more than 11 million and employ nearly 20 million workers. They generate $2.5 trillion in annual sales and tend to embrace technology.

They are philanthropic—70% of owners volunteer at least once per month. ■

Liability Accounts Liabilities are obligations to transfer assets or provide products or services to others. They are claims (by creditors) against assets. Creditors are individuals and organizations that have rights to receive payments from a company. Common liability accounts are described here.

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Accounts Payable Accounts payable are promises to pay later. Payables can come from purchases of merchandise-for-resale, supplies, equipment, and services. We record all increases and decreases in payables in the Accounts Payable account. When there are multiple suppliers, separate records are kept for each, titled Accounts Payable—‘Supplier Name’. Point: Accounts payable also are called trade payables.

Note Payable A note payable is a written promissory note to pay a future amount. It is recorded as either a short-term note payable or a long-term note payable, depending on when it must be repaid. We explain short- and long-term classification in the next two chapters. Point: A note payable is different than an account payable because it comes from a formal contract called a promissory note and requires interest.

Unearned Revenue Accounts Unearned revenue is a liability that is settled in the future when a company delivers its products or services. When customers pay in advance for products or services (before revenue is earned), the seller records this receipt as unearned revenue. Examples of unearned revenue include magazine subscriptions collected in advance by a publisher, rent collected in advance by a landlord, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions and Unearned Rent. When products and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees Revenue and Rent Revenue.1

Point: Two words that almost always identify liability accounts: “payable,” meaning liabilities that must be paid, and “unearned,” meaning liabilities that must be fulfilled.

Accrued Liabilities Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These often are recorded in separate liability accounts by the same title. If they are not a large amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial statements often report totals of several ledger accounts.)

Decision Insight

©Mike Zarrilli/Getty Images

Unearned Revenue The Dallas Cowboys, Atlanta Falcons, New England Patriots, and most NFL teams have over $100 million in advance ticket sales in Unearned Revenue. When a team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenue. Teams in other major sports such as the National Women’s Soccer League and the Women’s National Basketball Association also have unearned revenue. ■

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Equity Accounts The owner’s claim on a company’s assets is called equity or owner’s equity. Equity is the owner’s residual interest in the assets of a business after subtracting liabilities. Equity is impacted by four types of accounts.

We show this in Exhibit 2.2 by expanding the accounting equation. We also organize assets and liabilities into subgroups that have similar attributes. An important subgroup for both assets and liabilities is the current items. Current items are expected to be either collected or owed within the next year. The next chapter explains this. At this point, know that a classified balance sheet groups accounts into classifications (such as land and buildings into Plant Assets) and it reports current assets before noncurrent assets and current liabilities before noncurrent liabilities.

EXHIBIT 2.2 Accounts Classified by the Expanded Accounting Equation

Owner Capital When an owner invests in a company, it increases both assets and equity. The increase to equity is recorded in the account titled Owner, Capital (where the owner’s name is inserted in place of “Owner”). C. Taylor, Capital is used for FastForward. Owner investments are recorded in this account.

Owner Withdrawals When an owner withdraws assets for personal use, it decreases both company assets and total equity. The decrease to equity is recorded in an account titled Owner, Withdrawals. C. Taylor, Withdrawals is used for FastForward. Withdrawals are not expenses of the business; they are simply the opposite of owner investments. Point: Owner, Withdrawals account is a contra equity account because it reduces the normal balance of equity.

Revenue Accounts Amounts received from sales of products and services to customers are recorded in revenue accounts, which increase equity. Examples of revenue accounts are Sales, Commissions Earned, Professional Fees Earned, Rent Revenue, and Interest Revenue. Revenues always increase equity.

Expense Accounts Amounts used for costs of providing products and services are recorded in expense accounts, which decrease equity. Examples of expense accounts are

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Advertising Expense, Salaries Expense, Rent Expense, Utilities Expense, and Insurance Expense. Expenses always decrease equity. A variety of revenues and expenses are in the chart of accounts at the end of this book. (Different companies use different account titles to describe the same thing. For example, some use Interest Revenue instead of Interest Earned.)

Decision Insight

Sporting Accounts The Cleveland Cavaliers, Boston Celtics, Golden State Warriors, and other NBA teams have revenue accounts that include Ticket Sales, Broadcast Fees, and Advertising Revenues. Expense accounts include Player Salaries, NBA Franchise Costs, and Promotional Costs. ■

Ledger and Chart of Accounts

C3_______ Describe a ledger and a chart of accounts.

The collection of all accounts and their balances is called a ledger (or general ledger). A company’s size and diversity of operations affect the number of accounts needed. A small company can have as few as 20 accounts; a large company can require thousands. The chart of accounts is a list of all ledger accounts and has an identification number assigned to each account. Exhibit 2.3 shows a common numbering system of accounts for a smaller business.

EXHIBIT 2.3 Typical Chart of Accounts for a Smaller Business

These account numbers have a three-digit code that is useful in recordkeeping. In this example, the first digit of asset accounts is a 1, the first digit of liability accounts is a 2, and so on. The second and third digits relate to the accounts’ subcategories. Exhibit 2.4 shows a partial chart of accounts for FastForward.

EXHIBIT 2.4 Partial Chart of Accounts for FastForward

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1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

NEED-TO-KNOW 2-1

Classifying Accounts C1 C2 C3

Classify each of the following accounts as either an asset (A), liability (L), or equity (EQ) account.

Prepaid Rent Owner, Capital Note Receivable Accounts Payable Accounts Receivable Equipment Interest Payable Unearned Revenue Land Prepaid Insurance Wages Payable Rent Payable

Solution

1. A 2. EQ 3. A 4. L 5. A 6. A 7. L 8. L 9. A 10. A 11. L 12. L

Do More: QS 2-2, QS 2-3

DOUBLE-ENTRY ACCOUNTING

Debits and Credits

C4_______ Define debits and credits and explain double-entry accounting.

A T-account represents a ledger account and is used to show the effects of transactions. Its name comes from its shape like the letter T. The layout of a T-account is shown in Exhibit 2.5.

EXHIBIT 2.5 The T-Account

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The left side of an account is called the debit side, or Dr. The right side is called the credit side, or Cr. To enter amounts on the left side of an account is to debit the account. To enter amounts on the right side is to credit the account. The term debit or credit, by itself, does not mean increase or decrease. Whether a debit or a credit is an increase or decrease depends on the account.

The difference between total debits and total credits for an account, including any beginning balance, is the account balance. When total debits exceed total credits, the account has a debit balance. It has a credit balance when total credits exceed total debits. When total debits equal total credits, the account has a zero balance. Point: Dr. and Cr. come from 18th-century English where terms debitor and creditor were used instead of debit and credit. Dr. and Cr. use the first and last letters of these terms, just as we still do for Saint (St.) and Doctor (Dr.).

Double-Entry System

Double-entry accounting demands the accounting equation remain in balance, which means that for each transaction:

At least two accounts are involved, with at least one debit and one credit. Total amount debited must equal total amount credited.

This means total debits must equal total credits for all entries, and total debit account balances in the ledger must equal total credit account balances. The system for recording debits and credits follows the accounting equation—see Exhibit 2.6.

EXHIBIT 2.6 Debits and Credits in the Accounting Equation

Point: Debit and credit are accounting directions for left and right.

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Net increases or decreases on one side have equal net effects on the other side. For example, a net increase in assets must include an equal net increase on the liabilities and equity side. Some transactions affect only one side of the equation, such as acquiring a land asset by giving up a cash asset, but their net effect on this one side is zero.

The left side is the normal balance side for assets; the right side is the normal balance side for liabilities and equity. This matches their layout in the accounting equation, where assets are on the left side and liabilities and equity are on the right. Point: Assets are on the left-hand side of the equation and thus increase on the left. Liabilities and equity are on the right-hand side of the equation and thus increase on the right.

Equity increases from revenues and owner investments and it decreases from expenses and owner withdrawals. We see this by expanding the accounting equation to include debits and credits in double-entry form, as shown in Exhibit 2.7.

EXHIBIT 2.7 Debit and Credit Effects for Component Accounts

Increases (credits) to owner’s capital and revenues increase equity; increases (debits) to withdrawals and expenses decrease equity. The normal balance of each account is the side where increases are recorded.

The T-account for FastForward’s Cash account, reflecting its first 11 transactions (from Exhibit 1.9), is shown in Exhibit 2.8. The total increases (debits) in its Cash account are $36,100, and the total decreases (credits) are $31,300. Total debits exceed total credits by $4,800, resulting in its ending debit balance of $4,800. Point: DrEAD means debit (Dr) is the normal balance side for Expense, Asset, and Drawing accounts; credit the others.

EXHIBIT 2.8 Computing the Balance for a T-Account

Point: The ending balance is on the side with the larger dollar amount. Also, a plus (+) and minus (−) are not used in a T-account.

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________ 1. ________ 2. ________ 3. ________ 4. ________ 5. ________ 6. ________ 7. ________ 8. ________ 9. ________10. ________11. ________12.

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NEED-TO-KNOW 2-2

Normal Account Balance C4

Identify the normal balance (debit [Dr] or credit [Cr]) for each of the following accounts.

Prepaid Rent Owner, Capital Note Receivable Accounts Payable Accounts Receivable Equipment Interest Payable Unearned Revenue Land Prepaid Insurance Owner, Withdrawals Utilities Expense

Solution

1. Dr. 2. Cr. 3. Dr. 4. Cr. 5. Dr. 6. Dr. 7. Cr. 8. Cr. 9. Dr. 10. Dr. 11. Dr. 12. Dr.

Do More: QS 2-4, QS 2-5, QS 2-7, E 2-4

ANALYZING AND PROCESSING TRANSACTIONS This section explains the analyzing, recording, and posting of transactions.

Journalizing and Posting Transactions

P1_______ Record transactions in a journal and post entries to a ledger.

The four steps of processing transactions are shown in Exhibit 2.9. Steps 1 and 2— transaction analysis and the accounting equation—already were covered. This section focuses on steps 3 and 4. Step 3 is to record each transaction chronologically in a journal. A journal is a complete record of each transaction in one place. It also shows debits and credits for each transaction. Recording transactions in a journal is called journalizing. Step 4 is to transfer (or post) entries from the journal to the ledger. Transferring journal entry information to the

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ⓐ

ⓑ

ⓒ

ⓓ

ledger is called posting.

EXHIBIT 2.9 Steps in Processing Transactions

Journalizing Transactions Journalizing transactions requires an understanding of a journal. While companies can use various journals, every company uses a general journal. It can be used to record any transaction. Exhibit 2.10 shows how the first two transactions of FastForward are recorded in a general journal.

EXHIBIT 2.10 Partial General Journal for FastForward

To record entries in a general journal, apply these steps; refer to Exhibit 2.10.

Date the transaction: Enter the year at the top of the first column and the month and day on the first line of each journal entry.

Enter titles of accounts debited and then enter amounts in the Debit column on the same line. Account titles are taken from the chart of accounts and are aligned with the left margin of the Account Titles and Explanation column.

Enter titles of accounts credited and then enter amounts in the Credit column on the same line. Account titles are from the chart of accounts and are indented from the left margin of the Account Titles and Explanation column to separate them from debited accounts.

Enter a brief explanation of the transaction on the line below the entry (it often references a source document). This explanation is indented about half as far as the credited account titles to avoid confusing it with accounts, and it is italicized.

Point: There are no exact rules for a journal entry explanation—it should be short yet describe why an entry is made.

A blank line is left between each journal entry for clarity. When a transaction is first recorded, the posting reference (PR) column is left blank (in a manual system). Later, when posting entries to the ledger, the identification numbers of the individual ledger accounts are entered in the PR column.

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Balance Column Account T-accounts are simple and show how the accounting process works. However, actual accounting systems need more structure and therefore use a different formatting of T-accounts, called balance column accounts, shown in Exhibit 2.11.

EXHIBIT 2.11 Cash Account in Balance Column Format

The balance column account format is similar to a T-account in having columns for debits and credits. It is different in including transaction date and explanation columns. It also has a column with the balance of the account after each entry is recorded. FastForward’s Cash account in Exhibit 2.11 is debited on December 1 for the $30,000 owner investment, yielding a $30,000 debit balance. The account is credited on December 2 for $2,500, yielding a $27,500 debit balance. On December 3, it is credited for $26,000, and its debit balance is reduced to $1,500. The Cash account is debited for $4,200 on December 10, and its debit balance increases to $5,700; and so on.

The heading of the Balance column does not show whether it is a debit or credit balance. Instead, an account is assumed to have a normal balance. Unusual events can sometimes temporarily create an abnormal balance. An abnormal balance is a balance on the side where decreases are recorded. For example, a customer might mistakenly overpay a bill. This gives that customer’s account receivable an abnormal (credit) balance. An abnormal balance often is identified by setting it in brackets or entering it in red. A zero balance is shown by writing zero or a dash in the Balance column. Point: Explanations are included in ledger accounts only for unusual transactions or events.

Posting Journal Entries Step 4 of processing transactions is to post journal entries to ledger accounts. All entries are posted to the ledger before financial statements are prepared so that account balances are up-to-date. When entries are posted to the ledger, the debits in journal entries are transferred into ledger accounts as debits, and credits are transferred into ledger accounts as credits. Exhibit 2.12 shows four parts to posting a journal entry. First, identify the ledger account(s) that is debited in the entry. Next, in the ledger, enter the entry date, the journal and page in its PR column, the debit amount, and the new balance of the ledger account. (G shows it came from the general journal.) Second, enter the ledger account number in the PR column of the journal. Parts C and D repeat the first two steps for credit entries and amounts. The posting process creates a link between the ledger and the journal entry. This link is a useful cross-reference for tracing an amount from one record to another. Point: Posting is automatic with accounting software. Point: The fundamental concepts of a manual system are identical to those of a computerized information system.

EXHIBIT 2.12 Posting an Entry to the Ledger

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Step 1 Step 2 Step 3 Step 4

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Processing Transactions—An Example

A1_______ Analyze the impact of transactions on accounts and financial statements.

We use FastForward to show how double-entry accounting is used in analyzing and processing transactions. Analysis of each transaction follows the four steps of Exhibit 2.9.

Identify the transaction and any source documents.

Analyze the transaction using the accounting equation.

Record the transaction in journal entry form applying double-entry accounting.

Post the entry (for simplicity, we use T-accounts to represent ledger accounts).

Study each transaction before moving to the next. The first 11 transactions are from Chapter 1, and we analyze five additional December transactions of FastForward (numbered 12 through 16). Point: In Need-To-Know 2-5, we show how to use balance column accounts for the ledger.

1. Receive Investment by Owner

2. Purchase Supplies for Cash

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3. Purchase Equipment for Cash

4. Purchase Supplies on Credit

5. Provide Services for Cash

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6. Payment of Expense in Cash

7. Payment of Expense in Cash

Point: Salary usually refers to compensation of a fixed amount for a given time period. Wages is compensation based on time worked.

8. Provide Consulting and Rental Services on Credit

Point: The revenue recognition principle requires revenue to be recognized when the company provides products and services to a customer. This is not necessarily the same time that the customer pays.

Point: Transaction 8 is a compound journal entry, which is an entry that affects three or more accounts. The rule that total debits equal total credits continues.

9. Receipt of Cash on Account

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11. Withdrawal of Cash by Owner

Point: Owner withdrawals always decrease equity.

12. Receipt of Cash for Future Services

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Point: “Unearned” accounts are liabilities that must be fulfilled.

13. Pay Cash for Future Insurance Coverage

14. Purchase Supplies for Cash

Point: Luca Pacioli, a 15th-century monk and famous mathematician, was the first to devise double-entry accounting.

15. Payment of Expense in Cash

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16. Payment of Expense in Cash

Summarizing Transactions in a Ledger Exhibit 2.13 shows the ledger accounts (in T-account form) of FastForward after all 16 transactions are recorded and posted and the balances computed. The accounts are grouped into three columns following the accounting equation: assets, liabilities, and equity.

Totals for the three columns obey the accounting equation: Assets equal $42,395 ($4,275 + $0 + $9,720 + $2,400 + $26,000). Liabilities equal $9,200 ($6,200 + $3,000). Equity equals $33,195 ($30,000 − $200 + $5,800 + $300 − $1,400 − $1,000 − $305). These obey the accounting equation: $42,395 = $9,200 + $33,195.

Capital, withdrawals, revenue, and expense accounts reflect transactions that change equity. Revenue and expense account balances are reported in the income statement.

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EXHIBIT 2.13 Ledger for FastForward (in T-Account Form)

NEED-TO-KNOW 2-3

Recording Transactions P1 A1

Assume Tata Company began operations on January 1 and completed the following

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transactions during its first month of operations. For each transaction, (a) analyze the transaction using the accounting equation, (b) record the transaction in journal entry form, and (c) post the entry using T-accounts to represent ledger accounts. Tata Company has the following (partial) chart of accounts—account numbers in parentheses: Cash (101); Accounts Receivable (106); Equipment (167); Accounts Payable (201); J. Tata, Capital (301); J. Tata, Withdrawals (302); Services Revenue (403); and Wages Expense (601).

Solution

Jan. 1 Receive Investment by Owner

Jan. 5 Purchase Equipment on Credit

Jan. 14 Provide Services on Credit

Do More: QS 2-6, E 2-7, E 2-9, E 2-11, E 2-12

TRIAL BALANCE

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P2_______ Prepare and explain the use of a trial balance.

A trial balance is a list of all ledger accounts and their balances at a point in time. Exhibit 2.14 shows the trial balance for FastForward after its 16 entries are posted to the ledger. (This is an unadjusted trial balance. Chapter 3 explains adjustments.)

Preparing a Trial Balance Preparing a trial balance has three steps.

1. List each account title and its amount (from the ledger) in the trial balance. If an account has a zero balance, list it with a zero in its normal balance column (or omit it).

2. Compute the total of debit balances and the total of credit balances. 3. Verify (prove) total debit balances equal total credit balances.

The total of debit balances equals the total of credit balances for the trial balance in Exhibit 2.14. Equality of these two totals does not guarantee that no errors were made. For example, the column totals will be equal when a debit or credit of a correct amount is made to a wrong account. Another error not identified with a trial balance is when equal debits and credits of an incorrect amount are entered.

EXHIBIT 2.14 Trial Balance (Unadjusted)

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Point: A trial balance is not a financial statement but a tool for checking equality of debits and credits in the ledger.

Searching for Errors If the trial balance does not balance (when its columns are not equal), the error(s) must be found and corrected. An efficient way to search for an error is to check the journalizing, posting, and trial balance preparation in reverse order. Step 1 is to verify that the trial balance columns are correctly added. If step 1 does not find the error, step 2 is to verify that account balances are accurately entered from the ledger. Step 3 is to see whether a debit (or credit) balance is mistakenly listed in the trial balance as a credit (or debit). A clue to this error is when the difference between total debits and total credits equals twice the amount of the incorrect account balance. Step 4 is to recompute each account balance in the ledger. Step 5 is to verify that each journal entry is properly posted. Step 6 is to verify that the original journal entry has equal debits and credits. At this point, the errors should be uncovered. Example: If a credit to Unearned Revenue was incorrectly posted to the Revenue ledger account, would the ledger still balance? Answer: The ledger would balance, but liabilities would be understated, equity would be overstated, and income would be overstated.

Ethical Risk

Accounting Quality Recording valid and accurate transactions enhances the quality of financial statements. Roughly 30% of employees in IT report observing misconduct such as falsifying accounting data. They also report increased incidences of such misconduct in recent years. Source: KPMG.■

Financial Statements Prepared from Trial Balance

P3_______ Prepare financial statements from business transactions.

Financial Statements across Time How financial statements are linked in time is shown in Exhibit 2.15. A balance sheet reports an organization’s financial position at a point in time. The income statement, statement of owner’s equity, and statement of cash flows report financial performance over a period of time. The three statements in the middle column of Exhibit 2.15 explain how financial position changes from the beginning to the end of a reporting period.

EXHIBIT 2.15 Links between Financial Statements across Time

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A one-year (annual) reporting period is common, as are semiannual, quarterly, and monthly periods. The one-year reporting period is called the accounting, or fiscal, year. Businesses whose accounting year begins on January 1 and ends on December 31 are called calendar-year companies.

Financial Statement Preparation This section shows how to prepare financial statements from the trial balance. (These are unadjusted statements. Chapter 3 explains adjustments.) We prepare these statements in the following order.

1 Income Statement An income statement reports revenues earned minus expenses incurred over a period of time. FastForward’s income statement for December is shown at the top right side of Exhibit 2.16. Information about revenues and expenses is taken from the trial balance on the left side. Net income of $3,395 is the bottom line for the income statement. Owner investments and withdrawals are not part of income. Point: An income statement also is called an earnings statement, a statement of operations, or a P&L (profit and loss) statement. A balance sheet also is called a statement of financial position.

2 Statement of Owner’s Equity The statement of owner’s equity reports how equity changes over the reporting period. FastForward’s statement of owner’s equity is the second report in Exhibit 2.16. It shows the $30,000 owner investment, the $3,395 of net income, the $200 withdrawal, and the $33,195 end-of-period (capital) balance. (The beginning balance in the statement of owner’s equity is rarely zero, except in the first period of operations. The beginning balance in January 2020 is $33,195, which is December 2019’s ending balance.) Point: Revenues and expenses are not reported in detail in the statement of owner’s equity. Instead, their effects are reflected through net income.

3 Balance Sheet The balance sheet reports the financial position of a company at a point in time. FastForward’s balance sheet is the third report in Exhibit 2.16. This statement shows financial condition at the close of business on December 31. The left side of the balance sheet lists its assets: cash, supplies, prepaid insurance, and equipment. The upper right side of the balance sheet shows that it owes $6,200 to creditors and $3,000 in services to customers who paid in advance. The equity section shows an ending capital balance of $33,195. Note the link between the ending balance of the statement of owner’s equity and the capital balance. (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity. Either presentation is acceptable.)

EXHIBIT 2.16 Financial Statements Prepared from Trial Balance

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Point: A statement’s heading lists the 3 W’s: Who—name of organization, What—name of statement, When—point in time or period of time. Point: Arrow lines show how the statements are linked. Point: To foot a column of numbers is to add them.

Presentation Issues Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports such as trial balances. We usually put dollar signs beside only the first and last numbers in a column. Apple’s financial statements in Appendix A show this. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level. Apple, like many large companies, rounds its financial statement amounts to the nearest million. This decision is based on the impact of rounding for users’ decisions.

Decision Maker

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Entrepreneur You open a wholesale business selling entertainment equipment to retail outlets. Most of your customers want to buy on credit. How can you use the balance sheets of customers to decide which ones to extend credit to? ■ Answer: We use the accounting equation (Assets = Liabilities + Equity) to identify risky customers to whom we would not want to extend credit. A balance sheet provides amounts for each of these key components. The lower a customer’s equity is relative to liabilities, the less likely you would be to extend credit. A low equity means the business already has many creditor claims to it.

NEED-TO-KNOW 2-4

Preparing Trial Balance P2

Prepare a trial balance for Apple using the following condensed data from its recent fiscal year ended September 30 ($ in millions).

Solution ($ in millions)

Do More: E 2-8, E 2-10

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Decision Analysis Debt Ratio

A2_______ Compute the debt ratio and describe its use in analyzing financial condition.

It is important to assess a company’s risk of failing to pay its debts. Companies finance their assets with either liabilities or equity. A company that finances a relatively large portion of its assets with liabilities is said to have higher financial leverage. Higher financial leverage means greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). One measure of the risk associated with liabilities is the debt ratio as defined in Exhibit 2.17.

EXHIBIT 2.17 Debt Ratio

Costco’s total liabilities, total assets, and debt ratio for the past three years are shown in Exhibit 2.18. Costco’s debt ratio ranges from a low of 0.63 to a high of 0.70. Its ratio exceeds Walmart’s in each of the last three years, suggesting a higher than average risk from financial leverage. So, is financial leverage good or bad for Costco? The answer: If Costco is making more money with this debt than it is paying the lenders, then it is successfully borrowing money to make more money. A company’s use of debt can turn unprofitable quickly if its return from that money drops below the rate it is paying lenders.

EXHIBIT 2.18 Computation and Analysis of Debt Ratio

Decision Maker

Investor You consider buying stock in Converse. As part of your analysis, you compute the company’s debt ratio for 2017, 2018, and 2019 as 0.35, 0.74, and 0.94, respectively. Based on the debt ratio, is Converse a low-risk investment? Has the risk of buying Converse stock changed over this period? (The industry debt ratio averages 0.40.) ■ Answer: The debt ratio suggests that Converse’s stock is of higher risk than normal and that this risk is rising. The average industry ratio of 0.40 supports this conclusion. The 2019 debt ratio for Converse is twice the industry norm. Also, a debt ratio approaching 1.0 indicates little to no equity.