Prepare a tabular analysis of the transactions

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LEARNING OBJECTIVE 1

Identify the forms of business organization and the uses of accounting information. 

Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, especially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.

FORMS OF BUSINESS ORGANIZATION Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.

SOLE PROPRIETORSHIP

You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner-operated businesses such as barber shops, law of�ices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

PARTNERSHIP

Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certi�ied public accountants), often organize as partnerships.

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Alternative Terminology notes present synonymous terms that you may come across in practice.

CORPORATION

As a third alternative, you might organize as a corporation. A business organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money. Therefore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate.

Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.

Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among

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these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes.

The combined number of proprietorships and partnerships in the United States is more than �ive times the number of corporations. However, the revenue produced by corporations is eight times greater. Most of the largest businesses in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this textbook is on the corporate form of organization.

ALTERNATIVE TERMINOLOGY

Stockholders are sometimes called shareholders.

USERS AND USES OF FINANCIAL INFORMATION The purpose of �inancial information is to provide inputs for decision-making. Accounting is the information system that identi�ies, records, and communicates the economic events of an organization to interested users. Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, �inance directors, and company of�icers. In running a business, managers must answer many important questions, as shown in Illustration 1-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0001) .

ILLUSTRATION 1-1 Questions that internal users ask

Accounting Across the Organization boxes show applications of accounting information in various business functions.

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To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as �inancial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized �inancial information in the form of �inancial statements.

 ACCOUNTING ACROSS THE ORGANIZATION 

Clif Bar & Company

Owning a Piece of the Bar

The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor's Breakaway Brands®. One of Clif Bar & Company's proudest moments was the creation of an employee stock ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its �inances. Armed with basic accounting knowledge, employees are more aware of the �inancial impact of their actions, which leads to better decisions.

What are the bene�its to the company and to the employees of making the �inancial statements available to all employees? (Go to WileyPLUS for this answer and additional questions.)

External Users

There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0002) .

ILLUSTRATION 1-2 Questions that external users ask

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The information needs and questions of other external users vary considerably. Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. Customers are interested in whether a company like General Motors will continue to honor product warranties and otherwise support its product lines. Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and bene�its. Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record pro�its at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to investigate the energy traders to make sure that the pro�its were earned by legitimate and fair practices.

ACCOUNTING ACROSS THE ORGANIZATION

Spinning the Career Wheel

How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every �ield of business. Some examples of how accounting is used in business careers include the following.

General management: Managers of Ford Motors, Massachusetts General Hospital, California State University– Fullerton, a McDonald's franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.

Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and bene�its, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a pro�itable sale.

Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These �ields rely heavily on accounting knowledge to analyze �inancial statements. In fact, it is dif�icult to get a good job in a �inance function without two or three courses in accounting.

Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank —is almost always involved in �inancing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash �low from an industrial property justify the purchase price? What are the tax bene�its of the purchase?

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How might accounting help you? (Go to WileyPLUS for this answer and additional questions.)

ETHICS IN FINANCIAL REPORTING People won't gamble in a casino if they think it is “rigged.” Similarly, people won't “play” the stock market if they think stock prices are rigged. At one time, the �inancial press was full of articles about �inancial scandals at Enron, WorldCom, HealthSouth, and AIG. As more scandals came to light, a mistrust of �inancial reporting in general seemed to be developing. One article in the Wall Street Journal noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent stock prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the �inancial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable �inancial reporting.

United States regulators and lawmakers were very concerned that the economy would suffer if investors lost con�idence in corporate accounting because of unethical �inancial reporting. Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. As a result of SOX, top management must now certify the accuracy of �inancial information. In addition, penalties for fraudulent �inancial activity are much more severe. Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate �inancial statements and the oversight role of boards of directors.

ETHICS NOTE

Circus-founder P.T. Barnum is alleged to have said, “Trust everyone, but cut the deck.” What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

Effective �inancial reporting depends on sound ethical behavior. To sensitize you to ethical situations and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook. (1) A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to �inancial reporting. (2) Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. (3) Many of the People, Planet, and Pro�it Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. (4) At the end of each chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case.

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When analyzing these various ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01lo1#c01-�ig-0003) .

ILLUSTRATION 1-3 Steps in analyzing ethics cases

 ETHICS INSIGHT 

Dewey & LeBoeuf LLP

I Felt the Pressure—Would You?

“I felt the pressure.” That's what some of the employees of the now- defunct law �irm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former �inance director and former chief �inancial of�icer (CFO) of the �irm. Here are some of their comments:

“I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”

“I intentionally gave the auditors incorrect information in the course of the audit.”

What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their �inancial manipulations as accounting tricks, cooking the books, and fake income.

Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).

Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to WileyPLUS for this answer and additional questions.)

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Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and corporate social responsibility. Guideline answers to the critical thinking questions are available in WileyPLUS and at www.wiley.com/college/weygandt (http://www.wiley.com/college/weygandt) . Additional questions are offered in WileyPLUS.

DO IT! 1

Business Organization Forms

DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.

In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.

1. Easier to raise funds.

2. Simple to establish.

3. No personal legal liability.

4. Tax advantages.

5. Easier to transfer ownership.

Action Plan ✓ Know which organizational form best matches the business

type, size, and preferences of the owner(s).

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SOLUTION

1. Easier to raise funds: Corporation.

2. Simple to establish: Sole proprietorship and partnership.

3. No personal legal liability: Corporation.

4. Tax advantages: Sole proprietorship and partnership.

5. Easier to transfer ownership: Corporation.

Related exercise material: BE1-1 and DO IT! 1-1.

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3

The Accounting Information System

 CHAPTER PREVIEW 

As indicated in the Feature Story, a reliable information system is a necessity for any company. The purpose of this chapter is to explain and illustrate the features of an accounting information system.

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Accidents Happen

How organized are you �inancially? Take a short quiz. Answer yes or no to each question:

Does your wallet contain so many cash machine receipts that you've been declared a walking �ire hazard?

Do you wait until your debit card is denied before checking the status of your funds?

Was Aaron Rodgers (the quarterback for the Green Bay Packers) playing high school football the last time you veri�ied the accuracy of your bank account?

If you think it is hard to keep track of the many transactions that make up your life, imagine how dif�icult it is for a big corporation to do so. Not only that, but now consider how important it is for a big company to have good accounting records, especially if it has control of your life savings. MF Global Holdings Ltd was such a company. As a large investment broker, it held billions of dollars of investments for clients. If you had your life savings invested at MF Global, you might be slightly displeased if you heard this from one of its representatives: “You know, I kind of remember an account for someone with a name like yours—now what did we do with that?”

Unfortunately, that is almost exactly what happened to MF Global's clients shortly before it �iled for bankruptcy. During the days immediately following the bankruptcy �iling, regulators and auditors struggled to piece things together. In the words of one regulator, “Their books are a disaster … we're trying to �igure out what numbers are real numbers.” One company that considered buying an interest in MF Global walked away from the deal because it “couldn't get a sense of what was on the balance sheet.” That company said the information that should have been instantly available instead took days to produce.

It now appears that MF Global did not properly segregate customer accounts from company accounts. And, because of its sloppy recordkeeping, customers were not protected when the company had �inancial troubles. Total customer losses were approximately $1 billion. As you can see, accounting matters!

Source: S. Patterson and A. Lucchetti, “Inside the Hunt for MF Global Cash,” Wall Street Journal Online (November 11, 2011).

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LEARNING OBJECTIVE 1

Analyze the effect of business transactions on the basic accounting equation. 

The accounting cycle graphic above illustrates the steps companies follow each period to record transactions and eventually prepare �inancial statements.

The system of collecting and processing transaction data and communicating �inancial information to decision-makers is known as the accounting information system. Factors that shape an accounting information system include the nature of the company's business, the types of transactions, the size of the company, the volume of data, and the information demands of management and others.

Most businesses use computerized accounting systems—sometimes referred to as electronic data processing (EDP) systems. These systems handle all the steps involved in the recording process, from initial data entry to preparation of the �inancial statements. In order to remain competitive, companies continually improve their accounting systems to provide accurate and timely data for decision-making. For example, in a recent annual report, Tootsie Roll stated, “We also invested in additional processing and data storage hardware during the year. We view information technology as a key strategic tool, and are committed to deploying leading edge technology in this area.” In addition, many companies have upgraded their accounting information systems in response to the requirements of Sarbanes-Oxley.

Accounting information systems rely on a process referred to as the accounting cycle. As you can see from the graphic above, the accounting cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. We explain each of the steps in this chapter as well as in Chapter 4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04#ch04) .

In this chapter, in order to emphasize the underlying concepts and principles, we focus on a manual accounting system. The accounting concepts and principles do not change whether a system is computerized or manual.

ACCOUNTING TRANSACTIONS To use an accounting information system, you need to know which economic events to recognize (record). Not all events are recorded and reported in the �inancial statements. For example, suppose General Motors hired a new employee and purchased a new computer. Are these events entered in its accounting records?

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The �irst event would not be recorded, but the second event would. We call economic events that require recording in the �inancial statements accounting transactions.

An accounting transaction occurs when assets, liabilities, or stockholders' equity items change as a result of some economic event. The purchase of a computer by General Motors, the payment of rent by Microsoft, and the sale of a multi-day guided trip by Sierra Corporation are examples of events that change a company's assets, liabilities, or stockholders' equity. Illustration 3-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo1#c03-�ig-0001) summarizes the decision process companies use to decide whether or not to record economic events.

ILLUSTRATION 3-1 Transaction identi�ication process

ANALYZING TRANSACTIONS In Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , you learned the basic accounting equation:

Assets=Liabilities+Stockholders' Equity

In this chapter, you will learn how to analyze transactions in terms of their effect on assets, liabilities, and stockholders' equity. Transaction analysis is the process of identifying the speci�ic effects of economic events on the accounting equation.

The accounting equation must always balance. Each transaction has a dual (double-sided) effect on the equation. For example, if an individual asset is increased, there must be a corresponding:

Decrease in another asset, or

Increase in a speci�ic liability, or

Increase in stockholders' equity.

Two or more items could be affected when an asset is increased. For example, if a company purchases a computer for $10,000 by paying $6,000 in cash and signing a note for $4,000, one asset (equipment) increases $10,000, another asset (cash) decreases $6,000, and a liability (notes payable) increases $4,000.

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The result is that the accounting equation remains in balance—assets increased by a net $4,000 and liabilities increased by $4,000, as shown below.

Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) presented the �inancial statements for Sierra Corporation for its �irst month. You should review those �inancial statements (on page 16) at this time. To illustrate how economic events affect the accounting equation, we will examine events affecting Sierra during its �irst month.

In order to analyze the transactions for Sierra, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transactions on stockholders' equity. Recall from the balance sheets in Chapters 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) and 2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02#ch02) that stockholders' equity is comprised of two parts: common stock and retained earnings. Common stock is affected when the company issues new shares of stock in exchange for cash. Retained earnings is affected when the company recognizes revenue, incurs expenses, or pays dividends. Illustration 3-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo1#c03-�ig-0002) shows the expanded equation.

ILLUSTRATION 3-2 Expanded accounting equation

If you are tempted to skip ahead after you've read a few of the following transaction analyses, don't do it. Each has something unique to teach, something you'll need later. (We assure you that we've kept them to the minimum needed!)

DECISION TOOLS

The accounting equation is used to determine if an accounting transaction has occurred.

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EVENT (1). INVESTMENT OF CASH BY STOCKHOLDERS.

On October 1, cash of $10,000 is invested in the business by investors in exchange for $10,000 of common stock. This event is an accounting transaction that results in an increase in both assets and stockholders' equity.

The equation is in balance after the issuance of common stock. Keeping track of the source of each change in stockholders' equity is essential for later accounting activities. In particular, items recorded in the revenue and expense columns are used for the calculation of net income.

EVENT (2). NOTE ISSUED IN EXCHANGE FOR CASH.

On October 1, Sierra borrowed $5,000 from Castle Bank by signing a 3-month, 12%, $5,000 note payable. This transaction results in an equal increase in assets and liabilities. The speci�ic effect of this transaction and the cumulative effect of the �irst two transactions are as follows.

Total assets are now $15,000, and liabilities plus stockholders' equity also total $15,000.

EVENT (3). PURCHASE OF EQUIPMENT FOR CASH.

On October 2, Sierra purchased equipment by paying $5,000 cash to Superior Equipment Sales Co. This transaction results in an equal increase and decrease in Sierra's assets.

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The total assets are now $15,000, and liabilities plus stockholders' equity also total $15,000.

EVENT (4). RECEIPT OF CASH IN ADVANCE FROM CUSTOMER.

On October 2, Sierra received a $1,200 cash advance from R. Knox, a client. Sierra received cash, it does not record revenue until it has performed the work. In some industries, such as the magazine and airline industries, customers are expected to prepay. These companies have a liability to the customer until they deliver the magazines or provide the �light. When the company eventually provides the product or service, it records the revenue.

Since Sierra received cash prior to performance of the service, Sierra has a liability for the work due.

EVENT (5). SERVICES PERFORMED FOR CASH.

On October 3, Sierra received $10,000 in cash (an asset) from Copa Company for guide services performed for a corporate event. Guide service is the principal revenue-producing activity of Sierra. Revenue increases stockholders' equity. This transaction, then, increases both assets and stockholders' equity.

Often companies perform services “on account.” That is, they perform services for which they are paid at a later date. Revenue, however, is recorded when services are performed. Therefore, revenues would increase when services are performed, even though cash has not been received. Instead of receiving cash, the company receives a different type of asset, an account receivable. Accounts receivable represent the right to receive payment at a later date. Suppose that Sierra had performed these services on account rather than for cash. This event would be reported using the accounting equation as:

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Later, when Sierra collects the $10,000 from the customer, Accounts Receivable decreases by $10,000, and Cash increases by $10,000.

Note that in this case, revenues are not affected by the collection of cash. Instead Sierra records an exchange of one asset (Accounts Receivable) for a different asset (Cash).

EVENT (6). PAYMENT OF RENT.

On October 3, Sierra paid its of�ice rent for the month of October in cash, $900. This rent payment is a transaction that results in a decrease in an asset, cash.

Rent is a cost incurred by Sierra in its effort to generate revenues. It is treated as an expense because it pertains only to the current month. Expenses decrease stockholders' equity. Sierra records the rent payment by decreasing cash and increasing expenses to maintain the balance of the accounting equation.

EVENT (7). PURCHASE OF INSURANCE POLICY FOR CASH.

On October 4, Sierra paid $600 for a one-year insurance policy that will expire next year on September 30. Payments of expenses that will bene�it more than one accounting period are identi�ied as assets called prepaid expenses or prepayments.

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The balance in total assets did not change; one asset account decreased by the same amount that another increased.

EVENT (8). PURCHASE OF SUPPLIES ON ACCOUNT.

On October 5, Sierra purchased an estimated three months of supplies on account from Aero Supply for $2,500. In this case, “on account” means that the company receives goods or services that it will pay for at a later date. This transaction increases both an asset (supplies) and a liability (accounts payable).

EVENT (9). HIRING OF NEW EMPLOYEES.

On October 9, Sierra hired four new employees to begin work on October 15. Each employee will receive a weekly salary of $500 for a �ive-day work week, payable every two weeks. Employees will receive their �irst paychecks on October 26. On the date Sierra hires the employees, there is no effect on the accounting equation because the assets, liabilities, and stockholders' equity of the company have not changed.

EVENT (10). PAYMENT OF DIVIDEND.

On October 20, Sierra paid a $500 cash dividend. Dividends are a reduction of stockholders' equity but not an expense. Dividends are not included in the calculation of net income. Instead, a dividend is a distribution of the company's assets to its stockholders.

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EVENT (11). PAYMENT OF CASH FOR EMPLOYEE SALARIES.

Employees have worked two weeks, earning $4,000 in salaries, which were paid on October 26. Salaries and Wages Expense is an expense that reduces stockholders' equity. In this transaction, both assets and stockholders' equity are reduced.

INVESTOR INSIGHT   Why Accuracy Matters

While most companies record transactions very carefully, the reality is that mistakes still happen. For example, bank regulators �ined Bank One Corporation (now JPMorgan Chase) $1.8 million because they felt that the unreliability of the bank's accounting system caused it to violate regulatory requirements.

Also, in recent years Fannie Mae, the government-chartered mortgage association, announced a series of large accounting errors. These announcements caused alarm among investors, regulators, and politicians because they feared that the errors might suggest larger, undetected problems. This was important because the home-mortgage market depends on Fannie Mae to buy hundreds of billions of dollars of mortgages each year from banks, thus enabling the banks to issue new mortgages.

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Finally, before a major overhaul of its accounting system, the �inancial records of Waste Management Company were in such disarray that of the company's 57,000 employees, 10,000 were receiving pay slips that were in error.

The Sarbanes-Oxley Act was created to minimize the occurrence of errors like these by increasing every employee's responsibility for accurate �inancial reporting.

In order for these companies to prepare and issue �inancial statements, their accounting equations (debits and credits) must have been in balance at year-end. How could these errors or misstatements have occurred? (Go to WileyPLUS for this answer and additional questions.)

SUMMARY OF TRANSACTIONS Illustration 3-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo1#c03-�ig-0003) summarizes the transactions of Sierra Corporation to show their cumulative effect on the basic accounting equation. It includes the transaction number in the �irst column on the left. The right-most column shows the speci�ic effect of any transaction that affects stockholders' equity. Remember that Event (9) did not result in a transaction, so no entry is included for that event. The illustration demonstrates three important points:

1. Each transaction is analyzed in terms of its effect on assets, liabilities, and stockholders' equity.

2. The two sides of the equation must always be equal.

3. The cause of each change in stockholders' equity must be indicated.

ILLUSTRATION 3-3 Summary of transactions

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DO IT! 1

Transaction Analysis

A tabular analysis of the transactions made by Roberta Mendez & Co., a certi�ied public accounting �irm, for the month of August is shown below. Each increase and decrease in stockholders' equity is explained.

Describe each transaction that occurred for the month.

Action Plan ✓ Analyze the tabular analysis to determine the nature and

effect of each transaction.

✓ Keep the accounting equation in balance.

✓ Remember that a change in an asset will require a change in another asset, a liability, or in stockholders' equity.

SOLUTION

1. The company issued shares of stock to stockholders for $25,000 cash.

2. The company purchased $7,000 of equipment on account.

3. The company received $8,000 of cash in exchange for services performed.

4. The company paid $850 for this month's rent.

Related exercise material: BE3-1, BE3-2, BE3-3, DO IT! 3-1, E3-1, E3-2, E3-3, and E3-4.

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LEARNING OBJECTIVE 2

Explain how accounts, debits, and credits are used to record business transactions. 

Rather than using a tabular summary like the one in Illustration 3-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo1#c03-�ig-0003) for Sierra Corporation, an accounting information system uses accounts. An account is an individual accounting record of increases and decreases in a speci�ic asset, liability, stockholders' equity, revenue, or expense item. For example, Sierra Corporation has separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so on. (Note that whenever we are referring to a speci�ic account, we capitalize the name.)

In its simplest form, an account consists of three parts: (1) the title of the account, (2) a left or debit side, and (3) a right or credit side. Because the alignment of these parts of an account resembles the letter T, it is referred to as a T-account. The basic form of an account is shown in Illustration 3-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0004) .

ILLUSTRATION 3-4 Basic form of account

We use this form of account often throughout this textbook to explain basic accounting relationships.

DEBITS AND CREDITS The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account.

When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.

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Note the position of the debit side and credit side in Illustration 3-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0004) .

The procedure of recording debits and credits in an account is shown in Illustration 3-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0005) for the transactions affecting the Cash account of Sierra Corporation. The data are taken from the Cash column of the tabular summary in Illustration 3-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo1#c03-�ig-0003) .

ILLUSTRATION 3-5 Tabular summary and account form for Sierra Corporation's Cash account

Every positive item in the tabular summary represents a receipt of cash; every negative amount represents a payment of cash. Notice that in the account form, we record the increases in cash as debits and the decreases in cash as credits. For example, the $10,000 receipt of cash (in blue) is debited to Cash, and the −$5,000 payment of cash (in red) is credited to Cash.

Having increases on one side and decreases on the other reduces recording errors and helps in determining the totals of each side of the account as well as the account balance. The balance is determined by netting the two sides (subtracting one amount from the other). The account balance, a debit of $15,200, indicates that Sierra had $15,200 more increases than decreases in cash. That is, since it started with a balance of zero, it has $15,200 in its Cash account.

DEBIT AND CREDIT PROCEDURES Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry accounting system.

Under the double-entry system, the two-sided effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. The double-entry system also helps to ensure the accuracy of the recorded amounts and helps to detect errors such as those at MF Global as discussed in the Feature Story. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits. The double-entry system for determining the equality of the accounting equation is much more ef�icient than the plus/minus procedure used earlier.

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INTERNATIONAL NOTE Rules for accounting for speci�ic events sometimes differ across countries. For example, European companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double-entry accounting system is the basis of accounting systems worldwide.

Dr./Cr. Procedures for Assets and Liabilities

In Illustration 3-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig- 0005) for Sierra Corporation, increases in Cash—an asset—are entered on the left side, and decreases in Cash are entered on the right side. We know that both sides of the basic equation (Assets=Liabilities+Stockholders' Equity) must be equal. It therefore follows that increases and decreases in liabilities have to be recorded opposite from increases and decreases in assets. Thus, increases in liabilities are entered on the right or credit side, and decreases in liabilities are entered on the left or debit side. The effects that debits and credits have on assets and liabilities are summarized in Illustration 3-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0006) .

ILLUSTRATION 3-6 Debit and credit effects–assets and liabilities

Asset accounts normally show debit balances. That is, debits to a speci�ic asset account should exceed credits to that account. Likewise, liability accounts normally show credit balances. That is, credits to a liability account should exceed debits to that account. The normal balances may be diagrammed as in Illustration 3-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0007) .

ILLUSTRATION 3-7 Normal balances–assets and liabilities

Knowing which is the normal balance in an account may help when you are trying to identify errors. For example, a credit balance in an asset account, such as Land, or a debit balance in a liability account, such as Salaries and Wages Payable, usually indicates errors in recording. Occasionally, however, an abnormal

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balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance by spending more than it has in its account. In automated accounting systems, the computer is programmed to �lag violations of the normal balance and to print out error or exception reports. In manual systems, careful visual inspection of the accounts is required to detect normal balance problems.

▼ HELPFUL HINT

The normal balance is the side where increases in the account are recorded.

Dr./Cr. Procedures for Stockholders' Equity

In Chapter 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) , we indicated that stockholders' equity is comprised of two parts: common stock and retained earnings. In the transaction events earlier in this chapter, you saw that revenues, expenses, and the payment of dividends affect retained earnings. Therefore, the subdivisions of stockholders' equity are common stock, retained earnings, dividends, revenues, and expenses.

COMMON STOCK

Common stock is issued to investors in exchange for the stockholders' investment. The Common Stock account is increased by credits and decreased by debits. For example, when cash is invested in the business, Cash is debited and Common Stock is credited. The effects of debits and credits on the Common Stock account are shown in Illustration 3-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0008) .

ILLUSTRATION 3-8 Debit and credit effects–common stock

The normal balance in the Common Stock account may be diagrammed as in Illustration 3-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0009) .

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ILLUSTRATION 3-9 Normal balance–common stock

RETAINED EARNINGS

Retained earnings is net income that is retained in the business. It represents the portion of stockholders' equity that has been accumulated through the pro�itable operation of the company. Retained Earnings is increased by credits (for example, by net income) and decreased by debits (for example, by a net loss), as shown in Illustration 3-10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0010) .

ILLUSTRATION 3-10 Debit and credit effects–retained earnings

The normal balance for the Retained Earnings account may be diagrammed as in Illustration 3-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0011) .

ILLUSTRATION 3-11 Normal balance–retained earnings

DIVIDENDS

A dividend is a distribution by a corporation to its stockholders. The most common form of distribution is a cash dividend. Dividends result in a reduction of the stockholders' claims on retained earnings. Because dividends reduce stockholders' equity, increases in the Dividends account are recorded with debits. As shown in Illustration 3-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0012) , the Dividends account normally has a debit balance.

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ILLUSTRATION 3-12 Normal balance–dividends

REVENUES AND EXPENSES

When a company recognizes revenues, stockholders' equity is increased. Revenue accounts are increased by credits and decreased by debits.

Expenses decrease stockholders' equity. Thus, expense accounts are increased by debits and decreased by credits. The effects of debits and credits on revenues and expenses are shown in Illustration 3-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0013) .

ILLUSTRATION 3-13 Debit and credit effects–revenues and expenses

Credits to revenue accounts should exceed debits; debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. The normal balances may be diagrammed as in Illustration 3-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0014) .

ILLUSTRATION 3-14 Normal balances–revenues and expenses

INVESTOR INSIGHT  

Chicago Cubs

Keeping Score

The Chicago Cubs baseball team has these major revenue and expense accounts:

Revenues Expenses Admissions (ticket sales) Players' salaries

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Revenues Expenses

Concessions Administrative salaries Television and radio Travel Advertising Ballpark maintenance

Do you think that the Chicago Bears football team would be likely to have the same major revenue and expense accounts as the Cubs? (Go to WileyPLUS for this answer and additional questions.)

STOCKHOLDERS' EQUITY RELATIONSHIPS Companies report the subdivisions of stockholders' equity in various places in the �inancial statements:

Common stock and retained earnings: in the stockholders' equity section of the balance sheet.

Dividends: on the retained earnings statement.

Revenues and expenses: on the income statement.

Dividends, revenues, and expenses are eventually transferred to retained earnings at the end of the period. As a result, a change in any one of these three items affects stockholders' equity. Illustration 3-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0015) shows the relationships of the accounts affecting stockholders' equity.

ILLUSTRATION 3-15 Stockholders' equity relationships

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SUMMARY OF DEBIT/CREDIT RULES Illustration 3-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03lo2#c03-�ig-0016) summarizes the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. No matter what the transaction, total debits must equal total credits in order to keep the accounting equation in balance.

ILLUSTRATION 3-16 Summary of debit/credit rules

DO IT! 2

Debits and Credits for Balance Sheet Accounts

Kate Browne, president of Hair It Is Inc., has just rented space in a shopping mall for the purpose of opening and operating a beauty salon. Long before opening day and before purchasing equipment, hiring assistants, and remodeling the space, Kate was strongly advised to set up a double-entry set of accounting records in which to record all of her business transactions.

Identify the balance sheet accounts that Hair It Is Inc. will likely need to record the transactions necessary to establish and open for business. Also, indicate whether the normal balance of each account is a debit or a credit.

Action Plan ✓ First identify asset accounts for each different type of asset

invested in the business.

✓ Then identify liability accounts for debts incurred by the business.

✓ Hair It Is Inc. needs only one stockholders' equity account, Common Stock, when it begins the business. The other

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stockholders' equity account, Retained Earnings, will be needed after the business is operating.

SOLUTION

Hair It Is Inc. would likely need the following accounts in which to record the transactions necessary to establish and ready the beauty salon for opening day: Cash (debit balance); Equipment (debit balance); Supplies (debit balance); Accounts Payable (credit balance); Notes Payable (credit balance), if the business borrows money; and Common Stock (credit balance).