Services performed but unbilled totals $600

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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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4

Accrual Accounting Concepts

 CHAPTER PREVIEW 

As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and expenses such as those at Groupon. In this chapter, we introduce you to the accrual accounting concepts that make such adjustments possible.

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Keeping Track of Groupons

Who doesn't like buying things at a discount? That's why it's not surprising that three years after it started as a company, Groupon, Inc. was estimated to be worth $16 billion. This translates into an average increase in value of almost $15 million per day.

Now consider that Groupon had previously been estimated to be worth even more than that. What happened? Well, accounting regulators and investors began to question the way that Groupon had accounted for some of its transactions. Groupon sells coupons (“Groupons”), so how hard can it be to account for that? It turns out that accounting for coupons is not as easy as you might think.

First, consider what happens when Groupon makes a sale. Suppose it sells a Groupon for $30 for Highrise Hamburgers. When it receives the $30 from the customer, it must turn over half of that amount ($15) to Highrise Hamburgers. So should Groupon record revenue for the full $30 or just $15? Until recently, Groupon recorded the full $30. But, in response to an SEC ruling on the issue, Groupon now records revenue of $15 instead. This caused Groupon to restate its previous �inancial statements. This restatement reduced annual revenue by $312.9 million.

A second issue is a matter of timing. When should Groupon record this $15 revenue? Should it record the revenue when it sells the Groupon, or must it wait until the customer uses the Groupon at Highrise Hamburgers? The accounting becomes even more complicated when you consider the company's loyalty programs. Groupon offers free or discounted Groupons to its subscribers for doing things such as referring new customers or participating in promotions. These Groupons are to be used for future purchases, yet the company must record the expense at the time the customer receives the Groupon.

Finally, Groupon, like all other companies, relies on many estimates in its �inancial reporting. For example, Groupon reports that “estimates are utilized for, but not limited to, stock-based compensation, income taxes, valuation of acquired goodwill and intangible assets, customer refunds, contingent liabilities and the depreciable lives of �ixed assets.” It notes that “actual results could differ materially from those estimates.” So, next time you use a coupon, think about what that means for the company's accountants!

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LEARNING OBJECTIVE 1

Explain the accrual basis of accounting and the reasons for adjusting entries. 

Businesses need feedback about how well they are performing during a period of time. For example, management usually wants monthly reports on �inancial results, most large corporations are required to present quarterly and annual �inancial statements to stockholders, and the Internal Revenue Service requires all businesses to �ile annual tax returns. Accounting divides the economic life of a business into arti�icial time periods. As indicated in Chapter 2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch02#ch02) , this is the periodicity assumption. Accounting time periods are generally a month, a quarter, or a year. Companies often report using the calendar year (i.e., January 1 to December 31) but sometimes choose a different 12- month period (e.g., August 1 to July 31).

Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup or a new airplane purchased by Delta Air Lines will be used for many years. It would not make sense to expense the full cost of the building or the airplane at the time of purchase because each will be used for many subsequent periods. Instead, companies allocate the cost to the periods of use.

Determining the amount of revenues and expenses to report in a given accounting period can be dif�icult. Proper reporting requires an understanding of the nature of the company's business. Two principles are used as guidelines: the revenue recognition principle and the expense recognition principle.

▼ HELPFUL HINT

An accounting time period that is one year long is called a �iscal year.

THE REVENUE RECOGNITION PRINCIPLE When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satis�ied. To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the �irst week of July. Under the revenue recognition principle, Conrad records revenue in June when it satis�ies its performance obligation, which is when it performs the service, not in July when it receives the cash. At June 30, Conrad would report a receivable on its balance sheet and revenue in its income statement for the service performed. The journal entries for June and July would be as follows.

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THE EXPENSE RECOGNITION PRINCIPLE In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. Applied to the preceding example, this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue. The critical issue in expense recognition is determining when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries and wages payable on its June 30 balance sheet.

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The practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates that efforts (expenses) be matched with results (revenues). Illustration 4-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04lo1#c04-�ig-0001) shows these relationships.

ILLUSTRATION 4-1 GAAP relationships in revenue and expense recognition

INVESTOR INSIGHT  

Apple Inc.

Reporting Revenue Accurately

Until recently, electronics manufacturer Apple was required to spread the revenues from iPhone sales over the two-year period following the sale of the phone. Accounting standards required this because Apple was obligated to provide software updates after the phone was sold. Since Apple had service obligations after the initial date of sale, it was forced to spread the revenue over a two-year period. As a result, the rapid growth of iPhone sales was not fully re�lected in the revenue amounts reported in Apple's income statement. A new accounting standard now enables Apple to report much more of its iPhone revenue at the point of sale. It was estimated that under the new rule revenues would have been about 17% higher and earnings per share almost 50% higher.

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In the past, why was it argued that Apple should spread the recognition of iPhone revenue over a two-year period, rather than recording it upfront? (Go to WileyPLUS for this answer and additional questions.)

DECISION TOOLS

The revenue recognition principle and the expense recognition principle help to ensure that companies report the correct amount of revenues and expenses in a given period.

ACCRUAL VERSUS CASH BASIS OF ACCOUNTING Accrual-basis accounting means that transactions that change a company's �inancial statements are recorded in the periods in which the events occur, even if cash was not exchanged. For example, using the accrual basis means that companies recognize revenues when they perform the services (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle), even if cash was not paid.

An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue at the time they receive cash. They record an expense at the time they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading �inancial statements. For example, it fails to record revenue for a company that has performed services but has not yet received payment. As a result, the cash basis may not re�lect revenue in the period that a performance obligation is satis�ied. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

Illustration 4-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04lo1#c04-�ig-0002) compares accrual-based numbers and cash-based numbers. Suppose that Fresh Colors paints a large building in 2016. In 2016, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000 but does not receive payment until 2017. On an accrual basis, Fresh Colors reports $80,000 of revenue during 2016 because that is when it performed the service. The company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2016 net income is $30,000 ($80,000−$50,000). The $30,000 of net income reported for 2016 indicates the pro�itability of Fresh Colors' efforts during that period.

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ILLUSTRATION 4-2 Accrual-versus cash-basis accounting

If Fresh Colors instead used cash-basis accounting, it would report $50,000 of expenses in 2016 and $80,000 of revenues during 2017. As shown in Illustration 4-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04lo1#c04-�ig-0002) , it would report a loss of $50,000 in 2016 and net income of $80,000 in 2017. Clearly, the cash-basis measures are misleading because the �inancial performance of the company would be misstated for both 2016 and 2017.

INTERNATIONAL NOTE Although different accounting standards are often used by companies in other countries, the accrual basis of accounting is central to all of these standards.

THE NEED FOR ADJUSTING ENTRIES In order for revenues to be recorded in the period in which the performance obligations are satis�ied and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.

Adjusting entries are necessary because the trial balance—the �irst pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not ef�icient to do so. Examples are the use of supplies and the earning of wages by employees.

2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance.

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3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.

Adjusting entries are required every time a company prepares �inancial statements. The company analyzes each account in the trial balance to determine whether it is complete and up-to-date for �inancial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.

TYPES OF ADJUSTING ENTRIES Adjusting entries are classi�ied as either deferrals or accruals. As Illustration 4-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04lo1#c04-�ig-0003) shows, each of these classes has two subcategories.

ILLUSTRATION 4-3 Categories of adjusting entries

Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Sierra Corporation from Chapter 3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03#ch03) . It is reproduced in Illustration 4-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch04lo1#c04-�ig-0004) . Note that Retained Earnings has been added to this trial balance with a zero balance. We will explain its use later.

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ILLUSTRATION 4-4 Trial balance

We assume that Sierra uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31.

DO IT! 1

Timing Concepts

Below is a list of concepts in the left column, with descriptions of the concepts in the right column. There are more descriptions provided than concepts. Match the description of the concept to the concept.

1. ________ Accrual-basis accounting.

2. ________ Calendar year.

3. ________ Periodicity assumption.

4. ________ Expense recognition principle.

(a) Monthly and quarterly time periods.

(b) Efforts (expenses) should be matched with results (revenues).

(c) Accountants divide the economic life of a business into arti�icial time periods.

(d) Companies record revenues when they receive cash and record expenses when they pay out cash.

(e) An accounting time period that starts on January 1 and ends on December 31.

(f) Companies record transactions in the period in which the events occur.

Action Plan ✓ Review the terms identi�ied on pages 152–153.

✓ Study carefully the revenue recognition principle, the expense recognition principle, and the periodicity assumption.

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SOLUTION

1. f 2. e 3. c 4. b

Related exercise material: BE4-1, BE4-2, DO IT! 4-1, E4-1, E4-2, E4-3, and E4-5.

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LEARNING OBJECTIVE 2

Prepare adjusting entries for deferrals. 

To defer means to postpone or delay. Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferred expenses to record the portion that was incurred during the period. Companies also make adjusting entries for deferred revenues to record services performed during the period. The two types of deferrals are prepaid expenses and unearned revenues.

PREPAID EXPENSES Companies record payments of expenses that will bene�it more than one accounting period as assets. These prepaid expenses or prepayments are expenses paid in cash before they are used or consumed. When expenses are prepaid, an asset account is increased (debited) to show the service or bene�it that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations until they prepare �inancial statements. At each statement date, they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts.