Introduction to Financial Accounting, 11th Edition Class Notes
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1-1
CHAPTER 1
Accounting:
The Language of Business
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Explain how accounting information assists in making decisions.
2. Describe the components of the balance sheet.
3. Analyze business transactions and relate them to changes in the balance sheet.
4. Prepare a balance sheet from transactions data.
5. Compare the features of sole proprietorships, partnerships, and corporations.
6. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole
proprietorship or a partnership.
7. Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.
8. Describe auditing and how it enhances the value of financial information.
9. Evaluate the role of ethics in the accounting process.
10. Recognize career opportunities in accounting, and understand that accounting is important to both for-
profit and nonprofit organizations.
Chapter 1 provides a glimpse of the entire field of accounting. It describes the nature of accounting and its
role in providing useful information for a wide variety of decisions. In addition, the balance sheet equation is
introduced: Assets = Liabilities + Owners’equity.
An introduction to the basic terms accountants use—the accounting vocabulary—is an overall theme of
the chapter. Transaction analysis is introduced as well as the effect of a transaction on the balance sheet
equation. The chapter also looks at types of business organizations. The chapter concludes with a discussion
of the accounting profession, regulation, the auditing function, and professional ethics.
CHAPTER 1
Accounting:
The Language of Business
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Explain how accounting information assists in making decisions.
2. Describe the components of the balance sheet.
3. Analyze business transactions and relate them to changes in the balance sheet.
4. Prepare a balance sheet from transactions data.
5. Compare the features of sole proprietorships, partnerships, and corporations.
6. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole
proprietorship or a partnership.
7. Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.
8. Describe auditing and how it enhances the value of financial information.
9. Evaluate the role of ethics in the accounting process.
10. Recognize career opportunities in accounting, and understand that accounting is important to both for-
profit and nonprofit organizations.
Chapter 1 provides a glimpse of the entire field of accounting. It describes the nature of accounting and its
role in providing useful information for a wide variety of decisions. In addition, the balance sheet equation is
introduced: Assets = Liabilities + Owners’equity.
An introduction to the basic terms accountants use—the accounting vocabulary—is an overall theme of
the chapter. Transaction analysis is introduced as well as the effect of a transaction on the balance sheet
equation. The chapter also looks at types of business organizations. The chapter concludes with a discussion
of the accounting profession, regulation, the auditing function, and professional ethics.
1-1
CHAPTER 1
Accounting:
The Language of Business
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Explain how accounting information assists in making decisions.
2. Describe the components of the balance sheet.
3. Analyze business transactions and relate them to changes in the balance sheet.
4. Prepare a balance sheet from transactions data.
5. Compare the features of sole proprietorships, partnerships, and corporations.
6. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole
proprietorship or a partnership.
7. Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.
8. Describe auditing and how it enhances the value of financial information.
9. Evaluate the role of ethics in the accounting process.
10. Recognize career opportunities in accounting, and understand that accounting is important to both for-
profit and nonprofit organizations.
Chapter 1 provides a glimpse of the entire field of accounting. It describes the nature of accounting and its
role in providing useful information for a wide variety of decisions. In addition, the balance sheet equation is
introduced: Assets = Liabilities + Owners’equity.
An introduction to the basic terms accountants use—the accounting vocabulary—is an overall theme of
the chapter. Transaction analysis is introduced as well as the effect of a transaction on the balance sheet
equation. The chapter also looks at types of business organizations. The chapter concludes with a discussion
of the accounting profession, regulation, the auditing function, and professional ethics.
CHAPTER 1
Accounting:
The Language of Business
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Explain how accounting information assists in making decisions.
2. Describe the components of the balance sheet.
3. Analyze business transactions and relate them to changes in the balance sheet.
4. Prepare a balance sheet from transactions data.
5. Compare the features of sole proprietorships, partnerships, and corporations.
6. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole
proprietorship or a partnership.
7. Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.
8. Describe auditing and how it enhances the value of financial information.
9. Evaluate the role of ethics in the accounting process.
10. Recognize career opportunities in accounting, and understand that accounting is important to both for-
profit and nonprofit organizations.
Chapter 1 provides a glimpse of the entire field of accounting. It describes the nature of accounting and its
role in providing useful information for a wide variety of decisions. In addition, the balance sheet equation is
introduced: Assets = Liabilities + Owners’equity.
An introduction to the basic terms accountants use—the accounting vocabulary—is an overall theme of
the chapter. Transaction analysis is introduced as well as the effect of a transaction on the balance sheet
equation. The chapter also looks at types of business organizations. The chapter concludes with a discussion
of the accounting profession, regulation, the auditing function, and professional ethics.
1-2
Accounting is the language of business and is the process of identifying, recording, and
summarizing economic information to decision makers.
An organization’s accounting system is the series of steps it uses to record financial data and
convert them into informative financial statements.
Learning Objective 1. Explain how accounting information assists in making decisions.
Accounting information is useful to anyone making decisions that have economic consequences.
Financial accountingserves external decision makers (stockholders, suppliers, banks and
government agencies)whilemanagement accountingserves internal decision makers (top
executives, department heads, college deans, and hospital administrators).
A common source of financial information used by investors and others outside the company is
the annual report. It is prepared by management to inform current and potential investors about
the company’s past performance and future prospects. It contains financial statements and other
information about the corporation, such as a letter from corporate management, a discussion and
analysis by management of recent economic events, footnotes to the financial statements,
auditor’s report, and statements by management and the authors on the company’s internal
controls.
Financial statements also appear in Form 10-K, filed annually with the Securities and Exchange
Commission (SEC), the government agency responsible for regulating capital markets in theUnited
States. U.S. companies with publicly traded stock (companies that sell shares in their ownership to
the public) must file Form 10-K and other forms with the SEC.
DO MULTIPLE CHOICE 1, 2 and 3.
Learning Objective 2. Describe the components of the balance sheet.
The balance sheet(also called the statement of financial position) shows the financial status of
an organization at a particular instant in time.
The balance sheet has two counterbalancing sections. One section lists the resources of the firm
and the other the claims against the resources. The two sections form the balance sheet
equation: Assets = Liabilities + Owners’ equity.
Assets are economic resources that the company expects to generate future cash inflows or
reduce or prevent future cash outflows. Examples are cash, inventory, and equipment.
Liabilities are economic obligations of the organization to outsiders, or claims against its
assets by outsiders such as a debt to the bank.Notes payable describe the existence of
promissory notes that are signed when a company takes out a bank loan.
Owners’ equity is the owners’ claims on the organization’s assets and is equal to total
assets less total liabilities. The term net assets also refers to assets less liabilities.
DO MULTIPLE CHOICE 4 and 5.
DO EXERCISES 1 and 2.
Accounting is the language of business and is the process of identifying, recording, and
summarizing economic information to decision makers.
An organization’s accounting system is the series of steps it uses to record financial data and
convert them into informative financial statements.
Learning Objective 1. Explain how accounting information assists in making decisions.
Accounting information is useful to anyone making decisions that have economic consequences.
Financial accountingserves external decision makers (stockholders, suppliers, banks and
government agencies)whilemanagement accountingserves internal decision makers (top
executives, department heads, college deans, and hospital administrators).
A common source of financial information used by investors and others outside the company is
the annual report. It is prepared by management to inform current and potential investors about
the company’s past performance and future prospects. It contains financial statements and other
information about the corporation, such as a letter from corporate management, a discussion and
analysis by management of recent economic events, footnotes to the financial statements,
auditor’s report, and statements by management and the authors on the company’s internal
controls.
Financial statements also appear in Form 10-K, filed annually with the Securities and Exchange
Commission (SEC), the government agency responsible for regulating capital markets in theUnited
States. U.S. companies with publicly traded stock (companies that sell shares in their ownership to
the public) must file Form 10-K and other forms with the SEC.
DO MULTIPLE CHOICE 1, 2 and 3.
Learning Objective 2. Describe the components of the balance sheet.
The balance sheet(also called the statement of financial position) shows the financial status of
an organization at a particular instant in time.
The balance sheet has two counterbalancing sections. One section lists the resources of the firm
and the other the claims against the resources. The two sections form the balance sheet
equation: Assets = Liabilities + Owners’ equity.
Assets are economic resources that the company expects to generate future cash inflows or
reduce or prevent future cash outflows. Examples are cash, inventory, and equipment.
Liabilities are economic obligations of the organization to outsiders, or claims against its
assets by outsiders such as a debt to the bank.Notes payable describe the existence of
promissory notes that are signed when a company takes out a bank loan.
Owners’ equity is the owners’ claims on the organization’s assets and is equal to total
assets less total liabilities. The term net assets also refers to assets less liabilities.
DO MULTIPLE CHOICE 4 and 5.
DO EXERCISES 1 and 2.
1-2
Accounting is the language of business and is the process of identifying, recording, and
summarizing economic information to decision makers.
An organization’s accounting system is the series of steps it uses to record financial data and
convert them into informative financial statements.
Learning Objective 1. Explain how accounting information assists in making decisions.
Accounting information is useful to anyone making decisions that have economic consequences.
Financial accountingserves external decision makers (stockholders, suppliers, banks and
government agencies)whilemanagement accountingserves internal decision makers (top
executives, department heads, college deans, and hospital administrators).
A common source of financial information used by investors and others outside the company is
the annual report. It is prepared by management to inform current and potential investors about
the company’s past performance and future prospects. It contains financial statements and other
information about the corporation, such as a letter from corporate management, a discussion and
analysis by management of recent economic events, footnotes to the financial statements,
auditor’s report, and statements by management and the authors on the company’s internal
controls.
Financial statements also appear in Form 10-K, filed annually with the Securities and Exchange
Commission (SEC), the government agency responsible for regulating capital markets in theUnited
States. U.S. companies with publicly traded stock (companies that sell shares in their ownership to
the public) must file Form 10-K and other forms with the SEC.
DO MULTIPLE CHOICE 1, 2 and 3.
Learning Objective 2. Describe the components of the balance sheet.
The balance sheet(also called the statement of financial position) shows the financial status of
an organization at a particular instant in time.
The balance sheet has two counterbalancing sections. One section lists the resources of the firm
and the other the claims against the resources. The two sections form the balance sheet
equation: Assets = Liabilities + Owners’ equity.
Assets are economic resources that the company expects to generate future cash inflows or
reduce or prevent future cash outflows. Examples are cash, inventory, and equipment.
Liabilities are economic obligations of the organization to outsiders, or claims against its
assets by outsiders such as a debt to the bank.Notes payable describe the existence of
promissory notes that are signed when a company takes out a bank loan.
Owners’ equity is the owners’ claims on the organization’s assets and is equal to total
assets less total liabilities. The term net assets also refers to assets less liabilities.
DO MULTIPLE CHOICE 4 and 5.
DO EXERCISES 1 and 2.
Accounting is the language of business and is the process of identifying, recording, and
summarizing economic information to decision makers.
An organization’s accounting system is the series of steps it uses to record financial data and
convert them into informative financial statements.
Learning Objective 1. Explain how accounting information assists in making decisions.
Accounting information is useful to anyone making decisions that have economic consequences.
Financial accountingserves external decision makers (stockholders, suppliers, banks and
government agencies)whilemanagement accountingserves internal decision makers (top
executives, department heads, college deans, and hospital administrators).
A common source of financial information used by investors and others outside the company is
the annual report. It is prepared by management to inform current and potential investors about
the company’s past performance and future prospects. It contains financial statements and other
information about the corporation, such as a letter from corporate management, a discussion and
analysis by management of recent economic events, footnotes to the financial statements,
auditor’s report, and statements by management and the authors on the company’s internal
controls.
Financial statements also appear in Form 10-K, filed annually with the Securities and Exchange
Commission (SEC), the government agency responsible for regulating capital markets in theUnited
States. U.S. companies with publicly traded stock (companies that sell shares in their ownership to
the public) must file Form 10-K and other forms with the SEC.
DO MULTIPLE CHOICE 1, 2 and 3.
Learning Objective 2. Describe the components of the balance sheet.
The balance sheet(also called the statement of financial position) shows the financial status of
an organization at a particular instant in time.
The balance sheet has two counterbalancing sections. One section lists the resources of the firm
and the other the claims against the resources. The two sections form the balance sheet
equation: Assets = Liabilities + Owners’ equity.
Assets are economic resources that the company expects to generate future cash inflows or
reduce or prevent future cash outflows. Examples are cash, inventory, and equipment.
Liabilities are economic obligations of the organization to outsiders, or claims against its
assets by outsiders such as a debt to the bank.Notes payable describe the existence of
promissory notes that are signed when a company takes out a bank loan.
Owners’ equity is the owners’ claims on the organization’s assets and is equal to total
assets less total liabilities. The term net assets also refers to assets less liabilities.
DO MULTIPLE CHOICE 4 and 5.
DO EXERCISES 1 and 2.
1-3
Learning Objective 3. Analyze business transactions and relate them to changes in the
balance sheet (SeeEXHIBIT 1-2).
An entity is an organization or a section of an organization that stands apart from other
organizations and individuals as a separate economic unit. A transaction is any event that affects
the financial position of an entity and can be reliably recorded in monetary terms.
Every transaction affects the balance sheet. When accountants record transactions they always
make at least two entries(i.e., double-entry accounting system) so that the total assets always
equal the total liabilities and owners’ equity. The balance sheet equation always must remain in
balance.
Accountants record transactions in an organization’s accounts. An account is a summary record
of the changes in a particular asset, liability, or owners’ equity category, and the account balance
is the total of all entries to the account up to a particular date.
Transaction analysis determines which specific accounts are affected, whether the account
balances are increased or decreased, andthe amount of the change in each account balance. For
example, if the company borrows money from the bank, an asset (cash) increases, and a liability
(notes payable) increases.
Inventory refers to goods held by the company for the purpose of sale to customers. An account
payable is a liability that results from a purchase of goods or services on open account (i.e., on
credit). When inventory is purchased on account, both assets and liabilities are increased (if
purchased for cash, one asset will increase and another asset will decrease). A compound entry
affects more than two balance sheet accounts. A creditor is one to whom the company owes
money.
DO MULTIPLE CHOICE 6 and 7.
Learning Objective 4. Prepare a balance sheet from transactions data(See EXHIBIT 1-3)
Transactions data can be used to compute a cumulative total for each account at any date. Note
that a balance sheet represents the financial impact of all transactions up to a specific point in
time.
The account titles are listed with their respective balances on the specific date noted in the header
of the balance sheet. Each account is listed under the category that it belongs to—assets, liabilities,
or owner’s equity. Examples of actual corporate balance sheets can be found in EXHIBIT 1-5.
Although a new balance sheet could be prepared after each transaction, companies usually produce
balance sheets only when needed by managers and at the end of each quarter for reporting to the
public.
Learning Objective 5. Compare the features of sole proprietorships, partnerships, and
corporations.
A sole proprietorship is a business with a single owner. Sole proprietorships tend to be small
businesses such as local stores or restaurants.
Learning Objective 3. Analyze business transactions and relate them to changes in the
balance sheet (SeeEXHIBIT 1-2).
An entity is an organization or a section of an organization that stands apart from other
organizations and individuals as a separate economic unit. A transaction is any event that affects
the financial position of an entity and can be reliably recorded in monetary terms.
Every transaction affects the balance sheet. When accountants record transactions they always
make at least two entries(i.e., double-entry accounting system) so that the total assets always
equal the total liabilities and owners’ equity. The balance sheet equation always must remain in
balance.
Accountants record transactions in an organization’s accounts. An account is a summary record
of the changes in a particular asset, liability, or owners’ equity category, and the account balance
is the total of all entries to the account up to a particular date.
Transaction analysis determines which specific accounts are affected, whether the account
balances are increased or decreased, andthe amount of the change in each account balance. For
example, if the company borrows money from the bank, an asset (cash) increases, and a liability
(notes payable) increases.
Inventory refers to goods held by the company for the purpose of sale to customers. An account
payable is a liability that results from a purchase of goods or services on open account (i.e., on
credit). When inventory is purchased on account, both assets and liabilities are increased (if
purchased for cash, one asset will increase and another asset will decrease). A compound entry
affects more than two balance sheet accounts. A creditor is one to whom the company owes
money.
DO MULTIPLE CHOICE 6 and 7.
Learning Objective 4. Prepare a balance sheet from transactions data(See EXHIBIT 1-3)
Transactions data can be used to compute a cumulative total for each account at any date. Note
that a balance sheet represents the financial impact of all transactions up to a specific point in
time.
The account titles are listed with their respective balances on the specific date noted in the header
of the balance sheet. Each account is listed under the category that it belongs to—assets, liabilities,
or owner’s equity. Examples of actual corporate balance sheets can be found in EXHIBIT 1-5.
Although a new balance sheet could be prepared after each transaction, companies usually produce
balance sheets only when needed by managers and at the end of each quarter for reporting to the
public.
Learning Objective 5. Compare the features of sole proprietorships, partnerships, and
corporations.
A sole proprietorship is a business with a single owner. Sole proprietorships tend to be small
businesses such as local stores or restaurants.
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1-4
A partnership is aform of organization that joins two or more individuals together as co-owners.
Each partnership is an individual entity that is separate from the personal activities of each
partner.
Corporations are organizations created under state law in the United States with an unlimited
number of owners. Owners of a corporation have limited liability (i.e., corporation creditors
ordinarily have claims against the corporate assets only, not against the personal assets of the
owners).
A publicly owned corporation is one in which shares of ownershipare sold to the public.
Purchasers or shares are identified as shareholders or stockholders.
A privately owned (closely held, unlisted) corporation is owned by a family, a small
group of shareholders, or a single individual.
Advantages of the corporate form of ownership include ease of transfer of ownership (the
corporation issues stock certificates as formal evidence of ownership), ease of raising ownership
capital, and continuity of existence.
Tax laws may favor a sole proprietorship, a partnership, or a corporation, depending on the
personal tax situations of the owners.
Learning Objective 6. Identify how the owners’ equity section in a corporate
balance sheet differs from that in a sole proprietorship or a
partnership.
All business entities account for assets and liabilities similarly (See EXHIBIT 1-8).
a. Owners’ equities for proprietorships and partnerships are identified as capital.
b. Owners’ equities for the corporation are called stockholders’ equity or shareholders’
equity.
In a corporation, capital investment by the owners, known as paid-in capital,is recorded in two
parts: common stock at par value and paid-in capital in excess of par value.
Par value or stated value is the dollar amount printed on the stock certificates, and paid-in
capital in excess of par valueor additional paid-in capital is the difference
between the total amount received for the stock and the par value.
Common stock represents the par value purchased by the common stockholders of the
corporation. (See EXHIBIT 1-9). Common stockholders have a “residual” ownership in the
corporation.
DO MULTIPLE CHOICE 8 and 9.
In corporations, the ultimate responsibility for management is delegated by the stockholders to
the boardof directors. One of the duties of the board of directors is to appoint and monitor
managers. The chief executive officer (CEO) is the top manager in an organization and
sometimes serves as the chairman of the board.
A partnership is aform of organization that joins two or more individuals together as co-owners.
Each partnership is an individual entity that is separate from the personal activities of each
partner.
Corporations are organizations created under state law in the United States with an unlimited
number of owners. Owners of a corporation have limited liability (i.e., corporation creditors
ordinarily have claims against the corporate assets only, not against the personal assets of the
owners).
A publicly owned corporation is one in which shares of ownershipare sold to the public.
Purchasers or shares are identified as shareholders or stockholders.
A privately owned (closely held, unlisted) corporation is owned by a family, a small
group of shareholders, or a single individual.
Advantages of the corporate form of ownership include ease of transfer of ownership (the
corporation issues stock certificates as formal evidence of ownership), ease of raising ownership
capital, and continuity of existence.
Tax laws may favor a sole proprietorship, a partnership, or a corporation, depending on the
personal tax situations of the owners.
Learning Objective 6. Identify how the owners’ equity section in a corporate
balance sheet differs from that in a sole proprietorship or a
partnership.
All business entities account for assets and liabilities similarly (See EXHIBIT 1-8).
a. Owners’ equities for proprietorships and partnerships are identified as capital.
b. Owners’ equities for the corporation are called stockholders’ equity or shareholders’
equity.
In a corporation, capital investment by the owners, known as paid-in capital,is recorded in two
parts: common stock at par value and paid-in capital in excess of par value.
Par value or stated value is the dollar amount printed on the stock certificates, and paid-in
capital in excess of par valueor additional paid-in capital is the difference
between the total amount received for the stock and the par value.
Common stock represents the par value purchased by the common stockholders of the
corporation. (See EXHIBIT 1-9). Common stockholders have a “residual” ownership in the
corporation.
DO MULTIPLE CHOICE 8 and 9.
In corporations, the ultimate responsibility for management is delegated by the stockholders to
the boardof directors. One of the duties of the board of directors is to appoint and monitor
managers. The chief executive officer (CEO) is the top manager in an organization and
sometimes serves as the chairman of the board.
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1-5
Learning Objective 7. Explain the regulation of financial reporting, including differences
between U.S. GAAP and IFRS.
Generally accepted accounting principles (GAAP)consist of all the broad concepts and
detailed practices to be followed in preparing and distributing financial statements. Companies
reporting in more than 100 countries use International Financial Reporting Standards (IFRS)
while U.S. companies useFinancial Accounting Standards.
The Financial Accounting Standards Board is responsible for establishing U.S. GAAP. In
2009 it compiled all standards and other elements of U.S. GAAP into the FASB Accounting
Standards Codification.
The U. S. Congress has charged the Securities and Exchange Commission (SEC) with the
ultimate responsibility for authorizing GAAP for companies whose stock is held by the general
investing public. However, the SEC has informally delegated much rule-making power to the
FASB. Congress can, however, overrule both the SEC and the FASB.
The International Accounting Standards Board(IASB) was established to “develop, in the
public interest, a single set of high quality, understandable, and enforceable global accounting
standards.” The IASB sets International Financial Reporting Standards (IFRS). The IASB has 16
members who represent a diversity of geographic and professional backgrounds.
DO MULTIPLE CHOICE 10.
Learning Objective 8. Describe auditing and how it enhances the value of financial
information.
The credibility of financial statements is the ultimate responsibility of the managers who are
entrusted with the resources of the entity under their command.
Third-party assurance about the credibility of financial statements gave rise to the CPA
profession. An auditor examines the information that managers use to prepare the financial
statements and provides assurances about the credibility of those statements.
The desire for third-party assurance about the credibility of financial statements created the
profession of public accountants – accountants who offer services to the general public on a fee
basis. A certified public accountant (CPA) in the U.S. earns this designation by meeting
standards of knowledge and integrity set by a State Board of Accountancy.
To assess management’s financial disclosures, CPAs conduct anaudit, an examination of a
company’s transactions and the resulting financial statements.
The audit is conducted by an independent CPA to lend credibility to management’s financial
statements and is described in the auditor’s opinion (see EXHIBIT 1-10). An auditor’s opinion
(also called an independent opinion) describes the scope and results of the audit, and companies
include the opinion with the financial statements in their annual reports and 10K filings.
DO MULTIPLE CHOICE 11.
Accountants who do not offer services to the general public are known as private accountants.
They work for businesses, governmental agencies, and other nonprofit organizations.
Learning Objective 7. Explain the regulation of financial reporting, including differences
between U.S. GAAP and IFRS.
Generally accepted accounting principles (GAAP)consist of all the broad concepts and
detailed practices to be followed in preparing and distributing financial statements. Companies
reporting in more than 100 countries use International Financial Reporting Standards (IFRS)
while U.S. companies useFinancial Accounting Standards.
The Financial Accounting Standards Board is responsible for establishing U.S. GAAP. In
2009 it compiled all standards and other elements of U.S. GAAP into the FASB Accounting
Standards Codification.
The U. S. Congress has charged the Securities and Exchange Commission (SEC) with the
ultimate responsibility for authorizing GAAP for companies whose stock is held by the general
investing public. However, the SEC has informally delegated much rule-making power to the
FASB. Congress can, however, overrule both the SEC and the FASB.
The International Accounting Standards Board(IASB) was established to “develop, in the
public interest, a single set of high quality, understandable, and enforceable global accounting
standards.” The IASB sets International Financial Reporting Standards (IFRS). The IASB has 16
members who represent a diversity of geographic and professional backgrounds.
DO MULTIPLE CHOICE 10.
Learning Objective 8. Describe auditing and how it enhances the value of financial
information.
The credibility of financial statements is the ultimate responsibility of the managers who are
entrusted with the resources of the entity under their command.
Third-party assurance about the credibility of financial statements gave rise to the CPA
profession. An auditor examines the information that managers use to prepare the financial
statements and provides assurances about the credibility of those statements.
The desire for third-party assurance about the credibility of financial statements created the
profession of public accountants – accountants who offer services to the general public on a fee
basis. A certified public accountant (CPA) in the U.S. earns this designation by meeting
standards of knowledge and integrity set by a State Board of Accountancy.
To assess management’s financial disclosures, CPAs conduct anaudit, an examination of a
company’s transactions and the resulting financial statements.
The audit is conducted by an independent CPA to lend credibility to management’s financial
statements and is described in the auditor’s opinion (see EXHIBIT 1-10). An auditor’s opinion
(also called an independent opinion) describes the scope and results of the audit, and companies
include the opinion with the financial statements in their annual reports and 10K filings.
DO MULTIPLE CHOICE 11.
Accountants who do not offer services to the general public are known as private accountants.
They work for businesses, governmental agencies, and other nonprofit organizations.
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1-6
The American Institute of Certified Public Accountants (AICPA) is the principal professional
association of CPAs. The International Auditing and Assurance Standards Board (IAASB),
established by the International Federation of Accountants, is working to standardize audit regulation
around the globe, but regulation of auditing continues to differ significantly across countries.
In 2002, the U.S. Congress passed the Sarbanes-Oxley Act, which gave the government a larger
role in regulating the audit profession. Among its regulations were:
a. the establishment of the Public Company Accounting Oversight Board(PCAOB)with
powers to regulate many aspects of public accounting and to set standards for audit
procedures,
b. prohibiting public accounting firms from providing to audit clients certain nonaudit
services, and
c. requiring rotation every five years of the lead audit or coordinating partner and the
reviewing partner on an audit.
All accounting firms that audit companies with publicly traded stock in the U.S. must register
with the PCAOB, and they are referred to as registered public accounting firms. Additionally,
the PCAOB issues Generally AcceptedAuditing Standards (GAAS) that prescribe the
minimum steps that an auditor must take in examining the transactions and financial statements
and issuing an auditor’s opinion.
The American Institute of Certified Public Accountants (AICPA) is the principal professional
association of CPAs. The International Auditing and Assurance Standards Board (IAASB),
established by the International Federation of Accountants, is working to standardize audit regulation
around the globe, but regulation of auditing continues to differ significantly across countries.
In 2002, the U.S. Congress passed the Sarbanes-Oxley Act, which gave the government a larger
role in regulating the audit profession. Among its regulations were:
a. the establishment of the Public Company Accounting Oversight Board(PCAOB)with
powers to regulate many aspects of public accounting and to set standards for audit
procedures,
b. prohibiting public accounting firms from providing to audit clients certain nonaudit
services, and
c. requiring rotation every five years of the lead audit or coordinating partner and the
reviewing partner on an audit.
All accounting firms that audit companies with publicly traded stock in the U.S. must register
with the PCAOB, and they are referred to as registered public accounting firms. Additionally,
the PCAOB issues Generally AcceptedAuditing Standards (GAAS) that prescribe the
minimum steps that an auditor must take in examining the transactions and financial statements
and issuing an auditor’s opinion.
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Learning Objective 9. Evaluate the role of ethics in the accounting process.
Members of the AICPA, as well as members of the Institute of Management
Accountants and the Association of Government Accountants, must abide by codes
of professional conduct, which are especially concerned with integrity and
independence. Professional accounting organizations have procedures for reviewing
behavior alleged as not being consistent with the codes of professional conduct (see
EXHIBIT 1-11).
DO MULTIPLE CHOICE 12 and 13.
Learning Objective 10. Recognize career opportunities in accounting, and
understand that accounting is important to both for-
profit and nonprofit organizations.
Accounting is provides an excellent background for almost any manager and is especially
important for finance professionals.
Additionally, anyone who wants to move up in the management structure of a company
needs to know accounting.
Companies often rely on accountants to safeguard the ethics of a company. Therefore,
accountants have a special responsibility to ensure that managers act with integrity and
that information provided by the company is accurate.
Although this textbook focuses on profit-seeking organizations, accounting principles
also apply to nonprofit organizations such as hospitals, universities, and government
agencies.
Chapter 1 Quiz
Multiple Choice
1. Financial accounting focuses on the specific needs of decision makers external to the
organization. Which of the following would not be an external user?
a. Stockholders
b. Internal Revenue Service
c. Vice President—Marketing
d. Banks
2. The correct version of the accounting equation is
Learning Objective 9. Evaluate the role of ethics in the accounting process.
Members of the AICPA, as well as members of the Institute of Management
Accountants and the Association of Government Accountants, must abide by codes
of professional conduct, which are especially concerned with integrity and
independence. Professional accounting organizations have procedures for reviewing
behavior alleged as not being consistent with the codes of professional conduct (see
EXHIBIT 1-11).
DO MULTIPLE CHOICE 12 and 13.
Learning Objective 10. Recognize career opportunities in accounting, and
understand that accounting is important to both for-
profit and nonprofit organizations.
Accounting is provides an excellent background for almost any manager and is especially
important for finance professionals.
Additionally, anyone who wants to move up in the management structure of a company
needs to know accounting.
Companies often rely on accountants to safeguard the ethics of a company. Therefore,
accountants have a special responsibility to ensure that managers act with integrity and
that information provided by the company is accurate.
Although this textbook focuses on profit-seeking organizations, accounting principles
also apply to nonprofit organizations such as hospitals, universities, and government
agencies.
Chapter 1 Quiz
Multiple Choice
1. Financial accounting focuses on the specific needs of decision makers external to the
organization. Which of the following would not be an external user?
a. Stockholders
b. Internal Revenue Service
c. Vice President—Marketing
d. Banks
2. The correct version of the accounting equation is
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a. assets = liabilities – owners’ equity
b. assets = liabilities + owners’ equity
c. liabilities = assets + owners’ equity
d. owners’ equity = assets + liabilities
3. The annual report does not include
a. a report from the independent auditors.
b. footnotes.
c. statements on the company’s internal controls.
d. a letter from the board of directors.
4. Another term for owners’ equity is
a. assets.
b. liabilities.
c. net assets.
d. net liabilities.
5. The balance sheet shows the financial status of a company
a. at a particular point in time.
b. for a period of a month, quarter, or year.
c. from the beginning of a period to the end of the period.
d. only at the end of the year.
6. A loan from the bank
a. increases assets and owner’s equity.
b. increases assets and liabilities.
c. increases liabilities and owner’s equity.
d. has no effect on total assets.
7. The purchase of inventory by paying cash causes
a. an increase in one asset and a decrease in another.
b. an increase in owner’s equity and a decrease in an asset.
c. an increase in an asset and an increase in a liability.
d. none of the above
8. If the owners’ (stockholders’) equity section of the balance sheet includes “Additional
Paid-in-Capital,” the type of organization is a
a. nonprofit.
b. partnership.
c. corporation.
d. governmental entity.
9. Which of the following is a disadvantage of the corporate form of ownership?
a. assets = liabilities – owners’ equity
b. assets = liabilities + owners’ equity
c. liabilities = assets + owners’ equity
d. owners’ equity = assets + liabilities
3. The annual report does not include
a. a report from the independent auditors.
b. footnotes.
c. statements on the company’s internal controls.
d. a letter from the board of directors.
4. Another term for owners’ equity is
a. assets.
b. liabilities.
c. net assets.
d. net liabilities.
5. The balance sheet shows the financial status of a company
a. at a particular point in time.
b. for a period of a month, quarter, or year.
c. from the beginning of a period to the end of the period.
d. only at the end of the year.
6. A loan from the bank
a. increases assets and owner’s equity.
b. increases assets and liabilities.
c. increases liabilities and owner’s equity.
d. has no effect on total assets.
7. The purchase of inventory by paying cash causes
a. an increase in one asset and a decrease in another.
b. an increase in owner’s equity and a decrease in an asset.
c. an increase in an asset and an increase in a liability.
d. none of the above
8. If the owners’ (stockholders’) equity section of the balance sheet includes “Additional
Paid-in-Capital,” the type of organization is a
a. nonprofit.
b. partnership.
c. corporation.
d. governmental entity.
9. Which of the following is a disadvantage of the corporate form of ownership?
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a. Separation of ownership and management
b. Continuity of existence
c. Unlimited liability
d. Ease of raising capital
e. Both c and d
f. None of the above
10. Which organization has the responsibility to establish U.S. GAAP?
a. The FASB
b. The IASB
c. The SEC
d. Management
11. An audit opinion
a. is provided by the audited company’s president.
b. is provided by private accountants.
c. is provided by an independent CPA.
d. all of the above
12. A certified public accountant (CPA) in the U.S. earns certification through
a. being an accounting major in college.
b. having sufficient experience.
c. meeting Board of Accountancy standards of knowledge and integrity.
d. all of the above
13. The overall concern of the AICPA’s Code of Professional Conduct is which of the
following?
a. Whether the CPA is an officer in the corporation being audited
b. Whether the CPA owns stock in the corporation being audited
c. Whether the CPA is independent and acts with integrity and objectivity
d. Whether the CPA’s father is the controller of the corporation being audited
Exercises
1. If total assets are $85,000 and total liabilities are $45,000, what is total owner’s
equity?
2. If a company purchases $50,000 of equipment on credit, how much did total owners’
equity increase?
a. Separation of ownership and management
b. Continuity of existence
c. Unlimited liability
d. Ease of raising capital
e. Both c and d
f. None of the above
10. Which organization has the responsibility to establish U.S. GAAP?
a. The FASB
b. The IASB
c. The SEC
d. Management
11. An audit opinion
a. is provided by the audited company’s president.
b. is provided by private accountants.
c. is provided by an independent CPA.
d. all of the above
12. A certified public accountant (CPA) in the U.S. earns certification through
a. being an accounting major in college.
b. having sufficient experience.
c. meeting Board of Accountancy standards of knowledge and integrity.
d. all of the above
13. The overall concern of the AICPA’s Code of Professional Conduct is which of the
following?
a. Whether the CPA is an officer in the corporation being audited
b. Whether the CPA owns stock in the corporation being audited
c. Whether the CPA is independent and acts with integrity and objectivity
d. Whether the CPA’s father is the controller of the corporation being audited
Exercises
1. If total assets are $85,000 and total liabilities are $45,000, what is total owner’s
equity?
2. If a company purchases $50,000 of equipment on credit, how much did total owners’
equity increase?
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Chapter 1 Quiz Solutions
Multiple Choice
1. c 6. b 11. c
2. b 7. a 12. f
3. d 8. c 13. c
4. c 9. f
5. a 10. a
Exercises
1. The balance sheet equation holds that Total Assets equal Total Liabilities plus Total
Owner’s Equity. This means that $85,000 = $45,000 + x and x = $40,000, the Total
Owner’s Equity balance.
2. “ 0”: Assets increase and liabilities increase.
Chapter 1 Quiz Solutions
Multiple Choice
1. c 6. b 11. c
2. b 7. a 12. f
3. d 8. c 13. c
4. c 9. f
5. a 10. a
Exercises
1. The balance sheet equation holds that Total Assets equal Total Liabilities plus Total
Owner’s Equity. This means that $85,000 = $45,000 + x and x = $40,000, the Total
Owner’s Equity balance.
2. “ 0”: Assets increase and liabilities increase.
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CHAPTER 2
Measuring Income to
Assess Performance
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Explain how accountants measure income.
2. Determine when a company should record revenue from a sale.
3. Use the concept of matching to record the expenses for a period.
4. Prepare an income statement and show how it is related to a balance sheet.
5. Account for cash dividends and prepare a statement of stockholders’ equity.
6. Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividend-payout
ratio.
7. Explain how the conceptual framework guides the standard setting process and how accounting
regulators trade off relevance and faithful representation in setting accounting standards.
8. Explain how the following concepts affect financial statements: entity, going concern, materiality, stable
monetary unit, periodicity, and reliability.
Chapter 2 presents the rudiments of measuring income, including a discussion of revenues and
expenses. It introduces accrual accounting and what it means to recognize revenues when they are earned and
realized. The matching concept is then explained as to how expenses are assigned to a period in which the
pertinent goods and services are either used or appear to have no future benefit.
Other basic financial statements—the income statement and the statement of stockholders’ equity—are
introduced in more detail. The chapter discusses four financial ratios that decision makers use to analyze the
performance and prospects of a business entity. The chapter concludes with discussion of important concepts
and conventions and their effect on financial statements.
CHAPTER 2
Measuring Income to
Assess Performance
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Explain how accountants measure income.
2. Determine when a company should record revenue from a sale.
3. Use the concept of matching to record the expenses for a period.
4. Prepare an income statement and show how it is related to a balance sheet.
5. Account for cash dividends and prepare a statement of stockholders’ equity.
6. Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividend-payout
ratio.
7. Explain how the conceptual framework guides the standard setting process and how accounting
regulators trade off relevance and faithful representation in setting accounting standards.
8. Explain how the following concepts affect financial statements: entity, going concern, materiality, stable
monetary unit, periodicity, and reliability.
Chapter 2 presents the rudiments of measuring income, including a discussion of revenues and
expenses. It introduces accrual accounting and what it means to recognize revenues when they are earned and
realized. The matching concept is then explained as to how expenses are assigned to a period in which the
pertinent goods and services are either used or appear to have no future benefit.
Other basic financial statements—the income statement and the statement of stockholders’ equity—are
introduced in more detail. The chapter discusses four financial ratios that decision makers use to analyze the
performance and prospects of a business entity. The chapter concludes with discussion of important concepts
and conventions and their effect on financial statements.
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Learning Objective 1. Explain how accountants measure income.
The accounting measurement of income is the major means for evaluating a business entity’s
performance. Generally Accepted Accounting Principles (GAAP) specify rules that govern
income measurement so that investors can compare one company to another.
The operating cycle (cash cycle) is the time elapsing between the acquisition of goods and
services, in exchange for cash, and the subsequent sale of products to customers who in turn pay
for their purchases in cash.
Accounting time periods are imposed on a business to enable periodic reports of performance.
a. The calendar year is the most popular time period for measuring income or profits,
although a business may adopt a fiscal year that differs from the calendar year.
b. Interim periods are the time spans established for accounting purposes that are less
than a year.
Revenues (sales, sales revenue) are increases in net assets resulting from selling products or
services to customers.
Expenses are decreases in net assets as a result of consuming or giving up resources in the
process of providing products or services to a customer.
Income (profits, earnings) is the excess of revenues over expenses.
DO MULTIPLE CHOICE 1 and 2.
Retained earnings (retained income) is total cumulative owners’ equity that is generated by
income or profits (see EXHIBIT 2-3).
Accounts receivable (trade receivables, receivables) are amounts owed to a company by
customers as a result of the company’s delivering goods or services and extending credit in the
ordinary course of business.
Cost of goods sold expense (cost of sales, cost of revenue) is the original acquisition cost of the
inventory that a company sells to customers during the reporting period.
The accrual basis records revenue when the company earns it and expenses when the company
incurs them. Under the cash basis, revenues and expenses are recorded only when cash is
received or paid.
Learning Objective 1. Explain how accountants measure income.
The accounting measurement of income is the major means for evaluating a business entity’s
performance. Generally Accepted Accounting Principles (GAAP) specify rules that govern
income measurement so that investors can compare one company to another.
The operating cycle (cash cycle) is the time elapsing between the acquisition of goods and
services, in exchange for cash, and the subsequent sale of products to customers who in turn pay
for their purchases in cash.
Accounting time periods are imposed on a business to enable periodic reports of performance.
a. The calendar year is the most popular time period for measuring income or profits,
although a business may adopt a fiscal year that differs from the calendar year.
b. Interim periods are the time spans established for accounting purposes that are less
than a year.
Revenues (sales, sales revenue) are increases in net assets resulting from selling products or
services to customers.
Expenses are decreases in net assets as a result of consuming or giving up resources in the
process of providing products or services to a customer.
Income (profits, earnings) is the excess of revenues over expenses.
DO MULTIPLE CHOICE 1 and 2.
Retained earnings (retained income) is total cumulative owners’ equity that is generated by
income or profits (see EXHIBIT 2-3).
Accounts receivable (trade receivables, receivables) are amounts owed to a company by
customers as a result of the company’s delivering goods or services and extending credit in the
ordinary course of business.
Cost of goods sold expense (cost of sales, cost of revenue) is the original acquisition cost of the
inventory that a company sells to customers during the reporting period.
The accrual basis records revenue when the company earns it and expenses when the company
incurs them. Under the cash basis, revenues and expenses are recorded only when cash is
received or paid.
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Learning Objective 2. Determine when a company should record revenue from a sale.
To measure income on an accrual basis, accountants use a set of revenue recognition criteria to
determine whether revenues should be recorded in the financial statements of a given period.
Both U.S. GAAP and IFRS use revenue recognition criteria, although the criteria differ slightly.
To be recognized under U.S. GAAP, revenues must meet two criteria:
a. They must be earned. Goods or services are fully rendered, usually delivered to the
customer.
b. They must be realized or realizable. Revenues are realized when cash or claims to cash
are received in the exchange of goods or services. Revenues are realizable when the
company receives assets that are easily converted into cash or claims to cash. (If cash is
not received directly, the eventual collectability of cash must be reasonably assured.)
DO MULTIPLE CHOICE 3.
Learning Objective 3. Use the concept of matching to record the expenses for a period.
There are two types of expenses in every accounting period:
a. Those directly linked to the generation of revenues earned that period—product costs
(costs that are linked with revenues and charged as expenses when the related revenue
is recognized).
b. Those linked to the time period itself—period costs (costs supporting a company’s
operations for a given period that are charged to expense in the time period in which
the costs are incurred).
Matching is the concept of recording expenses in the same time period as the related revenues
are recognized.
DO MULTIPLE CHOICE 4.
Some purchases of goods or services are initially recorded as assets in order to match the costs
with revenues of future periods. For example, a firm might pay rent in advance for the entire year
and record the payment in the asset account Prepaid Rent. Each month the firm reduces the
prepaid rent account and increases rent expense.
The same matching concept applies to recognition of depreciation, the systematic allocation of
the acquisition cost of long-lived or fixed assets to the expense accounts of particular accounting
periods that benefit from the use of the assets.
In both cases (prepaid rent and depreciation), the business purchased an asset that gradually wore
out or was used.
Learning Objective 2. Determine when a company should record revenue from a sale.
To measure income on an accrual basis, accountants use a set of revenue recognition criteria to
determine whether revenues should be recorded in the financial statements of a given period.
Both U.S. GAAP and IFRS use revenue recognition criteria, although the criteria differ slightly.
To be recognized under U.S. GAAP, revenues must meet two criteria:
a. They must be earned. Goods or services are fully rendered, usually delivered to the
customer.
b. They must be realized or realizable. Revenues are realized when cash or claims to cash
are received in the exchange of goods or services. Revenues are realizable when the
company receives assets that are easily converted into cash or claims to cash. (If cash is
not received directly, the eventual collectability of cash must be reasonably assured.)
DO MULTIPLE CHOICE 3.
Learning Objective 3. Use the concept of matching to record the expenses for a period.
There are two types of expenses in every accounting period:
a. Those directly linked to the generation of revenues earned that period—product costs
(costs that are linked with revenues and charged as expenses when the related revenue
is recognized).
b. Those linked to the time period itself—period costs (costs supporting a company’s
operations for a given period that are charged to expense in the time period in which
the costs are incurred).
Matching is the concept of recording expenses in the same time period as the related revenues
are recognized.
DO MULTIPLE CHOICE 4.
Some purchases of goods or services are initially recorded as assets in order to match the costs
with revenues of future periods. For example, a firm might pay rent in advance for the entire year
and record the payment in the asset account Prepaid Rent. Each month the firm reduces the
prepaid rent account and increases rent expense.
The same matching concept applies to recognition of depreciation, the systematic allocation of
the acquisition cost of long-lived or fixed assets to the expense accounts of particular accounting
periods that benefit from the use of the assets.
In both cases (prepaid rent and depreciation), the business purchased an asset that gradually wore
out or was used.
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Learning Objective 4. Prepare an income statement and show how it is related to a
balance sheet.
An income statement (statement of earnings, statement of operations) is a report of all
revenues and expenses pertaining to a specific time period.
Net income (net earnings) is the remainder after all expenses have been deducted from revenue.
If expenses exceed revenues, a company has a net loss.
The income statement shows how an entity’s operations for the period have increased net assets
through revenues and decreased net assets through expenses.
The income statement is the major link between two balance sheets and shows the activities of an
entity between the two balance sheet dates.
DO EXERCISES 1 and 2.
Learning Objective 5. Account for cash dividends and prepare a statement of
stockholders’ equity.
Retained earnings increase by the amount of net income reported during the period (or decrease
by the amount of net loss).
DO MULTIPLE CHOICE 5 and 6.
Cash dividends are distributions of cash to shareholders that reduce retained earnings.
Cash dividends are not expenses, and, therefore, not deducted from revenues on the income
statement.
Cash dividends are declared by the board of directors of a company on the declaration date, are
payable to those stockholders on record as owning stock on a second date (record date), and are
paid on a third date (payment date).
Retained earnings and cash are two separate accounts. Cash is needed to pay the declared
dividend.
The statement of stockholders’ equity (statement of shareholders’ equity) shows all changes
during the year in each stockholders’ equity account. (See EXHIBIT 2-8.)
Changes in stockholders’ equity arise from three main sources:
a. A period’s net income (or net loss) increases (decreases) the balance in the retained
earnings portion of stockholders’ equity.
b. Transactions with shareholders such as the payment of dividends and purchase or sale of
shares of stock.
c. Other comprehensive income (OCI) - specific changes in stockholders’ equity that do
not result from net income or transactions with shareholders. Companies accumulate
these items in a stockholders’ equity account entitled Accumulated other
comprehensive income (AOCI).
Learning Objective 4. Prepare an income statement and show how it is related to a
balance sheet.
An income statement (statement of earnings, statement of operations) is a report of all
revenues and expenses pertaining to a specific time period.
Net income (net earnings) is the remainder after all expenses have been deducted from revenue.
If expenses exceed revenues, a company has a net loss.
The income statement shows how an entity’s operations for the period have increased net assets
through revenues and decreased net assets through expenses.
The income statement is the major link between two balance sheets and shows the activities of an
entity between the two balance sheet dates.
DO EXERCISES 1 and 2.
Learning Objective 5. Account for cash dividends and prepare a statement of
stockholders’ equity.
Retained earnings increase by the amount of net income reported during the period (or decrease
by the amount of net loss).
DO MULTIPLE CHOICE 5 and 6.
Cash dividends are distributions of cash to shareholders that reduce retained earnings.
Cash dividends are not expenses, and, therefore, not deducted from revenues on the income
statement.
Cash dividends are declared by the board of directors of a company on the declaration date, are
payable to those stockholders on record as owning stock on a second date (record date), and are
paid on a third date (payment date).
Retained earnings and cash are two separate accounts. Cash is needed to pay the declared
dividend.
The statement of stockholders’ equity (statement of shareholders’ equity) shows all changes
during the year in each stockholders’ equity account. (See EXHIBIT 2-8.)
Changes in stockholders’ equity arise from three main sources:
a. A period’s net income (or net loss) increases (decreases) the balance in the retained
earnings portion of stockholders’ equity.
b. Transactions with shareholders such as the payment of dividends and purchase or sale of
shares of stock.
c. Other comprehensive income (OCI) - specific changes in stockholders’ equity that do
not result from net income or transactions with shareholders. Companies accumulate
these items in a stockholders’ equity account entitled Accumulated other
comprehensive income (AOCI).
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Negative Retained Earnings is known as Accumulated Deficit.
DO MULTIPLE CHOICE 7 and 8.
Learning Objective 6. Compute and explain earnings per share, price-earnings ratio,
dividend-yield ratio, and dividend-payout ratio.
1. Basic earnings per share (EPS) is net income divided by the weighted-average number of
common shares outstanding during the period over which the net income is measured.
Net income
Earnings per share = Weighted-Average Number of Common Shares Outstanding
2. Price-Earning (P-E) Ratio (earnings multiple): measures how much the investing public is
willing to pay for a chance to share in a company’s potential earnings.
Market Price per Share of Common Stock
P – E Earnings per Share of Common Stock
3. Dividend-Yield Ratio: common dividends per share divided by market price per share
Dividend – Yield = Common Dividends per share
Market Price per Share
4. Dividend-Payout Ratio: common dividends per share divided by earnings per share
Common Dividends per Share
Dividend – Payout Earnings per Share
DO MULTIPLE CHOICE 9, 10, and 11.
Learning Objective 7. Explain how the conceptual framework guides the standard setting
process and how accounting regulators trade off relevance and
faithful representation in setting accounting standards.
When the FASB and the IASB are setting standards, they begin with the Objective of Financial
Reporting - to provide information that is useful to present and potential investors and creditors
and others in making investment, credit, and similar resource allocation decisions
Relevance and faithful representation are the two main qualities that make accounting
information useful for decision making (see EXHIBIT 2-9).
Relevance is the capability of the information to make a difference to the decision maker and is
characterized by the following:
a. Predictive value helps users form their expectations about the future.
b. Confirmatory value helps confirm or contradict existing expectations.
Faithful Representation means that the information truly captures the economic substance of the
transactions, events, or circumstances it describes. It requires information to be:
Negative Retained Earnings is known as Accumulated Deficit.
DO MULTIPLE CHOICE 7 and 8.
Learning Objective 6. Compute and explain earnings per share, price-earnings ratio,
dividend-yield ratio, and dividend-payout ratio.
1. Basic earnings per share (EPS) is net income divided by the weighted-average number of
common shares outstanding during the period over which the net income is measured.
Net income
Earnings per share = Weighted-Average Number of Common Shares Outstanding
2. Price-Earning (P-E) Ratio (earnings multiple): measures how much the investing public is
willing to pay for a chance to share in a company’s potential earnings.
Market Price per Share of Common Stock
P – E Earnings per Share of Common Stock
3. Dividend-Yield Ratio: common dividends per share divided by market price per share
Dividend – Yield = Common Dividends per share
Market Price per Share
4. Dividend-Payout Ratio: common dividends per share divided by earnings per share
Common Dividends per Share
Dividend – Payout Earnings per Share
DO MULTIPLE CHOICE 9, 10, and 11.
Learning Objective 7. Explain how the conceptual framework guides the standard setting
process and how accounting regulators trade off relevance and
faithful representation in setting accounting standards.
When the FASB and the IASB are setting standards, they begin with the Objective of Financial
Reporting - to provide information that is useful to present and potential investors and creditors
and others in making investment, credit, and similar resource allocation decisions
Relevance and faithful representation are the two main qualities that make accounting
information useful for decision making (see EXHIBIT 2-9).
Relevance is the capability of the information to make a difference to the decision maker and is
characterized by the following:
a. Predictive value helps users form their expectations about the future.
b. Confirmatory value helps confirm or contradict existing expectations.
Faithful Representation means that the information truly captures the economic substance of the
transactions, events, or circumstances it describes. It requires information to be:
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a. Complete
b. Neutral
c. Free from material errors
Relevance and faithful representation are both enhanced by the following characteristics:
a. Comparability means that companies use similar concepts and measurements and use
them consistently from period to period.
b. Verifiability means that information can be checked to make sure it is correct.
c. Timeliness means that information reaches decision makers while it can still influence
their decisions.
d. Understandability requires information to be presented clearly and concisely.
The cost-effectiveness constraint is a requirement that standard setting bodies choose rules whose
decision-making benefits exceed the cost of the information.
Learning Objective 8. Explain how the following concepts affect financial statements:
entity, going concern, materiality, and stable monetary unit,
periodicity, and reliability.
There are a number of concepts and conventions that are implicit in all financial statements.
The entity concept – an accounting entity stands apart from other organizations and
individuals as a separate economic unit.
The going concern (continuity) convention asserts that the entity will persist
indefinitely.
The materiality convention states that an item should be included in a financial
statement, if its omission or misstatement would tend to mislead the reader of the financial
statement under consideration.
The stable monetary unit is a monetary unit that is not expected to change significantly
over time.
The periodicity convention requires that a company break up its economic activity into
artificial time periods that will provide timely information to users.
The reliability concept assures decision makers that the information presented captures
the conditions or events it purports to represent.
a. Complete
b. Neutral
c. Free from material errors
Relevance and faithful representation are both enhanced by the following characteristics:
a. Comparability means that companies use similar concepts and measurements and use
them consistently from period to period.
b. Verifiability means that information can be checked to make sure it is correct.
c. Timeliness means that information reaches decision makers while it can still influence
their decisions.
d. Understandability requires information to be presented clearly and concisely.
The cost-effectiveness constraint is a requirement that standard setting bodies choose rules whose
decision-making benefits exceed the cost of the information.
Learning Objective 8. Explain how the following concepts affect financial statements:
entity, going concern, materiality, and stable monetary unit,
periodicity, and reliability.
There are a number of concepts and conventions that are implicit in all financial statements.
The entity concept – an accounting entity stands apart from other organizations and
individuals as a separate economic unit.
The going concern (continuity) convention asserts that the entity will persist
indefinitely.
The materiality convention states that an item should be included in a financial
statement, if its omission or misstatement would tend to mislead the reader of the financial
statement under consideration.
The stable monetary unit is a monetary unit that is not expected to change significantly
over time.
The periodicity convention requires that a company break up its economic activity into
artificial time periods that will provide timely information to users.
The reliability concept assures decision makers that the information presented captures
the conditions or events it purports to represent.
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2-7
Chapter 2 Quiz
Multiple Choice
1. A fiscal year
a. ends on December 31.
b. always ends at the end of the month.
c. ends on June 30.
d. is any 12 consecutive months.
2. The key components in measuring income are
a. revenue and assets.
b. assets and liabilities.
c. revenue and expenses.
d. retained earnings and expenses.
e. revenue and liabilities.
f. expenses and assets.
3. Which of the following help(s) determine when a sale should be included in the income statement?
a. Recognition principle
b. Cost recovery principle
c. Matching principle
d. Both a and c
4. The recording of expenses in the same time period as the related revenues is called
a. matching.
b. recognition.
c. allocation.
d. accuracy.
5. Given the following information at the end of the year, what was the balance in retained earnings at
the beginning of the year?
Total Assets = $190,000
Total Liabilities = 110,000
Contributed Capital = 30,000
Revenues = 85,000
Expenses = 70,000
a. $25,000
b. $35,000
c. $45,000
d. $80,000
Chapter 2 Quiz
Multiple Choice
1. A fiscal year
a. ends on December 31.
b. always ends at the end of the month.
c. ends on June 30.
d. is any 12 consecutive months.
2. The key components in measuring income are
a. revenue and assets.
b. assets and liabilities.
c. revenue and expenses.
d. retained earnings and expenses.
e. revenue and liabilities.
f. expenses and assets.
3. Which of the following help(s) determine when a sale should be included in the income statement?
a. Recognition principle
b. Cost recovery principle
c. Matching principle
d. Both a and c
4. The recording of expenses in the same time period as the related revenues is called
a. matching.
b. recognition.
c. allocation.
d. accuracy.
5. Given the following information at the end of the year, what was the balance in retained earnings at
the beginning of the year?
Total Assets = $190,000
Total Liabilities = 110,000
Contributed Capital = 30,000
Revenues = 85,000
Expenses = 70,000
a. $25,000
b. $35,000
c. $45,000
d. $80,000
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2-8
6. Which of the following accounts is not an expense?
a. depreciation
b. salaries
c. dividends
d. delivery expense
7. Given the following information at the end of the year, how much was net income for the year?
Beginning retained earnings = $54,000
Dividends = $20,000
Ending retained earnings = $69,000
a. $(5,000)
b. $15,000
c. $35,000
d. $40,000
8. Declaration of dividends to stockholders
a. increases paid-in capital.
b. decreases paid-in capital.
c. increases retained earnings.
d. decreases retained earnings.
e. increases assets.
f. increases liabilities.
9. The ratio that is sometimes referred to as the earnings multiple is the
a. earnings-per-share ratio.
b. dividend-yield ratio.
c. price-earnings ratio.
d. dividend-payment ratio.
10. The only financial ratio required to be a part of the financial statements is
a. price-earnings.
b. earnings per share.
c. dividend-yield.
d. dividend-payout.
11. Which of the following formulas is used to calculate dividend-yield ratio?
a. Net income / average number of shares outstanding
b. Common dividends per share / market price per share
c. Market price per share / gross profit per share
d. Revenue / average number of shares outstanding
6. Which of the following accounts is not an expense?
a. depreciation
b. salaries
c. dividends
d. delivery expense
7. Given the following information at the end of the year, how much was net income for the year?
Beginning retained earnings = $54,000
Dividends = $20,000
Ending retained earnings = $69,000
a. $(5,000)
b. $15,000
c. $35,000
d. $40,000
8. Declaration of dividends to stockholders
a. increases paid-in capital.
b. decreases paid-in capital.
c. increases retained earnings.
d. decreases retained earnings.
e. increases assets.
f. increases liabilities.
9. The ratio that is sometimes referred to as the earnings multiple is the
a. earnings-per-share ratio.
b. dividend-yield ratio.
c. price-earnings ratio.
d. dividend-payment ratio.
10. The only financial ratio required to be a part of the financial statements is
a. price-earnings.
b. earnings per share.
c. dividend-yield.
d. dividend-payout.
11. Which of the following formulas is used to calculate dividend-yield ratio?
a. Net income / average number of shares outstanding
b. Common dividends per share / market price per share
c. Market price per share / gross profit per share
d. Revenue / average number of shares outstanding
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2-9
Exercises
1. Calculate net income using the following data:
Interest expense $ 3,100 Revenue $ 110,000
Rent expense 3,000 Wages expense 80,000
Supplies expense 4,000 Interest income 7,100
2. The income statements for four different firms are shown next. Some of the account balances and
totals have been omitted and a letter substituted. Determine the omitted amounts.
Revenue from Operations $ 3,600 c e 3,000
Operating Expenses
Rent Expense 400 650 200 400
Wages Expense 700 330 200 265
Advertising Expense 600 d f 300
Total Expenses a 1,200 580 g
Net Income (Loss) b (210) 1,000 h
Exercises
1. Calculate net income using the following data:
Interest expense $ 3,100 Revenue $ 110,000
Rent expense 3,000 Wages expense 80,000
Supplies expense 4,000 Interest income 7,100
2. The income statements for four different firms are shown next. Some of the account balances and
totals have been omitted and a letter substituted. Determine the omitted amounts.
Revenue from Operations $ 3,600 c e 3,000
Operating Expenses
Rent Expense 400 650 200 400
Wages Expense 700 330 200 265
Advertising Expense 600 d f 300
Total Expenses a 1,200 580 g
Net Income (Loss) b (210) 1,000 h
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2-10
Chapter 2 Quiz Solutions
Multiple Choice
1. d 6. c 11. b
2. c 7. c
3. a 8. d
4. a 9. c
5. b 10. b
Chapter 2 Quiz Solutions
Multiple Choice
1. d 6. c 11. b
2. c 7. c
3. a 8. d
4. a 9. c
5. b 10. b
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2-11
Exercises
1. Sales Revenue $ 110,000
Interest Income 7,100
Expenses:
Interest 3,100
Rent 3,000
Supplies 4,000
Wages 80,000 90,100
Net Income $ 27,000
2. a = $1,700 b = $1,900 c = $990 d = $220 e = $1,580
f = $180 g = $965 h =$2,035
Exercises
1. Sales Revenue $ 110,000
Interest Income 7,100
Expenses:
Interest 3,100
Rent 3,000
Supplies 4,000
Wages 80,000 90,100
Net Income $ 27,000
2. a = $1,700 b = $1,900 c = $990 d = $220 e = $1,580
f = $180 g = $965 h =$2,035
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3-1
CHAPTER 3
Recording Transactions
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Use double-entry accounting.
2. Describe the five steps in the recording process.
3. Analyze and journalize transactions and post journal entries to the ledgers.
4. Prepare and use a trial balance.
5. Close revenue and expense accounts and update retained earnings.
6. Correct erroneous journal entries and describe how errors affect accounts.
7. Explain how computers have transformed the processing of accounting data.
Chapter 3 introduces the accounting recording process, concentrating on the general journal and
general ledger. The terms debit and credit are introduced and explained. Journal entries are illustrated.
Recording transactions in the general journal and general ledger is explained.
Analysis of transactions is discussed. Included in the discussion are the effects of errors in the
records and the methods for creating entries from incomplete files and data sources.
Trial balances are introduced and their purpose is discussed. Closing revenue and expense accounts
to retained earnings is demonstrated. Lastly, the importance of computers in data processing is discussed.
CHAPTER 3
Recording Transactions
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Use double-entry accounting.
2. Describe the five steps in the recording process.
3. Analyze and journalize transactions and post journal entries to the ledgers.
4. Prepare and use a trial balance.
5. Close revenue and expense accounts and update retained earnings.
6. Correct erroneous journal entries and describe how errors affect accounts.
7. Explain how computers have transformed the processing of accounting data.
Chapter 3 introduces the accounting recording process, concentrating on the general journal and
general ledger. The terms debit and credit are introduced and explained. Journal entries are illustrated.
Recording transactions in the general journal and general ledger is explained.
Analysis of transactions is discussed. Included in the discussion are the effects of errors in the
records and the methods for creating entries from incomplete files and data sources.
Trial balances are introduced and their purpose is discussed. Closing revenue and expense accounts
to retained earnings is demonstrated. Lastly, the importance of computers in data processing is discussed.
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3-2
Learning Objective 1. Use double-entry accounting.
In the double-entry system, at least two accounts are affected by every transaction. After a
transaction is recorded, the balance sheet equation
Assets = Liabilities + Stockholders’ Equity
must remain in balance.
The general journal is a complete chronological record of an organization’s transactions,
including how each transaction affects the balances of the organization’s accounts.
The general ledger is a collection of all ledger accounts that support the major financial
statements. A ledger account is a listing of all increases and decreases in a particular account.
DO MULTIPLE CHOICE 1.
a. Accounts are used to appropriately categorize transactions.
b. T-accounts are used to portray the individual accounts in the general ledger and
resemble the letter T. For example,
Cash
Left side Right side
Increases Decreases
A balance is the net result of all activity that has been recorded in an account as of a particular
point in time. In a T-account the balance is the difference between the total left-side and total
right-side amounts in the T-account. The balance in a general ledger account at the end of an
accounting period is computed as the beginning balance in the account, plus the amount of the
increases in the account during the period, minus the amount of the decreases.
Assets and expenses usually have left-side balances, while liabilities, equity, and revenues have
right-side balances.
The word debit means an entry or balance on the left side of any account. The word credit
means an entry or balance on the right side of any account. The word “charge” is sometimes
used instead of debit.
DO MULTIPLE CHOICE 2 and 3.
Learning Objective 1. Use double-entry accounting.
In the double-entry system, at least two accounts are affected by every transaction. After a
transaction is recorded, the balance sheet equation
Assets = Liabilities + Stockholders’ Equity
must remain in balance.
The general journal is a complete chronological record of an organization’s transactions,
including how each transaction affects the balances of the organization’s accounts.
The general ledger is a collection of all ledger accounts that support the major financial
statements. A ledger account is a listing of all increases and decreases in a particular account.
DO MULTIPLE CHOICE 1.
a. Accounts are used to appropriately categorize transactions.
b. T-accounts are used to portray the individual accounts in the general ledger and
resemble the letter T. For example,
Cash
Left side Right side
Increases Decreases
A balance is the net result of all activity that has been recorded in an account as of a particular
point in time. In a T-account the balance is the difference between the total left-side and total
right-side amounts in the T-account. The balance in a general ledger account at the end of an
accounting period is computed as the beginning balance in the account, plus the amount of the
increases in the account during the period, minus the amount of the decreases.
Assets and expenses usually have left-side balances, while liabilities, equity, and revenues have
right-side balances.
The word debit means an entry or balance on the left side of any account. The word credit
means an entry or balance on the right side of any account. The word “charge” is sometimes
used instead of debit.
DO MULTIPLE CHOICE 2 and 3.
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3-3
Learning Objective 2. Describe the five steps in the recording process.
Recording transactions consists of the following steps:
Transaction Documentation
Journal
Ledger
Trial Balance
Financial Statements
Step 1: The recording process begins with source documents, which are the original records
supporting any transaction.
Step 2: An analysis of the transaction, based on the course documents, is recorded in the general
journal (also known as the book of original entry).
Step 3: Enter transactions into the ledger accounts.
Step 4: Prepare the trial balance - a list of all of the accounts in the general ledger with their
balances.
Step 5: Closing the books and preparing the financial statements.
DO MULTIPLE CHOICE 4 and 5.
Learning Objective 3. Analyze and journalize transactions and post journal entries to the
ledgers.
Journalizing is the process of entering transactions into the general journal.
A journal entry is an analysis of the effects of a transaction on the various accounts—(see
EXHIBIT 3-1) and is recorded as follows:
a. The title of account(s) to be debited is placed left,
b. the title of account(s) to be credited is indented,
c. a brief explanation of the transaction is usually included, and
d. the account number column refers to the number of the account in the ledger.
Accountants use account numbers as a shorthand way to identify the accounts. The
ledger account number is found in the chart of accounts (a numbered or coded list of
all account titles).
Learning Objective 2. Describe the five steps in the recording process.
Recording transactions consists of the following steps:
Transaction Documentation
Journal
Ledger
Trial Balance
Financial Statements
Step 1: The recording process begins with source documents, which are the original records
supporting any transaction.
Step 2: An analysis of the transaction, based on the course documents, is recorded in the general
journal (also known as the book of original entry).
Step 3: Enter transactions into the ledger accounts.
Step 4: Prepare the trial balance - a list of all of the accounts in the general ledger with their
balances.
Step 5: Closing the books and preparing the financial statements.
DO MULTIPLE CHOICE 4 and 5.
Learning Objective 3. Analyze and journalize transactions and post journal entries to the
ledgers.
Journalizing is the process of entering transactions into the general journal.
A journal entry is an analysis of the effects of a transaction on the various accounts—(see
EXHIBIT 3-1) and is recorded as follows:
a. The title of account(s) to be debited is placed left,
b. the title of account(s) to be credited is indented,
c. a brief explanation of the transaction is usually included, and
d. the account number column refers to the number of the account in the ledger.
Accountants use account numbers as a shorthand way to identify the accounts. The
ledger account number is found in the chart of accounts (a numbered or coded list of
all account titles).
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3-4
DO MULTIPLE CHOICE 6.
“Posting” is the transferring of amounts from the general journal to the appropriate accounts in
the general ledger (see EXHIBITS 3-1 and 3-2 for examples). The process of using numbering,
dating, and/or some other form of identification to relate each ledger posting to the appropriate
journal entry is known as cross-referencing.
Analyzing a transaction for the journal and ledger requires
a. the accounts affected by the transaction to be identified,
b. deciding if the accounts should be decreased or increased, and
c. deciding if the accounts should be debited or credited.
Simple entries are for transactions that affect only two accounts. Compound entries are for
transactions that affect more than two accounts.
a. Assets and expenses normally have left-side (debit) balances. They are increased by
entries on the left side and decreased by the entries on the right side.
b. Liabilities and owners’ equity (including revenue) accounts have right-side (credit)
balances. They are increased by entries on the right side and decreased by the entries
on the left side (see EXHIBIT 3-3).
Revenue and expenses are summarized as net income (net loss) on the income statement. With
regard to the balance sheet, revenues serve to increase retained earnings and expenses serve to
decrease retained earnings.
When recording depreciation expense on an asset, accumulated depreciation is credited.
Accumulated depreciation is a contra account (a separate but related account that is an offset
or a deduction from a companion account). It is the cumulative sum of all depreciation
recognized since the date of acquisition of a long-term asset. Accumulated depreciation is a
contra asset because its companion account is an asset.
A contra account always has a companion account and it has a balance on the opposite side from
the companion account. The book value (net book value, carrying amount, or carrying
value) is the balance of an account shown on the books, net of any associated contra accounts.
EXHIBITS 3-4 and 3-5 illustrate the general journal and general ledger for Biwheels Company.
DO MULTIPLE CHOICE 6.
“Posting” is the transferring of amounts from the general journal to the appropriate accounts in
the general ledger (see EXHIBITS 3-1 and 3-2 for examples). The process of using numbering,
dating, and/or some other form of identification to relate each ledger posting to the appropriate
journal entry is known as cross-referencing.
Analyzing a transaction for the journal and ledger requires
a. the accounts affected by the transaction to be identified,
b. deciding if the accounts should be decreased or increased, and
c. deciding if the accounts should be debited or credited.
Simple entries are for transactions that affect only two accounts. Compound entries are for
transactions that affect more than two accounts.
a. Assets and expenses normally have left-side (debit) balances. They are increased by
entries on the left side and decreased by the entries on the right side.
b. Liabilities and owners’ equity (including revenue) accounts have right-side (credit)
balances. They are increased by entries on the right side and decreased by the entries
on the left side (see EXHIBIT 3-3).
Revenue and expenses are summarized as net income (net loss) on the income statement. With
regard to the balance sheet, revenues serve to increase retained earnings and expenses serve to
decrease retained earnings.
When recording depreciation expense on an asset, accumulated depreciation is credited.
Accumulated depreciation is a contra account (a separate but related account that is an offset
or a deduction from a companion account). It is the cumulative sum of all depreciation
recognized since the date of acquisition of a long-term asset. Accumulated depreciation is a
contra asset because its companion account is an asset.
A contra account always has a companion account and it has a balance on the opposite side from
the companion account. The book value (net book value, carrying amount, or carrying
value) is the balance of an account shown on the books, net of any associated contra accounts.
EXHIBITS 3-4 and 3-5 illustrate the general journal and general ledger for Biwheels Company.
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3-5
Learning Objective 4. Prepare and use a trial balance.
The trial balance (see EXHIBIT 3-6) is a list of all accounts with their balances. Its purpose is to
a. help check on the accuracy of posting by proving whether the total debits equal the
total credits in the general ledger, and
b. establish a convenient summary of balances in all accounts for the preparation of
formal financial statements.
DO MULTIPLE CHOICE 7 and 8.
DO EXERCISE 1.
Financial statements are derived from the trial balance (see EXHIBIT 3-7).
In the trial balance, all balance sheet accounts except Retained Earnings show their balances as
of the date of the trial balance. Retained Earnings show the balance at the beginning of the
period because any changes to Retained Earnings during the period are reflected in the balances
of the Revenue and Expense accounts.
Learning Objective 5. Close revenue and expense accounts and update retained earnings.
The last step in the process is to close the books. The closing process transfers the balances in
all revenue and expense accounts to Retained Earnings. Closing entries perform this transfer.
There are two procedures that may be used to close the books.
1. Alternative #1 is a two-step process.
a. Transfer the amounts in each revenue and expense account to a “temporary” Income
Summary account. The Income Summary account is used only for the closing process
and is credited to close a company’s revenues, and is debited to close a company’s
expenses.
b. Transfer the balance in the Income Summary account to Retained Earnings.
2. Alternative #2 is a single-step process, which transfers the amounts in the revenue and
expense accounts directly into the Retained Earnings account, bypassing the need for the
Income Summary account.
Either way, the revenue and expense account balances are “reset” to zero and the net income (net
loss) generated during the period increases (decreases) retained earnings (see EXHIBIT 3-8).
DO MULTIPLE CHOICE 9 and 10.
Learning Objective 4. Prepare and use a trial balance.
The trial balance (see EXHIBIT 3-6) is a list of all accounts with their balances. Its purpose is to
a. help check on the accuracy of posting by proving whether the total debits equal the
total credits in the general ledger, and
b. establish a convenient summary of balances in all accounts for the preparation of
formal financial statements.
DO MULTIPLE CHOICE 7 and 8.
DO EXERCISE 1.
Financial statements are derived from the trial balance (see EXHIBIT 3-7).
In the trial balance, all balance sheet accounts except Retained Earnings show their balances as
of the date of the trial balance. Retained Earnings show the balance at the beginning of the
period because any changes to Retained Earnings during the period are reflected in the balances
of the Revenue and Expense accounts.
Learning Objective 5. Close revenue and expense accounts and update retained earnings.
The last step in the process is to close the books. The closing process transfers the balances in
all revenue and expense accounts to Retained Earnings. Closing entries perform this transfer.
There are two procedures that may be used to close the books.
1. Alternative #1 is a two-step process.
a. Transfer the amounts in each revenue and expense account to a “temporary” Income
Summary account. The Income Summary account is used only for the closing process
and is credited to close a company’s revenues, and is debited to close a company’s
expenses.
b. Transfer the balance in the Income Summary account to Retained Earnings.
2. Alternative #2 is a single-step process, which transfers the amounts in the revenue and
expense accounts directly into the Retained Earnings account, bypassing the need for the
Income Summary account.
Either way, the revenue and expense account balances are “reset” to zero and the net income (net
loss) generated during the period increases (decreases) retained earnings (see EXHIBIT 3-8).
DO MULTIPLE CHOICE 9 and 10.
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3-6
Learning Objective 6. Correct erroneous journal entries and describe how errors affect
accounts.
When a journal entry contains an error, the entry can be erased or crossed out and corrected—if
the error is discovered immediately.
If the error is detected later, typically after posting to ledger accounts, then the accountant makes
a correcting entry (one that cancels an erroneous journal entry and adds the correct amounts to
the correct accounts), as distinguished from a regular entry.
Some errors in recording revenues and expenses are temporary in nature and are
counterbalanced by offsetting errors in the ordinary bookkeeping process in the next period.
Such errors misstate net income in both periods; they also affect the balance sheet of the first
period but not the second.
DO MULTIPLE CHOICE 11 and 12.
Other errors may not be counterbalanced in the ordinary bookkeeping process. Until specific
correcting entries are made, all subsequent balance sheets will be in error.
Accountants must sometimes construct financial statements from incomplete data (for example,
documents can be stolen, destroyed, or lost).
T-accounts help organize an accountant’s thinking and aid the discovery of unknown amounts.
a. Enter all known items into the key T-account.
b. Find the unknown. Simple arithmetic will often suffice.
Learning Objective 7. Explain how computers have transformed the processing of
accounting data.
Data processing and computers are used by almost all organizations to process transactions
efficiently. An accounting information system is a data processing system, which records,
analyzes, stores, and reports on an entity’s business transactions.
eXtensible Business Reporting Language (XBRL) is a computer language that can be used for
financial reporting and allows for easy comparisons across companies.
Learning Objective 6. Correct erroneous journal entries and describe how errors affect
accounts.
When a journal entry contains an error, the entry can be erased or crossed out and corrected—if
the error is discovered immediately.
If the error is detected later, typically after posting to ledger accounts, then the accountant makes
a correcting entry (one that cancels an erroneous journal entry and adds the correct amounts to
the correct accounts), as distinguished from a regular entry.
Some errors in recording revenues and expenses are temporary in nature and are
counterbalanced by offsetting errors in the ordinary bookkeeping process in the next period.
Such errors misstate net income in both periods; they also affect the balance sheet of the first
period but not the second.
DO MULTIPLE CHOICE 11 and 12.
Other errors may not be counterbalanced in the ordinary bookkeeping process. Until specific
correcting entries are made, all subsequent balance sheets will be in error.
Accountants must sometimes construct financial statements from incomplete data (for example,
documents can be stolen, destroyed, or lost).
T-accounts help organize an accountant’s thinking and aid the discovery of unknown amounts.
a. Enter all known items into the key T-account.
b. Find the unknown. Simple arithmetic will often suffice.
Learning Objective 7. Explain how computers have transformed the processing of
accounting data.
Data processing and computers are used by almost all organizations to process transactions
efficiently. An accounting information system is a data processing system, which records,
analyzes, stores, and reports on an entity’s business transactions.
eXtensible Business Reporting Language (XBRL) is a computer language that can be used for
financial reporting and allows for easy comparisons across companies.
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Chapter 3 Quiz
Multiple Choice
1. The general ledger
a. should always have a credit balance.
b. is a collection of accounts that support the financial statements.
c. is the book of original entry.
d. compiles all source documents.
2. Which of the following is a group of accounts that all normally have a debit balance?
a. Cash, Mortgage Payable, and Inventory
b. Land, Cost of Goods Sold, and Paid-in Capital
c. Accounts Receivable, Salaries Expense, and Inventory
d. Prepaid Rent, Building, and Notes Payable
3. The term credit means
a. to increase.
b. to decrease.
c. the left side of an account.
d. the right side of an account.
4. Source documents are
a. supporting original records of financial transactions.
b. journal entries.
c. ledger accounts.
d. increases on the left side of an account.
5. What is the correct order of the accounting process?
a. Ledger, journal, trial balance, balance sheet, income statement
b. Journal, trial balance, ledger, balance sheet, income statement
c. Trial balance, journal, ledger, income statement, balance sheet
d. Journal, ledger, trial balance, income statement, balance sheet
6. To find an explanation of a transaction, one would look at the
a. journal.
b. ledger.
c. chart of accounts.
d. trial balance.
Chapter 3 Quiz
Multiple Choice
1. The general ledger
a. should always have a credit balance.
b. is a collection of accounts that support the financial statements.
c. is the book of original entry.
d. compiles all source documents.
2. Which of the following is a group of accounts that all normally have a debit balance?
a. Cash, Mortgage Payable, and Inventory
b. Land, Cost of Goods Sold, and Paid-in Capital
c. Accounts Receivable, Salaries Expense, and Inventory
d. Prepaid Rent, Building, and Notes Payable
3. The term credit means
a. to increase.
b. to decrease.
c. the left side of an account.
d. the right side of an account.
4. Source documents are
a. supporting original records of financial transactions.
b. journal entries.
c. ledger accounts.
d. increases on the left side of an account.
5. What is the correct order of the accounting process?
a. Ledger, journal, trial balance, balance sheet, income statement
b. Journal, trial balance, ledger, balance sheet, income statement
c. Trial balance, journal, ledger, income statement, balance sheet
d. Journal, ledger, trial balance, income statement, balance sheet
6. To find an explanation of a transaction, one would look at the
a. journal.
b. ledger.
c. chart of accounts.
d. trial balance.
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3-8
7. The trial balance is
a. the listing of all accounts.
b. a listing of all accounts with their balances.
c. a place where a running balance of an account is kept.
d. the book of original entry.
8. The trial balance makes sure that
a. the proper accounts are affected.
b. each account has the appropriate dollar amount balance.
c. the debits equal the credits in the journal.
d. the debits equal the credits in the ledger.
e. None of the above
9. When the financial statements are completed, the Income Summary account is found on which
financial statement?
a. Balance sheet
b. Income statement
c. Statement of cash flows
d. None of the above
10. If the company ends the year with a net income, the balance in the Income Summary account
immediately preceding its closing will have a
a. debit balance.
b. credit balance (usually).
c. both a and b
d. credit balance (always).
11. If the bookkeeper (in 20X2) expenses the entire cost of a truck that normally would be used for three
years, then
a. net income will be understated for 20X2 and overstated for the years 20X3 and 20X4.
b. total assets will not equal liabilities plus owners’ equity.
c. net income will be overstated for 20X2 and understated for the years 20X3 and 20X4.
d. assets will be overstated for 20X2.
12. If the bookkeeper fails to make a revenue entry for 20X2,
a. both 20X2’s and 20X3’s net income will be overstated.
b. only 20X2’s net income will be overstated.
c. net income for 20X2 would be understated.
d. assets will be overstated for 20X2 and 20X3.
7. The trial balance is
a. the listing of all accounts.
b. a listing of all accounts with their balances.
c. a place where a running balance of an account is kept.
d. the book of original entry.
8. The trial balance makes sure that
a. the proper accounts are affected.
b. each account has the appropriate dollar amount balance.
c. the debits equal the credits in the journal.
d. the debits equal the credits in the ledger.
e. None of the above
9. When the financial statements are completed, the Income Summary account is found on which
financial statement?
a. Balance sheet
b. Income statement
c. Statement of cash flows
d. None of the above
10. If the company ends the year with a net income, the balance in the Income Summary account
immediately preceding its closing will have a
a. debit balance.
b. credit balance (usually).
c. both a and b
d. credit balance (always).
11. If the bookkeeper (in 20X2) expenses the entire cost of a truck that normally would be used for three
years, then
a. net income will be understated for 20X2 and overstated for the years 20X3 and 20X4.
b. total assets will not equal liabilities plus owners’ equity.
c. net income will be overstated for 20X2 and understated for the years 20X3 and 20X4.
d. assets will be overstated for 20X2.
12. If the bookkeeper fails to make a revenue entry for 20X2,
a. both 20X2’s and 20X3’s net income will be overstated.
b. only 20X2’s net income will be overstated.
c. net income for 20X2 would be understated.
d. assets will be overstated for 20X2 and 20X3.
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3-9
Exercise
1.
Date Description Debit Credit
March 2 Cash 3,000.00
Paid-in Capital 3,000.00
Issued 100 shares of $30 par value
March 31 Salary Expense 500.00
Salary Payable 500.00
Accrued wages owed to employees
April 1 Supplies 900.00
Cash 900.00
Paid cash for supplies
Required:
a. Classify each account and indicate its normal balance.
b. Show how these transactions would be posted to the Cash account using a T-
account format. Assume the Cash account had a $10,000 balance on March 1.
c. What balance would appear in the Cash account following these transactions?
Exercise
1.
Date Description Debit Credit
March 2 Cash 3,000.00
Paid-in Capital 3,000.00
Issued 100 shares of $30 par value
March 31 Salary Expense 500.00
Salary Payable 500.00
Accrued wages owed to employees
April 1 Supplies 900.00
Cash 900.00
Paid cash for supplies
Required:
a. Classify each account and indicate its normal balance.
b. Show how these transactions would be posted to the Cash account using a T-
account format. Assume the Cash account had a $10,000 balance on March 1.
c. What balance would appear in the Cash account following these transactions?
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Subject
Accounting