Financial accounting the impact on decision makers 9e

CHAPTER 1
Accounting as a Form
of Communication
QUESTIONS

1. Business is concerned with all the activities necessary to provide the members of an
economic system with goods and services. Some businesses are organized to earn a
profit, whereas others are organized for some other purpose. Regardless, all businesses are organized to provide goods and/or services to their customers.
2. An asset is a future economic benefit to a business. Cash, accounts receivable, merchandise inventories, and property and equipment are all examples of assets. They
are located on the left side of the accounting equation.
3. A liability is an obligation of a business. Assets and liabilities are related in that most
liabilities are satisfied by using assets, most often in the form of cash. They are located
on the right side of the equation along with owners’ equity.
4. The three forms of business entities are sole proprietorships, partnerships, and corporations.
5. The types of activities in which companies engage are financing, investing, and
operating. To start a new business, such as renting bicycles and skis, requires initial
financing, such as initial contributions by the owners and loans by a bank. Next, the
business would need to invest in the assets it will rent—that is, bicycles and skis. Once
investments in assets are made, the business would earn revenue by renting out
bicycles and skis. The business would also incur various operating expenses, such as
wages, advertising, and taxes.
6. Accounting is a communication process. Its purpose is to provide economic information about an organization that will be useful to those who need to make decisions
regarding that entity. For example, information provided by an accountant about an
entity is useful to a banker in reaching a decision about whether to loan money to a
business.
7. Financial accounting and management accounting differ with regard to the users of
the information provided by the two branches of the discipline. Management
accounting is the branch of accounting that provides management with information to
facilitate the planning and control functions. The information provided by a management accounting system can be tailored to meet the needs of managers.

1-1

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USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

Alternatively, financial accounting is concerned with the preparation of general-purpose financial statements for use by both management and outsiders. Because the
information provided by financial accounting must meet the needs of many
different groups, it is necessary to rely on a set of generally accepted accounting principles in preparing the financial statements.

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CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION

1-3

8. Many different groups rely on accounting information in making decisions. For
example, investors and potential investors rely on financial statements and related
disclosures in deciding whether to sell or buy stock in a company. This group is particularly concerned with the recent profitability of the company as shown on the
income statement. Bankers and other creditors need information to decide whether to
loan money to a company or whether to extend an existing loan. Many different government agencies have information needs that are specified by law. The Internal Revenue Service needs to know about a company’s profitability in levying taxes on it. The
Securities and Exchange Commission, the Interstate Commerce Commission, and the
Federal Trade Commission also depend on the information provided by accountants
in making decisions. Labor unions need information about a company’s profitability
and financial position in negotiating contracts with the company for the employees.
Trade associations rely on the information provided in financial statements in compiling information for use by their members.
9. Stockholders’ equity or owners’ equity is the difference between the assets of an entity
and its liabilities. Thus, it represents the claims of the owners to the assets of the

business. Therefore, it includes the contributions of the owners (e.g., capital stock)
and retained earnings.
10. The two distinct elements of owners’ equity in a corporation are contributed capital
and retained earnings. Contributed capital, as represented by capital stock, is the original contribution to the company by the owners. Retained earnings represents the
claims of the owners to the assets of the business. These claims result from the earnings of the company that have not been paid out in dividends.
11. The purpose of a balance sheet is to show the financial position of an entity as of a
particular point in time. It consists of three distinct elements: assets, liabilities, and
owners’ equity.
12. A balance sheet should be dated as of a particular day. It is a statement of financial
position and shows the assets, liabilities, and owners’ equity of a business at a particular point in time. Unlike an income statement, it is not a flow statement and therefore
is not dated for a particular period of time. Balance sheets are typically prepared to
coincide with the end of an accounting period, such as the end of the month or the
end of the year.
13. The cost principle is an accounting requirement to record an asset at the cost to acquire it and report it on subsequent balance sheets at this amount.
14. The purpose of an income statement is to summarize the revenues and expenses of
a company for a period of time. It is an indicator of the profitability of an entity.
15. An income statement should be dated for a particular period of time: for example, for
the month of June or for the year ended December 31, 2014. The income statement
is a flow statement because it summarizes revenues and expenses for a period of
time. Unlike a balance sheet, it is not an indication of position at any one particular
point in time.

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USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

16. If Rogers has $55,000 in Retained Earnings to begin the year and net income for the

year of $27,000, the ending balance in Retained Earnings would be $82,000 if no
dividends were paid during the year. Because the ending balance in Retained Earnings is $70,000, the company must have paid $12,000 in dividends.
17. Various groups are involved in determining the rules companies must follow in preparing their financial statements. In the United States, the Securities and Exchange
Commission (SEC) has ultimate authority for companies whose securities are sold to
the general public. However, the SEC has relegated much of the standard setting to
the private sector in the form of the Financial Accounting Standards Board (FASB).
Standard setters in the United States continue to work closely with those in the international community. For instance, at one time, foreign companies that filed their financial statements with the SEC were required to adjust those statements to conform to
U.S. accounting standards. The SEC dropped this requirement, as long as foreign
companies follow the standards of the IASB. However, there are significant differences between U.S. and international standards; it may be some time before all differences are eliminated.
18. In 2002, Congress passed the Sarbanes-Oxley Act. The act was a direct response to
corporate scandals and was an attempt to bring about major reforms in corporate accountability and stewardship, given the vast numbers of stockholders, creditors, employees, and others affected in one way or another by these scandals. Among the
most important provisions in the act are the following: (1) the establishment of a new
Public Company Accounting Oversight Board, (2) a requirement that the external auditors report directly to the company’s audit committee, and (3) a clause to prohibit
public accounting firms who audit a company from providing any other services that
could impair their ability to act independently in the course of their audit.
19. The auditors may be in an excellent position to evaluate a company, but not
because they have prepared the financial statements. The preparation of the statements is the responsibility of management. The role of the auditor is to perform
various tests and procedures as a basis for rendering an opinion on the fairness of the
presentation of the statements.
20. We assume in the absence of evidence to the contrary that a business will continue
indefinitely. This assumption, known as the going concern assumption, helps to justify
the use of historical costs in the statements. For example, if we knew that a company
was in the process of liquidation, it would not be appropriate to use historical costs in
assigning an amount to such assets as land and buildings. Instead, the
current or market values of the assets would be more meaningful to a user of the
balance sheet. Because the normal assumption is that a business will continue
indefinitely, the objectivity of historical cost makes it more attractive as a basis for
valuation.

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CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION

1-5

21. Inflation, as evidenced by the changing value of the dollar, poses a problem for the
accountant. Accountants make the assumption in preparing a set of financial statements that the dollar is a stable measuring unit. This assumption, called the monetary
unit assumption, may or may not be accurate, depending on the level of inflation in
the economy. The higher the rate of inflation, the less reliable is the dollar as a measuring unit.
22. Any profession must have a set of standards that govern the practice of the profession.
In accounting, generally accepted accounting principles, or GAAP, are those methods,
rules, practices, and other procedures that have evolved over time and that govern
the preparation of financial statements. Two important points are worth noting about
GAAP. First, these principles are not static but rather change in response to changes
in the ways companies conduct business. Second, there is not a single, identifiable
source of GAAP. Both the private and public sectors have contributed to the development of generally accepted accounting principles.
23. Although the Securities and Exchange Commission has the ultimate authority to determine the rules in preparing financial statements, it has to a large extent allowed the
accounting profession, through the Financial Accounting Standards Board, to establish its own rules. The SEC has at times taken an active role in the setting of accounting standards. It has stepped in when it has believed that the profession has not acted
quickly enough or in the correct manner. Since its inception in 1934, the commission
has been more involved in the enforcement of GAAP as a means of protecting the
rights of investors than it has been in setting standards.

BRIEF EXERCISES

LO 1

BRIEF EXERCISE 1-1 TYPES OF BUSINESSES

Students will provide a number of different examples of real companies that are manufacturers, retailers, and service providers.

LO 2

BRIEF EXERCISE 1-2 FORMS OF ORGANIZATION

When you own a share of stock in a corporation, you are part owner of that business. In
contrast, if you own one of the corporation’s bonds, you have made a loan to the company
and you are one of its creditors.

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LO 3

USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

BRIEF EXERCISE 1-3 BUSINESS ACTIVITIES

The first activity for a new business is to secure financing. Next, investing activities are
needed to secure the necessary assets to then begin operating the business. The order
of the activities is financing, investing, and operating.

LO 4

BRIEF EXERCISE 1-4 USERS OF ACCOUNTING INFORMATION

Stockholders, creditors (including banks, bondholders, and suppliers), and government
agencies are all examples of external users.

LO 5

BRIEF EXERCISE 1-5 THE ACCOUNTING EQUATION AND THE BALANCE SHEET

Assets = Liabilities + Stockholders’ Equity. The two parts that make up stockholders’ equity are capital stock and retained earnings.

LO 6

BRIEF EXERCISE 1-6 MONETARY UNIT

The dollar is the monetary unit used in the United States, and the yen is used in Japan.

LO 7

BRIEF EXERCISE 1-7 THE ROLE OF AUDITORS

The external auditors do not prepare the financial statements. Management of the company is responsible for preparation of the statements. The auditors provide an opinion as
to the fairness of the financial statements.

LO 8

BRIEF EXERCISE 1-8 MAKING ETHICAL DECISIONS

The four steps in the model presented in the chapter to help in making ethical decisions
are:
1. Recognize an ethical dilemma.
2. Analyze the key elements in the situation.
3. List alternatives and evaluate the impact of each on those affected.
4. Select the best alternative.

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CHAPTER 1 • ACCOUNTING AS A FORM OF COMMUNICATION

1-7

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CHAPTER 2
Financial Statements
and the Annual Report
QUESTIONS
1. The primary concern to an investor is the future cash to be received from the invest-

ment. However, this does not mean that the cash flows of the company that has been
invested in are not relevant. A relationship exists between the cash flows to the investor and those to the company. For example, a company that does not consistently
generate sufficient cash flows from its operations will not be able to pay cash dividends
to the investors over a sustained time.
2. The understandability characteristic does not imply that someone must have an
extensive accounting background to be able to use financial statements. However,
accounting information should be understandable to those who are willing to learn to
use it properly. In other words, the information should make sense to someone who
spends the time required to have a basic understanding of accounting.
3. Relevance is the capacity of accounting information to make a difference in a financial
decision. For example, an income statement is relevant when the use of it has at least
the potential to make a difference in an investment decision.
4. Comparability is the quality of accounting information that allows comparisons to be
made between or among companies. Without it, financial statements would be very

limited in their value. Financial decisions require choices to be made about the
investment of limited resources. Investors need assurance that the financial
statements of companies that they are considering as investments are comparable.
5. Comparability is the quality of information that allows for comparisons to be made
between two or more companies, whereas consistency is the quality that allows for
comparisons to be made within a single entity from one accounting period to the next.
6. The concept of materiality is closely related to the size of a company. For example,
assume that a company must decide whether a $500 expenditure that will benefit
future periods should be expensed immediately or capitalized (i.e., recorded as an
asset). The decision cannot be made without considering the amount in relation to the
size of the company. An amount that is immaterial for a large multinational corporation
may be material for a smaller business.
7. The IASB recognizes the same qualitative characteristics for useful information as
does the FASB. The two groups are working together on a joint conceptual framework
project, of which the chapter on qualitative characteristics is completed.


8. A current asset is an asset that a company expects to realize in cash, sell, or consume
during its normal operating cycle. Therefore, accounts receivable, inventory, and supplies all meet this definition and are classified as current assets. By their nature, the
benefits from each of these assets will be realized during the normal operating cycle
of the business.
9. The note payable will be classified on the balance sheet as long term until one year
from its maturity date. At that time, it should be reclassified from long term to current
because it will be paid within the next year. Any liability that will mature within one year
of the date of the balance sheet should be classified as current, regardless of the
original term of the loan (five years in this case).
10. Both capital stock and retained earnings represent claims of the stockholders on the
assets of the business. They differ, however, in the source of those claims. Capital
stock represents the claims of the stockholders that arise from their contributions of
cash and other assets to the business. Retained earnings represent the accumulated

earnings, or net income, of the business since its inception less all dividends declared
during that time.
11. Working capital is an absolute measure of liquidity. That is, it is the total dollar amount
of current assets minus current liabilities. One of the problems with working capital as
a measure of liquidity is that it does not allow someone to compare the relative liquidity
of two companies of different sizes. Even within a single company, it may be difficult
to compare the relative liquidity of the company over time if the company has grown.
The current ratio (current assets divided by current liabilities) overcomes these deficiencies by focusing attention on the relative size of the current
assets and current liabilities.
12. Capital structure refers to the right side of a balance sheet. All items on the right side
of the balance sheet represent claims against the assets of the business: liabilities are
the claims of outsiders, and stockholders’ equity is the claim of the owners on the
assets of the business. The capital structures of all companies differ in that some
companies rely more on outsiders to provide assets, whereas others rely more on the
owners to provide the necessary assets to run the business.
13. The single-step income statement shows a subtotal for all expenses and deducts this
amount from total revenues. The weakness of the single-step form for the income
statement is that relationships between key items on the statement are not highlighted.
For example, the relationship between sales revenue and the cost of the products sold
is very important for a product-oriented company. The difference between the two
amounts is called gross profit and would appear on a multiple-step statement but not
in the single-step form.


14. A statement of retained earnings links the income statement and the balance sheet in
the following way. A statement of retained earnings shows the beginning balance in
the account, the addition (deduction) to the account for the net income (loss) of the
period, and any deduction from the account for dividends. The beginning balance in
Retained Earnings is taken from the balance sheet at the end of the prior
period. The income statement indicates the net income for the period. The ending

balance in Retained Earnings appears on the balance sheet at the end of the period.
15. An audit of a set of financial statements does not ensure that the statements contain
no errors. Because of the sheer number of transactions entered into during a period
of time, it would be impossible for an auditor to check every single transaction to
determine that it was correctly recorded. Instead, through various types of tests, the
auditor renders an opinion as to whether the statements are free of material misstatement.
16. The first note is the summary of significant accounting policies. As the name implies,
the purpose of this note is to summarize all of the company’s important accounting
policies, such as those relating to the method of depreciating assets and the method
for valuing inventories.

BRIEF EXERCISES
LO 1

BRIEF EXERCISE 2-1 OBJECTIVES OF FINANCIAL REPORTING

The overriding objective of financial reporting is to provide financial information to permit
users of the information to make informed decisions. Financial statements do not report
the value of the reporting entity, but should provide useful information to allow users to
make estimates of the value of the entity.

LO 2

BRIEF EXERCISE 2-2 QUALITATIVE CHARACTERISTICS OF ACCOUNTING
INFORMATION

The two fundamental qualities that make accounting information useful are relevance and
faithful representation. Financial information is enhanced when it is understandable, comparable, and consistent.

LO 3

BRIEF EXERCISE 2-3 CLASSIFICATION OF ASSETS

Accounts receivable—CA

Furniture and fixtures—NCA

Land—NCA

Office supplies—CA

Inventories—CA

Buildings—NCA

Cash—CA

LO 4

BRIEF EXERCISE 2-4 WORKING CAPITAL AND CURRENT RATIO

Working Capital = Current Assets – Current Liabilities
Working Capital: $80,000 – $60,000 = $20,000
Current Ratio = Current Assets/Current Liabilities
Current Ratio: $80,000/$60,000 = 1.33 to 1

LO 5

BRIEF EXERCISE 2-5 MULTIPLE- VERSUS SINGLE-STEP INCOME STATEMENT

Lines that will appear on a multiple-step income statement, but not on a single-step income statement, are Gross profit, Total operating expenses, Income from operations,
Excess of other revenues over other expenses, and Income before income taxes.

LO 6

BRIEF EXERCISE 2-6 PROFIT MARGIN

Profit Margin = Net Income/Sales =
($100,000 – $60,000 – $15,000 – $10,000)/$100,000 = $15,000**/$100,000* = 15%
Sales
– Cost of goods sold
= Gross profit
– Total operating expenses
= Income before income taxes
– Income tax expense
= Net income

$100,000*
60,000
$ 40,000
15,000
$ 25,000
10,000
$ 15,000**


LO 7

BRIEF EXERCISE 2-7 RETAINED EARNINGS

Ending retained earnings = $200,000 + $80,000 – $50,000 = $230,000*
Retained earnings, beginning balance
Add: Net income for the year
Less: Dividends paid
Retained earnings, ending balance

LO 8

$200,000
80,000
$280,000
(50,000)
$230,000*

BRIEF EXERCISE 2-8 INVESTING AND FINANCING ACTIVITIES

The amount borrowed from the bank, $100,000, would be reported on the statement of
cash flows as an inflow from financing activities. The amount used to buy a new piece of
equipment, $80,000, would be shown on the statement of cash flows as an outflow from
investing activities.

LO 9

BRIEF EXERCISE 2-9 ELEMENTS OF AN ANNUAL REPORT

In addition to the financial statements, an annual report usually includes the following
items: a letter to the stockholders from either the president or the chair of the board of
directors, a section describing the company’s products/services and markets, the
auditors’ report, management discussion and analysis, and notes to the financial

statements.


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USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

CHAPTER 3
Processing Accounting Information
QUESTIONS
1. Both external and internal events affect an entity. An external event involves interaction with someone outside of the entity. For example, the purchase of land is an
external event. An internal event takes place entirely within the entity, with no
interaction with anyone outside of the company. The transfer of raw materials into
production is an internal event.
2. Source documents are the basis for recording transactions. They provide the evidence, or documentation, needed to recognize an event for accounting purposes. Purchase invoices, time cards, and cash register tapes are all examples of source documents.
3. Cash can take many different forms. One of the most common forms is a checking
account. Other forms include coin and currency on hand, savings accounts, money
orders, certified checks, and cashier’s checks.
4. An account receivable is an open account with a customer. That is, the customer is
not required to have prior written approval each time a purchase is made, and no
interest is charged. Most open accounts must be paid in a short period of time, such
as 30 or 60 days. A note receivable, however, involves a written promise from the
customer to repay a specified amount, with interest, at a specified date. Companies
usually require customers to sign promissory notes for relatively large dollar amounts
of purchases.
5. Assets and liabilities are opposites. An asset represents a future benefit, and a liability
is an obligation to relinquish benefits in the future. Therefore, an account payable is
the opposite of an account receivable. If Ace Corp. provides a service to Blue Corp.,
Ace records an account receivable on its books. Blue will record an account payable
on its books.

6. The term double-entry system of accounting means that every transaction is entered
in at least two accounts on opposite sides of T accounts. In this system, every transaction is recorded in such a way that the equality of debits and credits is maintained,
and in the process the accounting equation is kept in balance. (Appendix)
7. The right side of the accounting equation is merely a representation of the claims of
various groups on the assets of an entity. The claims of the owners, as represented
by owners’ equity, are divided into two types: capital stock and retained earnings.
Capital stock arises from amounts contributed by the owners to the business.
Retained earnings represents the claims of the owners on the assets from the

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undistributed income of the business. That is, it represents the accumulated earnings
over the life of the business that have not been returned to the owners in the form of
dividends.


8. Assets and liabilities appear on different sides of the accounting equation and are
therefore opposites. It is logical that if an asset is increased with a debit, a liability is
increased with a credit. Keep in mind that debits and credits are tools to record increases and decreases in accounts. To summarize, debits increase asset accounts,
and credits increase liability and stockholders’ equity accounts. Additionally, debits
increase expense accounts and credits increase revenue accounts . (Appendix)
9. Assets are positive in that they represent future economic benefits. It is merely a
matter of convention that an asset is increased with a debit. An expense is negative
in the sense that it reduces net income, which in turn reduces retained earnings, one
of the two elements of owners’ equity. Because owners’ equity is on the opposite side
of the accounting equation from assets, it is increased with a credit. Therefore, any
item that reduces owners’ equity, like an expense, is itself increased with a debit. You
should try to resist the temptation to associate the terms debit or credit with something
good or something bad. In accounting, debit means one thing: an entry made on the

left side of an account. A credit means an entry made on the right side of an account.
(Appendix)
10. There are two sides to every transaction. The two sides of the transaction when a
dividend is paid are the decrease in cash and the decrease in owners’ equity (owners’
equity is reduced because money is being returned to owners, and they have a smaller
claim on the assets of the business). Assets are increased with debits and decreased
with credits. Cash is an asset and is therefore decreased with a credit. Retained Earnings is on the opposite side of the accounting equation from assets and is therefore
increased with a credit. Retained Earnings is decreased with a debit. Because dividends are a decrease in retained earnings, they are increased with a debit. (Appendix)
11. When you deposit money in your account, the bank has a liability. The entry on the
bank’s books consists of a debit to Cash and a credit to some type of liability account,
such as Customers’ Deposits. Therefore, when you make a deposit, the bank “credits”
your account; that is, it increases its liability. (Appendix)
12. A business actually saves time by first recording transactions in a journal and then
posting them to the ledger. Because of the sheer volume of transactions, it would be
impractical to prepare financial statements directly from the journal. For example, without the use of ledger accounts, it would be necessary at the end of the period to go
back and scan the journal to find every debit and credit to the Cash account in order
to prepare a balance sheet. Whereas the journal serves as a book of original entry,
the ledger accounts are the basis for preparing a trial balance, which in turn is used
to prepare the financial statements. (Appendix)


13. The T account is a simple device used in the study of accounting as well as by
accountants in analyzing transactions. The left side of the account is used to record
debits and the right side to record credits. The running balance form for an account is
more formal and includes not only columns for increases and decreases, but also a
column for the balance in the account. Another important element of the running
balance form is a Posting Reference column. The accountant places the page number
of the general journal in this column so that each entry in the account can be traced
back to the relevant page in the journal. (Appendix)
14. At the time of posting, the Posting Reference column of the account in the ledger is

filled in with the page number of the journal entry. At the same time, the account number is placed in the Posting Reference column of the journal. This cross-referencing
system used in posting allows the accountant to trace an entry made in the journal to
the account it was posted to, or, conversely, to trace from an account back to the entry
in the journal. (Appendix)
15. There is no standard rule about the frequency of posting entries from the journal to
the ledger. The size of the company and the extent to which the accounting system is
computerized will affect how often entries are posted. For example, in a computerized
system, it is possible for entries to be posted instantaneously to the ledger at the time
they are recorded in the journal. (Appendix)
16. A trial balance proves the equality of debits and credits. It does not prove that the
correct accounts were debited and credited or that the correct amounts were necessarily recorded. It simply ensures that the balance of all of the debits in the ledger
accounts is equal to the balance of all of the credits at any point in time. (Appendix)

BRIEF EXERCISES
LO 1

BRIEF EXERCISE 3-1 EXTERNAL AND INTERNAL EVENTS

An external event involves interaction between an entity and its environment, such as a
sale to a customer, a purchase from a supplier, or payment of wages to an employee. An
internal event occurs entirely within the company such as the use of furniture and fixtures
within the company.

LO 2

BRIEF EXERCISE 3-2 SOURCE DOCUMENTS

Purchase invoice: acquisition of goods or services from a supplier
Sales invoice: sale of goods or services to a customer
Cash register tape: cash sale of goods or services to a customer

Time cards: payment of periodic payroll
Promissory note: borrowing money in return for promise to repay in future with interest


LO 3

BRIEF EXERCISE 3-3 EFFECTS OF TRANSACTIONS ON THE ACCOUNTING
EQUATION

The three elements in the accounting equation are assets, liabilities, and stockholders’
equity. Stockholders’ equity consists of capital stock and retained earnings. Net income,
as reported on the income statement, is an addition to retained earnings, which appears
on the balance sheet. This connection between net income and retained earnings provides a link between the income statement and the balance sheet.

LO 4

BRIEF EXERCISE 3-4 TYPES OF ACCOUNTS

Prepaid Insurance: BS
Sales Revenue: IS
Income Taxes Payable: BS
Accounts Receivable: BS
Utilities Expense: IS
Furniture and Fixtures: BS
Retained Earnings: BS
LO 5

BRIEF EXERCISE 3-5 DEBITS AND CREDITS (Appendix)

Accounts Payable: credit

Office Supplies: debit
Interest Revenue: credit
Income Tax Expense: debit
Income Tax Payable: credit
Cash: debit
Common Stock: credit
Land: debit


LO 6

BRIEF EXERCISE 3-6 JOURNALIZING TRANSACTIONS (Appendix)

Journal 1/10
Entry
Analysis

Cash .......................................................
Capital Stock.....................................
Issued capital stock
(3 owners × $50,000 each).
Balance Sheet

ASSETS

=

Income Statement
STOCKHOLDERS’
EQUITY

EXPENSES

Cash .......................................................
Notes Payable ..................................
Borrowed $100,000 at local bank.

100,000

+

Cash 150,000

Capital
Stock

REVENUES

=

Cash 100,000

Income Statement
STOCKHOLDERS’
EQUITY

EXPENSES

Land .......................................................
Cash .................................................

Acquired land for cash.

200,000

+

REVENUES

Balance Sheet

a. N
b. Y
c. Y

NET
INCOME

=

LIABILITIES

200,000

Income Statement
+

STOCKHOLDERS’
EQUITY

REVENUES

Land 200,000
Cash
(200,000)

LO 7

=

Notes Payable 100,000

Journal 1/15
Entry
Analysis

ASSETS

NET
INCOME

100,000

–

LIABILITIES

=

150,000

Balance Sheet
ASSETS

150,000

–

LIABILITIES

Journal 1/12
Entry
Analysis

150,000

BRIEF EXERCISE 3-7 TRIAL BALANCE (Appendix)

–

EXPENSES

=

NET
INCOME



CHAPTER 4
Income Measurement

and Accrual Accounting
QUESTIONS

1. The accountant cannot show a stockholder or other user the company’s assets, such
as cash and buildings. Instead, what the user sees is a representation or depiction of
the real thing. The accountant describes with words and numbers the various items in
the financial statements.
2. Accountants strive to present financial statements that are relevant to the decisions
made by users of the statements, but sometimes there are trade-offs. For example, in
deciding whether or not an asset that a company pledges as collateral for a loan is
sufficient, a banker may be most interested in the current value of the asset. That is,
this amount may be the most relevant attribute or characteristic of the asset for the
banker’s needs. The accountant, however, may be reluctant to present the current
value of the asset on the balance sheet because of the difficulty in measuring the
value of the asset. The amount paid for the asset—that is, its historical cost—may be
easy to determine, although not as relevant to the banker’s decision. Because of its
objective nature, historical cost is the attribute used to measure many of the assets
recognized on the balance sheet.
3. The realtor will recognize revenue from the sale of the home on July 8 if the cash basis
is used because this is the date cash is received. Revenue will be recognized on June
12 if the accrual basis is used because this is the date the sale takes place and thus
is the date on which the revenue is earned.
4. This statement is not entirely accurate. Because it is based on historical cash flows, a
statement of cash flows is not necessarily the most accurate source of information on
the future cash-flow prospects for a company. An income statement may in fact provide more important information about future cash flows. For example, an income
statement includes not only sales on a cash basis this period but also sales on credit
that will generate cash flows in future periods. Similarly, a statement of cash flows
reports only expenses that required a cash outlay in the current period. An accrualbased income statement provides information on accrued expenses that will result in
a cash outlay in future periods.
5. The time period assumption is important in accounting because financial statement

users want information about a company as of a particular point in time and for
distinct periods of time. For example, a potential stockholder wants to know the
financial position at the end of the most recent year and the profit of a business for the
most recent year. Under an accrual accounting system, revenues are recognized


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when they are earned regardless of when cash is received, and expenses are recognized when they are incurred regardless of when cash is paid. The accountant does
not wait until all of the cash from a sale has been collected to report the sale and does
not wait until the cash has been paid to report the expense on the income statement.
In this way, the user of the statement receives information on a timely basis.

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6. No, the recognition of revenue is not always the result of the acquisition of an asset.
Revenues are inflows of assets or reductions of liabilities from providing goods or services to customers. They must be realized and earned to be recognized on the income
statement. For instance, assume that a publisher sells a magazine subscription and
collects cash from the customer in advance. At the time cash is collected, the publisher
incurs a liability. As each month’s magazine is mailed to the customer, a portion of the
liability is satisfied and revenue is recognized. Thus, in some instances, revenue results from the settlement of a liability.
7. A company incurs a cost when it acquires an asset. For example, assume that a retailer buys office supplies for $100 on October 21. On this date, it has incurred a cost
of $100 to acquire an asset, namely office supplies. The asset will be removed from
the records and an expense recognized, namely office supplies expense, when the
supplies are used up. In summary, assets are unexpired costs and expenses are expired costs.
8. Depreciation is the process of allocating the cost of a tangible long-term asset to expense over its useful life. For example, the accountant attempts to recognize or match
the cost of a machine as an expense over the period of time that the machine is used

to manufacture products.
9. Adjustments are made at the end of an accounting period. They are internal transactions and therefore do not affect the Cash account. Each adjustment involves either
an asset or a liability with a corresponding change in either revenue or expense. The
four basic types of adjustments are:
a. To recognize the expired portion of a prepaid expense. For example, an adjustment is needed at the end of each month to recognize insurance expense for the
portion of an insurance policy that has expired during the period.
b. To recognize the earned portion of a deferred revenue or liability. For example, a
publisher has to make an adjustment at the end of each period to recognize the
earned portion of a subscription.
c. To recognize expense at the end of the period before cash is paid. For example,
an adjustment is made at the end of the year to recognize income tax expense,
even though the taxes will not be paid until early in the following year.
d. To recognize revenue at the end of the period before cash is received. For example, a landlord will need to make an adjustment at the end of the month for the rent
owed by a tenant but not payable until some time during the following month.
10. Balance sheet accounts are called real accounts because they are permanent and
are not closed at the end of a period. Conversely, income statement accounts are
called nominal or temporary accounts because they are closed at the end of the period. For example, it would not make sense to close the Equipment account at the end
of the period. The account should stay on the books as long as the company keeps
the asset. On the other hand, Depreciation Expense on the equipment is a temporary
account that indicates the expense associated with using the asset during the period
and is therefore closed along with all other income statement accounts at the end of
the period.


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11. Closing entries are made at the end of an accounting period. They have two important
purposes: (1) to return the balance in all temporary or nominal accounts (revenues,

expenses, and dividends) to zero to start the next accounting period and (2) to transfer
the net income (or net loss) and the dividends of the period to Retained Earnings.

BRIEF EXERCISES
LO 1

BRIEF EXERCISE 4-1 MEASUREMENT IN FINANCIAL STATEMENTS

The two possible attributes are historical cost and current value. The simplest approach
is to show the property on the balance sheet at its original cost, thus the designation
historical cost. The use of historical cost is not only simple but also an amount that can
be agreed upon. Assume that two accountants are asked to independently measure the
cost of a parcel of land. After examining the sales contract for the land, they should arrive
at the same amount. An alternative to historical cost as the attribute to be measured is
current value. Current value is the amount of cash or its equivalent that could be received
currently from the sale of the asset. Current value is not as simple and often not as easy
to get agreement upon. Because of its objective nature, historical cost is the attribute used
to measure many of the assets recognized on the balance sheet. How-ever, certain other
attributes, such as current value, have increased in popularity in recent years. The dollar
is the unit of money used in the United States to measure items.
LO 2

BRIEF EXERCISE 4-2 ACCRUAL BASIS OF ACCOUNTING

a. June 14
b. April 5
c. August 30

LO 3

BRIEF EXERCISE 4-3 REVENUE RECOGNITION

Revenues are inflows of assets or reductions of liabilities from providing goods or services
to customers. They must be realized and earned to be recognized on the income statement. It is not necessary for there to be an inflow of an asset in order to recognize revenue. For example, revenue can be recognized when a company provides a service for
which it had earlier received a deposit. The deposit represents a liability, and it is satisfied
when the service is provided. Revenue is recognized continuously over a period of time
for both rent and interest.
BRIEF EXERCISE 4-4 MATCHING PRINCIPLE
LO 4

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The merchandise will be reported on the December 31, 2014, balance sheet as a current
asset. Revenue from the sale, along with cost of goods sold expense, will be recorded in
2015, the year in which the merchandise is sold.

LO 5
1.
2.
3.
4.

BRIEF EXERCISE 4-5 ADJUSTMENTS

IE
IA
IE
DL*

IL
IR
DA
IR*

*This is how the company which issued the gift card will record the adjustment when
the card is redeemed.

LO 6

BRIEF EXERCISE 4-6 STEPS IN THE ACCOUNTING CYCLE

If a work sheet is not prepared, financial statements would only be prepared after recording and posting adjustments.


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