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Chapter One Accounting and the Business Environment 1

Accounting and theBusiness Environment

11C H A P T E R

CHAPTER OBJECTIVESAfter studying this chapter, you should be able to

1 Use accounting vocabulary for decision making

2 Apply accounting concepts and principles tobusiness situations

3 Use the accounting equation to describe anorganizations financial position

4 Use the accounting equation to analyze businesstransactions

5 Prepare and use the financial statements

6 Evaluate the performance of a business

role does accounting play in this situation? Briana Weill must decidehow to organize her company: as a proprietorshipa single-owner companywith Weill as the owner; as a partnershipshare ownership with another; or as acorporationa separate legal entity. In this chapter, we discuss all three forms of busi-ness organization: proprietorships, partnerships, and corporations, with the em-phasis on the corporate form.

You may already know various accounting terms and relationships, because ac-counting affects peoples behaviour in many ways. This first accounting course willsharpen your focus by explaining how accounting works. As you progress throughthis course, you will see how accounting helps people like Briana Weilland youachieve business goals.

Accounting:The Basis for Business Decisions

Accounting is the information system that measures business financial activities,processes that information into reports, and communicates the results to decisionmakers. For this reason it is called the language of business. The better you un-derstand the language, the better your decisions will be, and the better you canmanage the financial aspects of living. A recent survey indicates that business man-agers believe it is more important for college students to learn accounting than anyother business subject. Decisions concerning personal financial planning, educa-tion expenses, loans, car payments, income taxes, and investments are based onthe information system that we call accounting. Financial statements, a key product

2 Part One The Basic Structure of Accounting

Briana Weill, a businessstudent at the BritishColumbia Institute ofTechnology in Vancouver,wanted to earn some moneyto help pay for her educationand a trip to the Yukon nextsummer. She had only $75with the school year ahead.

Brianas father was a do-it-yourself person, and Brianaoften helped him as he fin-ished the basement of theWeill home, built a deck at the back of the house, andconstructed bookcases and all the other furniture in herroom. Briana decided to use her experience to do lightrepair jobs for customers. She purchased needed ma-terials and provided them to customers at cost plus 20percent for handling. She also charged $15 per hour forher time. Briana used her mothers van and paid onlyfor the cost of the gas used. Her father loaned her histools. She spent $30 on advertising leaflets, which shedistributed herself.

Briana started her business in September 2001 and

by April 2002 Briana hadworked on 12 jobs and hadbeen paid $1,550. She hadpaid her mother $125 for gasand had spent $230 for addi-tional tools and supplies. Afterpaying for leaflets, gas, tools,and supplies, Briana had$1,165 plus her original $75left to pay for her schoolingand trip and had gained valu-able business experience.Prospective employers like to

see experience like Brianas on a rsum.How well did Briana Weills business perform? In

common language, we might say that, during the periodSeptember to April, Briana Weill made $1,165. Thismeans that for the eight-month period, Briana earned aprofit of $1,165 after all expenses were subtracted fromall revenues she was paid. Earnings, profit, revenues, andexpenses are key accounting terms. This chapter coversthese and other terms and introduces the financial state-ments that businesses use to report their financial affairs.

What

OBJECTIVE 1Use accounting vocabulary fordecision making

of an accounting system, provide information that helps people make informedbusiness decisions. Financial statements report on a business in monetary amounts,providing information to help people make informed business decisions.

Is my business making a profit? Should I hire assistants? Am I earning enoughmoney to pay my rent? Answers to business questions like these are based on ac-counting information.

Please dont mistake bookkeeping for accounting. Bookkeeping is a proceduralelement of accounting, just as arithmetic is a procedural element of mathematics.Increasingly, people are using computers to do detailed bookkeepingin house-holds, businesses, and organizations of all types. Exhibit 1-1 illustrates the role ofaccounting in business. The process starts and ends with people making decisions.

Users of Accounting Information: Decision Makers

Decision makers need information. The more important the decision, the greater theneed for information. Virtually all businesses and most individuals keep account-ing records to aid decision making. The following sections discuss some of thepeople and groups who use accounting information.

Individuals People such as you use accounting information in day-to-day affairsto manage bank accounts, evaluate job prospects, make investments, and decidewhether to rent or buy a house.

Businesses Managers of businesses use accounting information to set goals fortheir organizations, evaluate their progress toward those goals, and take correctiveaction if necessary. Decisions based on accounting information may include whichbuilding to purchase, how much inventory to keep on hand, and how much cash toborrow. Briana Weill needed to know how much she could spend on advertising andon tools and supplies for her construction business.

Investors Investors provide the money a business needs to begin operations.Briana Weill was able to begin operations by investing only $75 in her business. Todecide whether to invest in a new venture, potential investors evaluate what re-turn they can reasonably expect on their investment. This means analyzing the fi-nancial statements of the business and keeping up with developments in the businesspress, for example, The Financial Post (a part of The National Post) and Report onBusiness published by The Globe and Mail.

Creditors Before making a loan, creditors (lenders) such as banks determine theborrowers ability to meet scheduled payments. This evaluation includes a report


EXHIBIT 1-1

The Flow of Information in anAccounting System

1. People make decisions. 2. Business transactions occur. 3. Businesses prepare reports to show the results of their operations.

of the borrowers financial position and a prediction of future operations, both ofwhich are based on accounting information.

Government Regulatory Agencies Most organizations face government regu-lation. For example, the provincial securities commissions in British Columbia,Alberta, Saskatchewan, Manitoba, Ontario, and Quebec see that businesses thatsell their shares to or borrow money from the public disclose certain financial in-formation to the investing public.

Taxing Authorities Local, provincial, and federal governments levy taxes onindividuals and businesses. Income tax is calculated using accounting information.Businesses determine their goods and services tax and sales tax based on their ac-counting records that show how much they have sold.

Nonprofit Organizations Nonprofit organizations such as churches, hospitals,government agencies, and colleges, which operate for purposes other than to earna profit, use accounting information in much the same way that profit-orientedbusinesses do.

Other Users Employees and labour unions may make wage demands based on theaccounting information that shows their employers reported income. Consumer groupsand the general public are also interested in the amount of income that businesses earn.And newspapers may report an improved profit picture of a major company as itemerges from economic difficulties. Such news, based on accounting information, isrelated to the companys health.

Financial Accounting and Management AccountingUsers of accounting information are a diverse population, but they may becategorized as external users or internal users. This distinction allows us to classifyaccounting into fieldsfinancial accounting and management accounting.

Financial accounting provides information to people outside the firm. Creditorsand outside investors, for example, are not part of the day-to-day management ofthe company. Likewise, government agencies and the general public are externalusers of a firms accounting information. Chapters 2 through 18 in Volumes I and IIof this book deal primarily with financial accounting.

Management accounting generates information for internal decision makers,such as top executives, department heads, college deans, and hospital administrators.Volume III of this book covers management accounting.

The History and Development ofAccounting

Accounting has a long history. Some scholars claim that writing arose in order torecord accounting information. Account records date back to the ancient civilizationsof China, Babylonia, Greece, and Egypt. The rulers of these civilizations used ac-counting to keep track of the cost of labour and materials used in building structureslike the great pyramids. The need for accounting has existed as long as there has beenbusiness activity.

Accounting developed further as a result of the information needs of merchantsin the city-states of Italy during the 1400s. In that busy commercial climate, themonk Luca Pacioli, a mathematician and friend of Leonardo da Vinci, publishedthe first known description of double-entry bookkeeping in 1494.

In the Industrial Revolution of the nineteenth century, the growth of corpora-tions spurred the development of accounting. The corporation ownersthe share-holderswere no longer necessarily the managers of their business. Managershad to create accounting systems to report to the owners how well their businesses


were doing. Because managers want their performance to look good, society needsa way to ensure that the business information provided is reliable.

In Canada, the Accounting Standards Board (AcSB) of the Canadian Institute ofChartered Accountants (CICA) determines how financial accounting is practised.The AcSB is made up of Chartered Accountants (CAs) from public accounting, in-dustry, government, and academe, plus individuals nominated by the CanadianCouncil of Financial Analysts, the Financial Executives Institute of Canada, theCanadian Academic Accounting Association, the Certified General AccountantsAssociation of Canada, and the Society of Management Accountants of Canada.As described in the Appendix following Chapter 1, the federal and provincial leg-islatures through the various companies acts and the various provincial securi-ties commissions have given the standards or generally accepted accounting principles(GAAP) issued by the AcSB their legal status.

Like other segments of society, accounting must be practised in an ethical man-ner. We look next at the ethical dimension of accounting.

Ethical Considerations in Accountingand Business

Ethical considerations pervade all areas of accounting and business. Consider a sit-uation that challenges the ethical conduct of the accountant.

A company is being sued by a competitor for allegedly copying the competi-tors process. Loss of the lawsuit will impose significant financial hardship on thecompany, jeopardize the companys relationships with its customers and creditors,and likely cause the price of the companys stock to fall. Should the company dis-close this sensitive information in its financial statements? Generally acceptedaccounting principles require the company to describe the lawsuit in its financialstatements and the companys auditor to indicate if he or she thinks the companysdisclosure is inadequate.

Of the 200 companies surveyed in the CICAs 1999 edition of Financial Reportingin Canada, Twenty-Fourth Edition, 102 reported information about lawsuits or possiblejudgments against the company in the notes to their financial statements.1

By what criteria do accountants address questions that challenge their ethical con-duct? The three accounting bodies described below all have rules of conduct thatgovern their members professional behaviour. Many companies have codes of con-duct that bind their management and employees to high levels of ethical conduct.

The Professional Accounting Bodies and TheirStandards of Professional ConductChartered Accountants (CAs), Certified General Accountants (CGAs), and CertifiedManagement Accountants (CMAs) are all governed by rules of conduct created bytheir respective organizations. Many of the rules apply whether the members arepublic accountants working in public practice or private accountants working inindustry or government, while other rules are applicable only to those membersin public practice.

The rules of conduct serve both the members of the accounting bodies and thepublic. The rules serve members by setting standards that they must meet, andproviding a benchmark against which they will be measured by their peers. Thepublic is served because the rules of conduct provide it with a list of the standardsto which the members of the body adhere. This helps the public determine its


1Byrd, C., I. Chen, and H. Chapman, Financial Reporting in Canada 1999, Twenty-fourth Edition. (Toronto:Canadian Institute of Chartered Accountants, 1999), p. 360.

expectations of members behaviour. However, the rules of conduct should beconsidered a minimum standard of performance; ideally, the members should con-tinually strive to exceed them.

There are certain rules that are fundamental to the practice of accounting andcommon to the rules of conduct of all three bodies. They concern the confidential-ity of information the accountant is privy to, maintenance of the reputation of theprofession, the need to perform their work with integrity and due care, compe-tence, refusal to be associated with false and misleading information, and compli-ance by the accountant with professional standards such as the accounting standardsfound in the CICA Handbook.

There are other rules that are fundamental to the practice of public accounting.They deal with the public accountants need for independence, and with the rulesgoverning advertising, the seeking of clients, and the conduct of practice.

Codes of Business Conduct of CompaniesMany companies have codes of conduct that apply to their employees in their deal-ings with each other and with the companies suppliers and customers. Some ofthese companies mention their code in the report of management section of the an-nual report. For example, the Schneider Corporation 1999 annual report stated:

The Corporation communicates throughout the organization the responsibilityfor employees to maintain high ethical standards in their conduct of theCorporations affairs. This responsibility is characterized in the Code of Conductsigned by each management employee which provides for compliance with lawsof each jurisdiction in which the Corporation operates and for observance of rulesof ethical business conduct.

The company indicates to its employees how management expects employeesto behave.

Types of Business OrganizationsA business takes one of three forms of organization, and in some cases accountingprocedures depend on the organizational form. Therefore, you should understandthe differences among the three types of business organizations: proprietorships, part-nerships, and corporations.

Proprietorships A proprietorship has a single owner, called the proprietor, who isusually also the manager. Briana Weill could choose to operate as a proprietorship andname her business Weill Do It For You. Proprietorships tend to be small retail es-tablishments and individual professional businesses, such as those of physicians,lawyers, and accountants, but also can be very large. From the accounting view-point, each proprietorship is distinct from its proprietor. Thus the accounting recordsof the proprietorship do not include the proprietors personal accounting records.

Partnerships A partnership joins two or more individuals together as co-own-ers. Each owner is a partner. Briana Weills business would be a partnership ifshe took on a partner and she could name her partnership Weill Do It For You.Many retail establishments, as well as some professional organizations of physi-cians, lawyers, and accountants, are partnerships. Most partnerships are smalland medium-sized, but some are quite large; there are public accounting firmsin Canada with more than 500 partners and law firms with more than 100 partners.Accounting treats the partnership as a separate organization distinct from thepersonal affairs of each partner.

Corporations A corporation is a business owned by shareholders, people orother corporations who own stock in or shares of ownership in the business. Thecorporation is the dominant form of business organization in Canada. Although


A proprietorship and a partnership(Ch. 12) are not legal entitiesseparate from their owners, so theincome from proprietorships andpartnerships is taxable to theirowners, not to the business. But inaccounting, the owner and thebusiness are considered separateentities, and separate records arekept for each. A corporation is aseparate legal entity. Thecorporation is taxed on its income,and the owners are taxed on anyincome they receive from thecorporation.

KEY POINT

proprietorships and partnerships are more numerous, corporations enact morebusiness and are generally larger in terms of total assets, income, and number of em-ployees. Most well-known companies, such as Bombardier Inc., McCain Foods Ltd.,and National Bank of Canada, are corporations. In Canada, corporations must haveLtd. or Limited, Inc. or Incorporated, or Corp. or Corporation in their legal name to indicatethat they are incorporated. Corporations need not be large; a business with only a fewassets and no employees could be organized as a corporation. Briana could incor-porate and name her business Weill Do It For You Ltd.

A business becomes a corporation when the federal or a provincial governmentapproves its articles of incorporation. From a legal perspective, a corporation is a dis-tinct entity. The corporation operates as an artificial person that exists apart fromits owners and that conducts business in its own name. The corporation has manyof the rights that a person has. For example, a corporation may buy, own, and sellproperty. The corporation may enter into contracts and sue and be sued. Like the pro-prietorship and the partnership, the corporation is an organization with an exis-tence separate from its owners.

Corporations differ significantly from proprietorships and partnerships in one im-portant way. If a proprietorship or partnership cannot pay its debts, lenders cantake the owners personal assetscash and belongingsto satisfy the businesssobligations. But if a corporation goes bankrupt, lenders cannot take the personalassets of the shareholders. The limited personal liability of shareholders for corpo-rate debts explains why corporations are the dominant form of business organiza-tion. People can invest in corporations with limited personal risk.

Another factor in corporate growth is the division of ownership into individualshares. Companies such as BCE, Inc., the Bank of Nova Scotia, and Canadian PacificLimited have issued millions of shares of stock and have tens of thousands of share-holders. An investor with no personal relationship either to the corporation or to anyother shareholder can become an owner by buying 1, 30, 100, 5,000, or any numberof shares of its stock. For most corporations, the investor may sell the shares at anytime. It is usually harder to sell ones investment in a proprietorship or a partnershipthan to sell ones investment in a corporation.

The ultimate control of the corporation rests with the shareholders, who gener-ally receive one vote for each share of stock they own. The shareholders elect themembers of the board of directors, which sets policy for the corporation and ap-points the officers. The board elects a chairperson, who usually is the most powerfulperson in the corporation. The board also designates the president, who is usuallyalso the chief operating officer in charge of managing day-to-day operations. Mostcorporations also have vice-presidents in charge of sales, manufacturing, account-ing and finance, and other key areas.

Exhibit 1-2 shows how the three types of business organizations compare.This texts focus is on the corporate form of business. We cover partnerships in

Chapter 12.


Proprietorship Partnership Corporation

1. Owner(s) Proprietorone Partnerstwo Shareholdersowner or more owners one to many

owners

2. Life of Limited by owners Limited by owners Indefiniteorganization choice or death choices or death

3. Personal liability Proprietor is Partners are Shareholders are notof owner(s) for personally liable personally liable personally liablebusiness debts

4. Accounting The proprietorship The partnership is The corporation is status is separate from separate from separate from the

the proprietor the partners shareholders

EXHIBIT 1-2

Comparison of the ThreeForms of BusinessOrganization

Accounting Concepts and PrinciplesAccounting practices follow certain guidelines. The rules that govern how ac-countants measure, process, and communicate financial information fall under theheading GAAP, which stands for generally accepted accounting principles.Accounting principles draw their authority from their acceptance in the businesscommunity. They are generally accepted by those people and organizations whoneed guidelines in accounting for their financial undertakings.

GAAP in Canada rests on Section 1000, Financial Statement Concepts, of theCICA Handbook. The primary objective of financial reporting is to provide informationuseful for making investment and lending decisions and for assessing managements stew-ardship. Decision makers who require useful accounting information include in-vestors, creditors, members (in the case of not-for-profit organizations such ascooperatives), contributors (in the case of not-for-profit organizations such as char-ities), and other users, including management. The objective of financial statementsappears at the top of the hierarchy shown in Exhibit 1-3.

To be useful, information must be understandable, relevant, and reliable, as well ascomparable and consistent. The information must be understandable to users if they are


Communicate informationthat is useful to users.

Benefits must exceed cost.Information must be material.

Information must beunderstandable.

Predictivevalue

Feedbackvalue

TimelinessRepresentational

faithfulness VerifiabilityNeutrality Conservatism

ConsistencyComparability

Relevance Reliability

Objective of financial statements

Constraints

Qualitativecharacteristics

Factors that increase the quality of information*

*Section 1000 of the CICA Handbook describes these factors as attributes that make accounting information relevant or reliable.Predictive value: the information can be used to make predictions. Feedback value: the information can be used to confirm the accuracy or inaccuracy of earlier predictions. Timeliness: the information must be received in time to make decisions. Representational faithfulness: the information presented agrees with the underlying transactions. Verifiability: the information can be confirmed by reference to other sources. Neutrality: the information is free of bias that would influence users' decisions. Conservatism: the assets, revenues, and gains are not overstated; the liabilities, expenses, and losses are not understated.

EXHIBIT 1-3

A Hierarchy of Qualities thatIncrease the Value ofInformation for DecisionMaking

to be able to use it. Relevant information influences decisions and is useful for mak-ing predictions and for evaluating past performance. Reliable information is freefrom error and the bias of a particular viewpoint; it is in agreement with the un-derlying events and transactions. Comparable information is information that is pro-duced by organizations using the same accounting principles and policies, andallows comparison between the organizations. Consistent application of theseprinciples over time allows year-to-year comparisons. Exhibit 1-3 summarizes thesequalitative characteristics that increase the value of accounting information.

There are two constraints to providing information to users that is understand-able, relevant, reliable, comparable, and consistent. The first constraint is that the ben-efits of the information produced should exceed the costs of producing theinformation, as stated in Paragraph 1000.16 in the CICA Handbook. For example, itmay be very costly to produce detailed information beyond that required by GAAPfor a forestry companys lumber inventory. If the cost of providing this informa-tion exceeds the benefits to decision makers of receiving this information, the detailedinformation should not be provided.

The second constraint is materiality, as stated in Paragraph 1000.17; a piece of in-formation is material if it would affect a decision makers decision. Materiality is notdefined in the standards but is a matter of the information preparers judgment.For example, information about inventory is important to users of Canadian Tiresfinancial statements, since a change in inventory could change a decision makersdecision about investing in Canadian Tire or selling products to Canadian Tire.Thus, such information would be provided to decision makers. However, infor-mation about the supplies inventory at Vancouver City Savings Credit Union wouldnot likely change the investment decision of a member of the credit union, so detailsof such information are not provided. Both of these constraints are reflected inExhibit 1-3.

The characteristics presented in Exhibit 1-3 combine to shape the concepts andprinciples that make up GAAP. This course will expose you to the generally ac-cepted methods of accounting. We begin the discussion of GAAP in this sectionand introduce additional concepts and principles as needed throughout the book.Appendix B at the end of Volume I and Volume II summarizes the major elementsof generally accepted accounting principles.

The Entity ConceptThe most basic concept in accounting is that of the entity. An accounting entity isan organization or a section of an organization that stands apart from other orga-nizations and individuals as a separate economic unit. From an accounting per-spective, sharp boundaries are drawn around each entity so as not to confuse itsaffairs with those of other entities.

Suppose Briana Weills bank account showed a $2,000 balance at the end of theyear. Suppose only $700 of that amount grew from the businesss operations. Theother $1,300 arose from a gift from her parents. If Briana follows the entity concept, shewill keep separate the money generated by the businessone economic unitfromthe money generated by the gift from her familya second economic unit. This sep-aration makes it possible to view the businesss operating result clearly.

Suppose Briana disregarded the entity concept and treated the full $2,000 amountas income from her business operations. She would be misled into believing that thebusiness produced more cash than it did. Any steps needed to make the businessmore successful might not be taken.

Consider Petro-Canada, a giant company with oil exploration, oil-refining, and re-tail gasoline sales operations (see Exhibit 1-4). Petro-Canada accounts for each of thesedivisions separately in order to know which part of the business is earning a profit,which needs to borrow money, and so on. If sales in the retail gasoline division weredropping drastically, Petro-Canada would do well to identify the reason. But if sales


OBJECTIVE 2Apply accounting conceptsand principles to businesssituations

Petro-Canada Corporationwww.petro-canada.ca

The entity concept requires thatthe transactions of each entity areaccounted for separately from thetransactions of all otherorganizations and persons.

KEY POINT

figures from all divisions were analyzed as a single amount, then management wouldnot even know that the company was selling less gasoline. Thus the entity conceptalso applies to the parts of a large organizationin fact, to any entity that needs to be eval-uated separately. When a company is preparing its financial statements for externalusers, all of these entities are consolidated into a single entity. Thus the divisions ofPetro-Canada are combined and reported in the consolidated financial statements ofPetro-Canada.

The entity concept also applies to nonprofit organizations such as churches,synagogues, and government agencies. A hospital, for example, may have an emer-gency room, a pediatrics unit, and a surgery unit. The accounting system of thehospital should account for each separately to allow the managers to evaluate theprogress of each unit.

In summary, the transactions of different entities making up the whole organizationshould not be accounted for together. Each entity should be accounted for separately.

The Reliability (Objectivity) PrincipleAccounting records and statements are based on the most reliable data available sothat they will be as accurate and useful as possible. This guideline is the reliabilityprinciple, also called the objectivity principle. Reliable data are verifiable. Theymay be confirmed by any independent observer. For example, Briana Weills pur-chase of tools and supplies for $230 is supported by paid invoices. This is objec-

tive evidence of her cost of the tools and supplies. Ideally,accounting records are based on information that flowsfrom activities that are documented using objective evi-dence. Without the reliability principle, accounting recordswould be based on whims and opinions and would besubject to dispute.

Suppose you want to open a stereo shop. To have aplace for operations, you transfer a small building to thebusiness. You believe the building is worth $155,000. Toconfirm its value, you hire two real-estate professionals,who appraise the building at $147,000. Is $155,000 or$147,000 the more reliable estimate of the buildings value?The real-estate appraisal of $147,000 is, because it is sup-ported by independent, objective observation. The busi-ness should record the building cost as $147,000.

The Cost PrincipleThe cost principle states that acquired assets and services should be recorded attheir actual cost (also called historical cost). Even though the purchaser may believethe price paid is a bargain, the item is recorded at the price paid in the transaction andnot at the expected cost. Suppose your stereo shop purchased some stereo equip-ment from a supplier who was going out of business. Assume you got a good deal

EXHIBIT 1-4

The Entity Petro-Canada


Petro-Canadaoil refining

Petro-Canadaoil exploration

Petro-Canada Corporation

Petro-Canadaretail gasoline

sales

Having the check figures for each chapter'sProblems in the back of this book is wonder-ful! It's nice to know that you're on the righttrack, especially if you do the extra problemsthat aren't handed in for homework.

Lynette S., Nanaimo

Student to Student

on this purchase and paid only $2,000 for merchandise that would have cost you$3,000 elsewhere. The cost principle requires you to record this merchandise at itsactual cost of $2,000, not the $3,000 that you believe the equipment to be worth.

The cost principle also holds that the accounting records should maintain thehistorical cost of an asset for as long as the business holds the asset. Why? Becausecost is a reliable measure. Suppose your store holds the stereo equipment for sixmonths. During that time, stereo prices increase, and the equipment can be soldfor $3,500. Should its accounting valuethe figure on the booksbe the actual costof $2,000 or the current market value of $3,500? According to the cost principle, theaccounting value of the equipment remains at actual cost, $2,000.

The Going-Concern ConceptAnother reason for measuring assets at historical cost is the going-concern concept,which holds that the entity will remain in operation for the forseeable future. Most as-setsthat is, the firms resources, such as supplies, land, buildings, and equipmentare acquired to use rather than to sell. Under the going-concern concept, accountantsassume the business will remain in operation long enough to use existing assets fortheir intended purpose.

To understand the going-concern concept, consider the alternative, which is to goout of business. A store that is holding a Going Out of Business Sale is trying to sell allits assets. In that case, the relevant measure of the assets is their current market value.Going out of business, however, is the exception rather than the rule.

The Stable-Monetary-Unit ConceptWe think of a loaf of bread and a months apartment rent in terms of their dollarvalue. In Canada, accountants record transactions in dollars because the dollar is themedium of exchange. French accountants record transactions in francs, and Japaneseaccountants record transactions in yen.

Unlike a litre, a kilometre, or a tonne, the value of a dollar or a British poundsterling changes over time. A rise in the general level of prices is called inflation.During inflation a dollar will purchase less milk, less toothpaste, and less of othergoods. When prices are relatively stablewhen there is little inflationa dollarspurchasing power is also stable.

Accountants assume that the dollars purchasing power is relatively stable. Thestable-monetary-unit concept is the basis for ignoring the effect of inflation in theaccounting records. It allows accountants to add and subtract dollar amounts asthough each dollar has the same purchasing power as any other dollar at any othertime. In certain countries in South America, where inflation rates are often high,accountants make adjustments to report monetary amounts in units of currentbuying powera very different concept.


STOP & THINK

Suppose you are considering the purchase of land for future expansion. The seller isasking $50,000 for land that cost her $35,000. An appraisal shows the land has a valueof $47,000. You first offer $44,000. The seller counteroffers with $48,000. Finally, youand the seller agree on a price of $46,000. What dollar amount for this land is reportedon your financial statements? Which accounting concept or principle guides your an-swer?

Answer: According to the cost principle, goods and services should be recorded attheir actual cost. You paid $46,000 for the land. Therefore $46,000 is the cost to reporton your financial statements.

The going-concern concept assumesthat a business will operate longenough for it to recover the cost ofits assets.

KEY POINT

The Accounting EquationFinancial statements tell us how a business is performing and where it stands. Theyare the final product of the accounting process. But how do we arrive at the itemsand amounts that make up the financial statements? The most basic tool of theaccountant is the accounting equation. This equation presents the resources of the busi-ness and the claims to those resources.

Assets and LiabilitiesAssets are the economic resources owned by a business that are expected to be ofbenefit to the business in the future. Cash, office supplies, inventory (goods pur-chased for resale), furniture, land, and buildings are examples.

Claims to those assets come from two sources. Liabilities are outsider claims,which are economic obligationsdebts payable to outsiders. These outside partiesare called creditors. For example, a creditor who has loaned money to a business has aclaima legal rightto a part of the assets until the business pays the debt. Insiderclaims to the business assets are called equity or capital. These are the claims held bythe owners of the business. An owner has a claim to the entitys assets because he orshe has invested in the business. The $75 Briana Weill invested in her home repairbusiness is an example. Equity is measured by subtracting liabilities from assets.

The accounting equation in Exhibit 1-5 shows the relationship among assets,liabilities, and equity. Assets appear on the left-hand side of the equation. The legaland economic claims against the assetsthe liabilities and equityappear on theright-hand side of the equation. As Exhibit 1-5 shows, the two sides must be equal:

Economic Resources Claims to Economic Resources

ASSETS = LIABILITIES + EQUITY

Let us take a closer look at the elements that make up the accounting equation.Suppose you own Top Cut Meats Ltd., which supplies beef to Harveys and otherrestaurants. Some customers may pay you in cash when you deliver the meat. Cashis an asset. Other customers may buy on credit and promise to pay you within acertain time after delivery. This promise is also an asset because it is an economicresource that will benefit you in the future when you receive cash from the cus-tomer. To Top Cut Meats Ltd., this promise is called an account receivable. A writ-ten promise that entitles you to receive cash in the future is called a note receivable.

Harveys promise to pay Top Cut Meats Ltd. in the future for the meat it purchaseson credit creates a debt for Harveys. This liability is an account payable of Harveysthe debt is not written out. Instead it is supported by the reputation and credit stand-ing of Harveys. A written promise of future payment is called a note payable.

EquityEquity is the amount of an entitys assets that remains after the liabilities are subtracted.For this reason, equity is often referred to as net assets. We often write the accountingequation to show that the owners claim to business assets is a residual; somethingthat is left over after subtracting the liabilities.

ASSETS LIABILITIES = EQUITY

As we discussed earlier, the purpose of the financial statements is to communi-cate useful information to financial statement users. Creditors, investors, suppli-ers, customers, and other users need to know the type of business organizationrepresented by the financial statementsthey need to who owns the business? Thebusiness structure (ownership) is communicated to users through the balance sheet,specifically by the name of the equity section of the balance sheet. If the business isa proprietorship, equity is named owners equity. If the business is a partnership,equity is named partnership equity or owners equity. If the business is a corpo-ration, equity is named shareholders equity.

EXHIBIT 1-5

The Accounting Equation


AssetsLiabilities

+ Equity

=

Assets

Equity

Liabilities

All receivables are assets. Allpayables are liabilities.

KEY POINT

(1) If the assets of a business are$174,300 and the liabilities are$82,000, how much is the equity? (2)If the equity in a business is $22,000and the liabilities are $36,000, howmuch are the assets?

A. (1) $92,300 (2) $58,000

WORKING IT OUT

OBJECTIVE 3Use the accounting equationto describe an organizationsfinancial position

Since this text emphasizes the corporate approach, from now on equity will be calledshareholders equity. The accounting equation can, therefore, be written as

ASSETS = LIABILITIES + SHAREHOLDERS EQUITY

and restated as

ASSETS LIABILITIES = SHAREHOLDERS EQUITY

NET ASSETS = SHAREHOLDERS EQUITY

Shareholders equity is divided into two main categories: capital stock and retainedearnings. For a corporation, the accounting equation can be written as


ASSETS = LIABILITIES + CAPITAL STOCK + RETAINED EARNINGS

Capital stock is the amount invested in the corporation by its owners. The basiccomponent of capital stock is common stock or common shares, which the corpo-ration issues to its shareholders as evidence of their ownership.

Retained earnings is the amount earned by income-producing activities andkept for use in the business. Two types of transactions that affect retained earningsare revenues and expenses. Revenues result from rendering a service or selling aproduct to customers. For example, a laundrys receipt of cash from a customer forcleaning of a coat brings in revenue and increases the laundrys retained earnings.Expenses result from consuming goods or services in the course of earning rev-enue. For example, the wages that the laundry pays its employees is an expenseand decreases retained earnings. Expenses are the cost of doing business and are theopposite of revenues. Expenses include office rent, salaries for employees, news-paper advertisements, and utility charges for electricity, gas, and so forth.

Businesses strive for profitability. When total revenues exceed total expenses,the result of operations is net income, net earnings, or net profit. When expensesexceed revenues, the result is a net loss.

If the business is successful in earning a net income, it may pay dividends, the thirdtype of transaction that affects retained earnings. Dividends are distributions to share-holders of assets (usually cash) generated by net income. Dividends are not expensesbecause the decision of whether or not to distribute them is made after expenses andrevenues are recorded. First the business measures its net income or net loss. Then a cor-poration may (or may not) pay dividends. Retained earnings must have a credit bal-ance before and after the payment of dividends. Exhibit 1-6 shows the relationshipsamong retained earnings, revenues, expenses, net income or net loss, and dividends.


Revenues forthe Period

minus

Expenses forthe Period

equals

BeginningBalance of

Retained Earnings

plus(or

minus)

Net Income(or Net Loss)for the Period

minus Dividends forthe Period

equalsEnding Balance

of RetainedEarnings

Increases in cash are not alwaysrevenues. Cash also increases whena company borrows money, butborrowing money creates aliabilitynot a revenue. Revenueresults from rendering a service orselling a product, not necessarilyfrom the receipt of cash.

KEY POINT

Decreases in cash are not alwaysexpenses. Cash decreases when landis purchased, for example, but thepurchase also increases the assetland, which is not an expense.Expenses result from using goods orservices in the course of earningrevenue, not necessarily from thepayment of cash.

KEY POINT

EXHIBIT 1-6

Components of RetainedEarnings

The owners equity of proprietorships and of partnerships is different. Thesetypes of business make no distinction between capital stock and retained earn-ings. Instead, the equity of each owner is accounted for under the single headingof Capital. For example, Briana Weill would account for her equity in her repair busi-ness as Briana Weill, Capital. As Exhibit 1-7 shows, revenues increase owners eq-uity and expenses decrease owners equity. Thus, net income to the proprietorshipwould increase the owners equity account Briana Weill, Capital, while a net losswould decrease the account. Owner withdrawals are those amounts removedfrom the business by the owner. Withdrawals are the opposite of owner invest-ments. Withdrawals of funds from the proprietorship would also decrease Brianascapital account.

If Briana took her friend Marie Jacina as a partner, the partnership of Weill andJacina would maintain a separate record of capital for each partner: Briana Weill,Capital, and Marie Jacina, Capital. Net income to the partnership of Weill and Jacinawould increase the partners capital accounts, while a net loss would decrease theaccounts. Partnerships are discussed in detail in Chapter 12.

Accounting for Business TransactionsIn accounting terms, a transaction is any event that both affects the financial positionof the business entity and can be reliably recorded. Many events may affect a com-pany, including (1) elections, (2) economic booms and recessions, (3) purchases andsales of merchandise inventory, (4) payment of rent, (5) collection of cash from cus-tomers, and so on. But, an accountant records only events with effects that can bemeasured reliably as transactions.

Which of the above five events would the accountant record? The answer isevents (3), (4), and (5) because their dollar amounts can be measured reliably. Theaccountant would not record events (1) and (2) because the dollar effects thatelections and economic trends have on a particular entity cannot be measuredreliably.

To illustrate accounting for business transactions, lets assume that Gary andMonica Lyon open a travel agency that they incorporate as Air & Sea Travel, Inc.We now consider 11 events and analyze each in terms of its effect on the account-ing equation of Air & Sea Travel, Inc. Transaction analysis is the essence ofaccounting.

Transaction 1: Starting the Business The Lyons invest $50,000 of their money tobegin the business. Specifically, they deposit $50,000 in a bank account entitled Air &Sea Travel, Inc. Air & Sea Travel, Inc. isues shares of common stock to Gary andMonica Lyon. The stock is printed on certificates and issued by the corporation. The


OBJECTIVE 4Use the accounting equationto analyze businesstransactions

Increases Decreases

Owner Investmentsin the Business

Owner Withdrawalsfrom the Business

Revenues Expenses

Owner's Equity

EXHIBIT 1-7

Transactions that Increase orDecrease Owners Equity


Accounting and the -World

Using the Internet to Increase Income

At the beginning of this chapter, you read about Briana Weill and her home repairbusiness Weill Do It For You Ltd. Briana needed to tell people about her business andhow she could solve their light repair problems. She followed the conventionalroute, printing and distributing leaflets to a large number of homes in her neigh-bourhood.

While some calls and some repair jobs were a result of the leaflets, Briana re-alized she could increase her income by reaching a wider market. She felt that byproviding more information to more prospective customers, she would be able toobtain more repair jobs and, therefore, more income. Briana discussed this ideawith her brother John, a computer science student at the University of BritishColumbia. He suggested she create a web page that explained her business.

Briana loved the idea and, with her brothers help, created a web page thatlisted her services, gave sample prices for certain jobs, and showed photos ofsome of her work. She then approached Mr. Donner, who owned the local hardwarestore where she and her father bought materials and tools. He agreed to link Brianasweb page to his stores website. She also linked her web page to the businesssection of her citys website.

Briana discovered that about one-third of her customers learned about Weill DoIt For You Ltd. from the web page; these customers had not seen her leaflets. Shecalculated that the increase in income as a result of the web page was much greaterthan the time and expense involved in creating it. She now recommends using theInternet to anyone thinking of starting a business.

certificates provide physical evidence that the Lyons have an ownership interest in thecorporation. The travel agency offers service in two ways. Some customers phone oremail Air & Sea Travel, Inc. Other customers do business with the travel agencystrictly on-line. On-line customers plan and pay for their trips through the Air & SeaTravel, Inc. website. The website is linked to airlines, hotels, and cruise lines, so clientscan obtain the latest information at any time. The website allows Air & Sea Travel, Inc.to transact more business and to operate with fewer employees, leading to lower op-erating costs. The travel agency passes the cost savings to customers by chargingthem lower commissions, making this a favourable situation for the business andthe customer.

The effect of this transaction on the accounting equation of the Air & Sea Travel,Inc. business entity is

Type of ShareholdersAssets Liabilities + Shareholders Equity Equity Transaction

CommonCash Stock

(1) +50,000 +50,000 Owner investment

For every transaction, the amount on the left side of the equation must equal theamount on the right side. The first transaction increases both the assets (in this case,Cash) and the equity of the business (Common Stock). The transaction involves noliabilities of the business because it creates no obligation for Air & Sea Travel, Inc. topay an outside party. To the right of the transaction we write Owner investment to

=

The asset affected is Office Supplies, and the liability is called an account payable.The term payable signifies a liability. Because Air & Sea Travel, Inc. is obligated to pay$500 in the future but signs no formal promissory note, we record the liability as anAccount Payable, not as a Note Payable.

Transaction 4: Earning of Service Revenue Air & Sea Travel, Inc. earns servicerevenue by providing travel arrangement services for clients. Assume the business


STOP & THINKThe realtor that arranged Air & Sea Travel, Inc.s land purchase assures the companythat the land is worth $75,000. Could the company ethically record the land at$75,000?

Answer: Regardless of the realtors belief about the true value of the land, it isrecorded at $40,000 because of the cost principle and the reliability principle. Actual costis a reliable measure of an asset.

keep track of the reason for the effect on shareholders equity. This transaction is iden-tical to Briana Weills investment of $75 to start her business.

Transaction 2: Purchase of Land Air & Sea Travel, Inc. purchases land for a fu-ture office location, paying cash of $40,000. The effect of this transaction on the ac-counting equation is

Shareholders Type of ShareholdersAssets Liabilities + Equity Equity Transaction

CommonCash + Land

=Stock

Bal. 50,000 50,000(2) 40,000 + 40,000Bal. 10,000 40,000 50,000

50,000 50,000

The cash purchase of land increases one asset, Land, and decreases another asset,Cash, by the same amount. After the transaction is completed, Air & Sea Travel, Inc.has cash of $10,000, land of $40,000, no liabilities, and shareholders equity of $50,000.

Transaction 3: Purchase of Office Supplies Air & Sea Travel, Inc. buys stationeryand other office supplies, agreeing to pay $500 within 30 days. This transactionincreases both the assets and the liabilities of the company. Its effect on theaccounting equation is

ShareholdersAssets Liabilities + Equity

Office Accounts CommonCash + Supplies + Land

=Payable + Stock

Bal. 10,000 40,000 50,000(3) +500 +500Bal. 10,000 500 40,000 500 50,000

50,500 50,500

Note that the sums of balances(which we abbreviate Bal.) on bothsides of the equation are equal.This equality must always exist.

LEARNING TIP



Office Accounts Common RetainedCash + Supplies + Land Payable + Stock + Earnings

Bal. 10,000 500 40,000 = 500 50,000(4) + 5,500 5,500 Service revenueBal. 15,500 500 40,000 500 50,000 5,500

56,000 56,000

earns $5,500 and collects this amount in cash. The effect on the accounting equationis an increase in the asset Cash and an increase in Retained Earnings, as follows:

This revenue transaction caused the business to grow, as shown by the increase intotal assets and in the sum of total liabilities plus shareholders equity. A companythat sells goods to customers is a merchandising business. Its revenue is called salesrevenue. In contrast, Air & Sea Travel, Inc. and Briana Weill perform services forclients; their revenue is called service revenue.

STOP & THINK

Air & Sea Travel, Inc. has now completed four business transactions. Answer thesequestions about the business:1. How much in total assets does Air & Sea Travel, Inc. have to work with?2. How much of the total assets does Air & Sea Travel, Inc. actually own? How much

does the business owe to outsiders?

Answers:1. Air & Sea Travel, Inc. owns three assets totalling $56,000, the sum of cash ($15,500)

+ office supplies ($500) + land ($40,000).2. Air & Sea Travel, Inc. owns $55,500: Common Stock of $50,000 and Retained

Earnings of $5,500. It owes $500 (Accounts Payable) to outsiders.

Transaction 5: Earning of Service Revenue on Account Air & Sea Travel, Inc. per-forms services for clients who do not pay immediately. In return for the services, Air& Sea Travel, Inc. issues an invoice and receives the clients promise to pay the$3,000 amount within one month. This promise is an asset to Air & Sea Travel, Inc.,an account receivable because the business expects to collect the cash in the future.In accounting, we say that Air & Sea Travel, Inc. performed this service on account.When the business performs service for a client or a customer, the business earns rev-enue regardless of whether it receives cash immediately or expects to collect cashlater. This $3,000 of service revenue is as real an increase in the wealth of Air & SeaTravel, Inc.s business as the $5,500 of revenue that was collected immediately inTransaction 4. Air & Sea Travel, Inc. records an increase in the asset AccountsReceivable and an increase in Service Revenue, which increases, as follows:


Accounts Office Accounts Common + RetainedCash + Receivable + Supplies + Land Payable + Stock Earnings

Bal. 15,500 500 40,000 500 50,000 5,500(5) +3,000 3,000 Service revenueBal. 15,500 3,000 500 40,000 500 50,000 8,500

59,000 59,000

=

Because expenses have the opposite effect of revenues, they cause the business toshrink, as shown by the smaller amounts of total assets and total liabilities andshareholders equity.

Each expense should be recorded in a separate transaction. Here, for simplic-ity, they are listed together. The balance of the equation holds, as we know itmust.

Businesspeople, the Lyons and Briana Weill included, run their businesses withthe objective of having more revenues than expenses. An excess of total revenuesover total expenses is called net income, net earnings, or net profit. If total expensesexceed total revenues, the result is called a net loss.

Transaction 7: Payment on Account Air & Sea Travel, Inc. pays $400 to the storefrom which it purchased $500 worth of office supplies in Transaction 3. In ac-counting, we say that the business pays $400 on account. The effect on the account-ing equation is a decrease in the asset Cash and a decrease in the liability AccountsPayable as follows:

Transaction 6: Payment of Expenses During the month, Air & Sea Travel, Inc.pays $2,700 in cash expenses: office rent, $1,100; employee salary $1,200 (for a part-time assistant); and total utilities, $400. The effects on the accounting equation are



Accounts Office Accounts Common RetainedCash + Receivable + Supplies + Land Payable + Stock + Earnings

Bal. 15,500 3,000 500 40,000 500 50,000 8,500(6) 1,100 -1,100 Rent expense

1,200 -1,200 Salary expense 400 -400 Utility expense

Bal. 12,800 3,000 500 40,000 500 50,000 5,800

56,300 56,300

=

A company reported monthlyrevenues of $77,600 and expenses of$81,300. What is the result ofoperations for the month? Why?

A: Net loss of $3,700, becauseexpenses exceed revenues.

WORKING IT OUT

Assets Liabilities + Shareholders Equity

Accounts Office Accounts Common+

RetainedCash + Receivable + Supplies + Land Payable

+Stock Earnings

Bal. 12,800 3,000 500 40,000 500 50,000 5,800(7) 400 400Bal. 12,400 3,000 500 40,000 100 50,000 5,800

55,900 55,900

The payment of cash on account has no effect on the asset Office Supplies becausethe payment does not increase or decrease the supplies available to the business.

Transaction 8: Personal Transaction Gary and Monica Lyon remodel their homeat a cost of $30,000, paying cash from personal funds. This event is not a transactionof Air & Sea Travel, Inc. It has no effect on Air & Sea Travel, Inc.s business affairsand therefore is not recorded by the business. It is a transaction of the personal en-tity the Lyon family, not the business entity Air & Sea Travel, Inc. We are focusingnow solely on the business entity, and this event does not affect it. This transactionillustrates the application of the entity concept.

=

=Chapter One Accounting and the Business Environment 19



Bal. 12,400 3,000 500 40,000 100 50,000 5,800(9) + 1,000 1,000Bal. 13,400 2,000 500 40,000 100 50,000 5,800

55,900 55,900

Transaction 9: Collection on Account In Transaction 5, Air & Sea Travel, Inc. per-formed services for clients on account. The business now collects $1,000 from a client.We say that it collects the cash on account. It will record an increase in the asset Cash.Should it also record an increase in service revenue? No, because Air & Sea Travel, Inc.already recorded the revenue when it performed the service in Transaction 5. Thephrase collect cash on account means to record an increase in Cash and a decreasein the asset Accounts Receivable. The effect on the accounting equation is

Total assets are unchanged from the preceding transactions total. Why? BecauseAir & Sea Travel, Inc. merely exchanged one asset for another. Also, the total of li-abilities and shareholders equity is unchanged.

Transaction 10: Sale of Land An individual approaches the Lyons about sellinga parcel of land owned by the Air & Sea Travel, Inc. entity. The Lyons and the otherperson agree to a sale price of $22,000, which is equal to the businesss cost of theland. Air & Sea Travel, Inc. sells the land and receives $22,000 cash, and the effect onthe accounting equation is

Transaction 11: Cash for Personal Use There are two ways the shareholders ofa business can receive cash. First, the shareholder can receiv a pay cheque provid-ing the shareholder is actively working in the business, either fulltime or part-time.Second, the corporation can declare and distribute cash dividends to all the commonshareholders providing there is sufficient cash, after the dividend, and retainedearnings has a credit balance.

=



Bal. 13,400 2,000 500 40,000 100 50,000 5,800(10)+22,000 22,000Bal. 35,400 2,000 500 18,000 100 50,000 5,800

55,900 55,900



Bal. 35,400 2,000 500 18,000 100 50,000 5,800(5) 2,100 2,100 DividendsBal. 33,300 2,000 500 18,000 100 50,000 3,700

53,800 53,800

=


The dividend decreases the asset Cash and also the retained earnings of the busi-ness. The double underlines below each column indicate a final total.

The dividend does not represent a business expense because the cash is paid to the share-holders for their personal use. We record this decrease in shareholders equity asDividends. The double underlines below each column indicate a final total.

The 11 transactions illustrated above show how the Lyons would account fortheir travel business in a corporate form, Air & Sea Travel, Inc. The shareholders eq-uity was divided between two accounts: Common Stock and Retained Earnings.

If Air & Sea Travel had been a proprietorship and Gary Lyon was the sole owner,then owners equity would consist of a single amount entitled Capital that wouldinclude both capital invested and accumulated earnings net of owner withdrawals.The entries under the headings Assets and Liabilities would be the same for the11 transactions as illustrated. The difference would be in the entries under OwnersEquity. For a proprietorship, the Owners Equity entries would appear as follows:

Type of OwnersTransaction Number Owners Equity Equity Transaction

Gary Lyon, Capital

1 + 50,000 Owner investmentBal. 50,000

4 +...5,500 Service revenueBal. 55,500

5 +...3,000 Service revenueBal. 58,500

6 ...1,100 Rent expense...1,200 Salary expense......400 Utilities expense

Bal. 55,80011 ...2,100 Owner withdrawal

Bal. 53,700

If Gary and Monica Lyon had been in partnership carrying on the business Air& Sea Travel, Inc. then owners equity would include a capital account for each ofthe two partners entitled Gary Lyon, Capital, and Monica Lyon, Capital. Assume theLyons contribute equal amounts of capital and that profits and losses are sharedequally. The entries under the headings Assets and Liabilities would be thesame for the 11 transactions as illustrated. The difference would be in the entriesunder Owners Equity. For a partnership, the Owners Equity entries would ap-pear as follows:

Type of OwnersTransaction Number Owners Equity Equity Transaction

Gary Lyon, Monica Lyon,Capital Capital

1 +.25,000 +.25,000 Owner investmentBal. 25,000 Bal. 25,000

4 +...2,750 +...2,750 Service revenueBal. 27,750 Bal. 27,750

5 +...1,500 +...1,500 Service revenueBal. 29,250 Bal. 29,250

6 ......550 ......550 Rent expense......600 ......600 Salary expense......200 ......200 Utilities expense

Bal. 27,900 Bal. 27,90011 ...1,050 ...1,050 Owner withdrawals

Bal. 26,850 Bal. 26,850

Note that revenues and expenses are shared equally, and the final balances in the twocapital accounts sum to $53,700.

Evaluating Business TransactionsExhibit 1-8 summarizes the 11 preceding transactions. Panel A of the exhibit lists thedetails of the transactions, and Panel B presents the analysis. As you study theexhibit, note that every transaction maintains the equality



Panel A: Details of Transactions

(1) The owners invested $50,000 cash in the business and received shares in exchange.(2) Paid $40,000 cash for land.(3) Bought $500 of office supplies on account.(4) Received $5,500 cash from clients for service revenue earned.(5) Performed services for clients on account, $3,000.(6) Paid cash expenses: rent, $1,100; employee salary, $1,200; utilities, $400.(7) Paid $400 on the account payable created in Transaction 3.(8) Remodelled his personal residence. This is not a transaction of the business.(9) Collected $1,000 on the account receivable created in Transaction 5.

(10) Sold land for cash equal to its cost of $22,000.(11) Declared and paid a dividend of $2,100 to the shareholders.

Panel B: Analysis of Transactions

Type of Shareholders Assets Liabilities + Shareholders Equity Equity Transaction

Accounts Office Accounts Common RetainedCash + Receivable + Supplies + Land Payable + Stock + Earnings

(1) +50,000 +50,000 Owner investmentBal. 50,000 50,000(2) 40,000 +40,000Bal. 10,000 40,000 50,000(3) +500 + 500Bal. 10,000 500 40,000 500 50,000(4) + 5,500 + 5,500 Service revenueBal. 15,500 500 40,000 500 50,000 5,500(5) +3,000 + 3,000 Service revenueBal. 15,500 3,000 500 40,000 = 500 50,000 8,500(6) 1,100 1,100 Rent expense

1,200 1,200 Salary expense 400 400 Utilities expense

Bal. 12,800 3,000 500 40,000 500 50,000 5,800(7) 400 400Bal. 12,400 3,000 500 40,000 100 50,000 5,800(8)Not a transaction of the business (9) + 1,000 1,000Bal. 13,400 2,000 500 40,000 100 50,000 5,800(10) +22,000 22,000Bal. 35,400 2,000 500 18,000 100 50,000 5,800(11) 2,100 2,100 DividendsBal. 33,300 2,000 500 18,000 100 50,000 3,700

53,800 53,800

EXHIBIT 1-8

Analysis of Transactions ofAir & Sea Travel, Inc.


The Financial StatementsOnce the analysis of the transactions is complete, what is the next step in the ac-counting process? How does a business present the results of the analysis? We nowlook at the financial statements, which are the formal reports of an entitys financialinformation. The primary financial statements are the (1) income statement, (2)statement of retained earnings, (3) balance sheet, and (4) cash flow statement.

Income Statement The income statement presents a summary of the revenuesand expenses of an entity for a specific period of time, such as a month or a year. Theincome statement, also called the statement of earnings or statement of operations,is like a video of the entitys operationsit presents a moving financial picture of busi-ness operations during the period. The income statement holds perhaps the mostimportant single piece of information about a businessits net income, revenuesminus expenses. If expenses exceed revenues, a net loss results for the period.

Statement of Retained Earnings The statement of retained earnings presents asummary of the changes that occurred in the retained earnings of the entity during aspecific time period, such as a month or a year. An increase in retained earningsarises from net income earned during the period. A decrease results from dividendsto the owner and from a net loss for the period. net income or net loss comes di-rectly from the income statement. Dividends are capital transactions between thebusiness and its owners, so they do not affect the income statement.

Balance Sheet The balance sheet lists all the assets, liabilities, and shareholdersequity of an entity as of a specific date, usually the end of a month or a year. The bal-ance sheet is like a snapshot of the entity. For this reason, it is also called the state-ment of financial position.

Cash Flow Statement The cash flow statement reports the amount of cash com-ing in (cash receipts) and the amount of cash going out (cash payments or disburse-ments) during a period. Business activities result in a net cash inflow (receipts greaterthan payments) or a net cash outflow (payments greater than receipts). The cashflow statement shows the net increase or decrease in cash during the period andthe cash balance at the end of the period. We will cover the cash flow statement ingreater depth in Chapter 17.

Computers and software programs have had a significant impact on the prepa-ration of the financial statements. Financial statements can be produced instanta-neously after the data from the financial records are entered into the computer. Ofcourse, any errors that exist in the financial records will be passed on to the finan-cial statements. For this reason, the person responsible for analyzing the accountingdata is critical to the accuracy of the financial statements.

Financial Statement HeadingsEach financial statement has a heading, which gives the name of the business (in ourdiscussion Air & Sea Travel, Inc.), the name of the particular statement, and thedate or time period covered by the statement. A balance sheet prepared at the end

STOP & THINK

Why do Gary and Monica Lyon, or anyone else, go into business? If you could iden-tify only one reason, what would it be? How will accounting serve to meet this need?

Answer: The Lyons went into business to earn a profitand thereby to make a living.They hope Air & Sea Travel, Inc.s accounting revenues exceed its expenses to providean excessa net income. Accounting tells the Lyons how much income the businesshas earned, how much cash and other assets the business has, and how much in lia-bilities the business owes.

OBJECTIVE 5Prepare and use the financialstatements


of year 2002 would be dated December 31, 2002. A balance sheet prepared at theend of March 2003 is dated March 31, 2003.

An income statement or a statement of retained earnings covering an annualperiod ending on December 31, 2002 is dated For the Year Ended December 31,2002. A monthly income statement or statement of retained earnings for September2003 has in its heading For the Month Ended September 30, 2003. Income is mean-ingless unless identified with a particular time period.

Relationships among the FinancialStatements

Exhibit 1-9 on page 24 illustrates all four statements. Their data come from thetransaction analysis in Exhibit 1-8. We are assuming the transactions occurred dur-ing the month of April 2002. Study the exhibit carefully, because it shows the rela-tionships among the four financial statements.

Observe the following in Exhibit 1-9:

1. The income statement for the month ended April 30, 2002a. Reports all revenues and all expenses during the period. Expenses are often

listed alphabetically.b. Reports net income of the period if total revenues exceed total expenses, as

in the case of Air & Sea Travel, Inc.s operations for April. If total expensesexceed total revenues, a net loss is reported instead.

2. The statement of retained earnings for the month ended April 30, 2002a. Opens with the retained earnings balance at the

beginning of the period. The opening balancemust be dated.

b. Adds net income (or subtracts net loss, as the casemay be). Net income (or net loss) comes directlyfrom the income statement (see arrow inExhibit 1-9).

c. Subtracts dividends. The parentheses around anamount indicate a subtraction.

d. Ends with the retained earnings balance at theend of the period. The ending balance must bedated.

3. The balance sheet at April 30, 2002, the end of the perioda. Reports all assets, all liabilities, and shareholders

equity of the business at the end of the period.b. Reports that total assets equal the sum of total

liabilities plus total shareholders equity.c. Reports the ending retained earnings balance, taken directly from the state-

ment of retained earnings (see arrow ).4. The cash flow statement for the month ended April 30, 2002

a. Reports cash flows from three types of business activities (operating, investing,and financing activities) during the month. Operating activities bring in revenues and the related cash collections from

customers. They also include the payment of expenses. Investing activities are the purchase and sale of assets that the business

uses for its operations. Financing activities are the receipts of cash from people or companies that

finance the business and also payments back to those people or companies.Each category of cash-flow activities includes both cash receipts, which arepositive amounts, and cash payments, which are negative amounts (denotedby parentheses). Each category results in a net cash inflow or a net cash out-flow for the period. We discuss these categories in detail in Chapter 17.

I had trouble understanding the relationshipsbetween all of the financial statements andwhy they need to be done in a particularorder. Exhibit 1-9 on page 24 shows you theorder to do your statements in. The guidingarrows tell you where some of the figures onthose statements come from.

Jonny M., Kitchener

Student to Student

OBJECTIVE 6Evaluate the performance of abusiness

b. Reports a net increase in cash during the month and ends with the cash bal-ance at April 30, 2002. This is the amount of cash to report on the balancesheet (see arrow ).


1

2

3

AIR & SEA TRAVEL, INC.Statement of Retained Earnings

For the Month Ended April 30, 2002

Retained earnings, April 1, 2002 ....................................................................... $ 0Add: Net income for the month ....................................................................... 5,800

5,800Less: Dividends ................................................................................................... (2,100)Retained earnings, April 30, 2002 ..................................................................... $3,700

AIR & SEA TRAVEL, INC.Cash Flow Statement*


Cash flows from operating activitiesCash collections from customers** ............................... $ 6,500Cash payments to suppliers***...................................... $(1,900)Cash payments to employees........................................ (1,200) (3,100)

Net cash inflow from operating activities ............. 3,400Cash flows from investing activities

Acquisition of land.......................................................... $(40,000)Proceeds from sale of land............................................. 22,000

Net cash outflow from investing activities............ (18,000)Cash flows from financing activities

Proceeds from issuance of stock ................................... $50,000Dividends declared and paid ........................................ (2,100)

Net cash inflow from financing activities.............. 47,900Net increase in cash.............................................................. $33,300Cash balance, April 1, 2002 ................................................. 0Cash balance, April 30, 2002 ............................................... $33,300

* Chapter 17 explains how to prepare this statement.** $5,500 + $1,000 = $6,500*** $1,100 + $400 + $400 = $1,900

AIR & SEA TRAVEL, INC.Income Statement


Revenue:Service revenue....................................................................... $8,500

Expenses:Rent expense ........................................................................... $1,100Salary expense ........................................................................ 1,200Utilities expense ..................................................................... 400

Total expenses ..................................................................... 2,700Net income.................................................................................... $5,800

AssetsCash ......................................... $33,300Accounts receivable .............. 2,000Office supplies ....................... 500Land ........................................ 18,000

Total assets .............................. $53,800

LiabilitiesAccounts payable .................. $ 100

Shareholders EquityCommon stock........................ 50,000Retained earnings................... 3,700

Total liabilities andshareholders equity ........ $53,800

AIR & SEA TRAVEL, INC.Balance SheetApril 30, 2002

EXHIBIT 1-9

Financial Statements of Air &Sea Travel, Inc.


STOP & THINK

Study Exhibit 1-9, which gives the financial statements for Air & Sea Travel, Inc. atApril 30, 2002, the end of the first month of operations. Answer these questions forAir & Sea Travel, Inc. to evaluate the businesss results.

1. What was the businesss result of operations for the month of Aprila net income(profit) or a net loss, and how much? Which financial statement provides this in-formation?

2. How much revenue did the business earn during April? What was the businessslargest expense? How much were total expenses?

3. Is the income statement dated at the last day of the period or for the entire period?Why?

4. Did the company have retained earnings at the beginning of April? At the end ofApril? Identify all the items that changed retained earnings during the month,along with their amounts. Which financial statement provides this information?

5. How much cash does the company have as it moves into the next monththat is,May 2002? Which financial statement provides this information?

6. How much do clients owe Air & Sea Travel, Inc. at April 30? Is this an asset or a li-ability for the business? What does the business call this item?

7. How much does the business owe outsiders at April 30? Is this an asset or a liabil-ity for the business? What does the business call this item?

8. How is the balance sheet dated? Why is it dated this way? Why does the balancesheets date differ from the date on the income statement?

Answers:1. Net income = $5,800. The income statement provides this information.

2. From the income statement: Total revenue = $8,500. Salary was the largest expense,at $1,200. Total expenses = $2,700.

3. The income statement is dated For the Month Ended April 30, 2002. The incomestatement is dated for the entire period because the revenues and the expensesoccurred during the month, not at the end of the month. The income statementreports on the businesss operations during the whole span of the period.

4. From the statement of retained earnings:

Beginning retained earnings = $0 Ending retained earnings = $3,700

Increase: Net income for the month = $5,800

Decrease: Dividends by owner = $2,100

5. Cash = $33,300. The balance sheet or cash flow statement provides this informa-tion.

6. Clients owe the business $2,000, which is an asset called Accounts Receivable.

7. The business owes outsiders $100, for a liability called Accounts Payable.

8. The balance sheet is dated April 30, 2002, which means the close of business onApril 30, 2002. The balance sheet is dated at a single moment in time (in this case,April 30, 2002) to show the amount of assets, liabilities, and shareholders equitythe business had on that date. The balance sheet is like a snapshot, while the in-come statement provides a moving picture of the business through time.


Decision Guidelines

Major Business Decisions

How to organize the business?

What to account for?

How much to record for assets and liabilities?

How to organize the various effects of a transaction?

How to measure profits and losses?

Did retained earnings increase or decrease?

Where does the business stand financially?

Where did the businesss cash come from?Where did the cash go?

If a single owner, but not incorporateda proprietorship.If two or more owners, but not incorporateda partnership.If the business issues shares of stock to shareholdersa corporation.

Account for the business, which is a separate entity apart from itsowner (Entity concept).Account for transactions and events that affect the business and canbe measured objectively. (Reliability principle).

Actual historical amount (Cost principle).

The accounting equation:


Note: Shareholders equity is called owners equity if the entity is aproprietorship.

Income statement:

REVENUES EXPENSES = NET INCOME (or NET LOSS)

Statement of retained earnings

Beginning retained earnings+ Net income (or Net loss) Dividends

= Ending retained earnings

Balance sheet (accounting equation):


Cash flow statement:Operating activities: Net cash inflow (or outflow)

+ Investing activities: Net cash inflow (or outflow)+ Financing activities: Net cash inflow (or outflow)

= Net increase (decrease) in cash

The Decision Guidelines feature below summarizes the chapter by examiningsome decisions that businesspeople must make. A Decision Guidelines feature ap-pears in each chapter of this book. The Decision Guidelines serve as useful sum-maries of the decision-making process and its foundation in accounting information.

Summary ProblemSummary Problemfor Your Review

Visit the Student Resources area of the Accounting CompanionWebsite for extra practice with the new material in Chapter 1.

www.pearsoned.ca/horngren

CyberCoach


Jill Smith opens an apartment-locator business in Regina. She incorporates thebusiness, which she names Fast Apartment Locators Inc. During the first monthof operations, July 2002, the following transactions occurred:

a. Smith invests $35,000 of personal funds to acquire the common stock of thebusiness.

b. The business purchases, on account, office supplies costing $350.c. Fast Apartment Locators Inc. pays cash of $30,000 to acquire a parcel of land. The busi-

ness intends to use the land as a future building site for its business office.d. The business locates apartments for clients and receives cash of $1,900.e. The business pays $100 on the account payable created in Transaction (b).f. Jill Smith pays $2,000 of personal funds for a vacation for her family.g. The business pays cash expenses for office rent, $400, and utilities, $100.h. The business returns to the supplier office supplies that cost $150. The wrong

supplies were shipped.i. The business declares and pays a cash dividend of $1,200.

Required

1. Analyze the preceding transactions in terms of their effects on the accountingequation of Fast Apartment Locators Inc. Use Exhibit 1-8 as a guide but showbalances only after the last transaction.

2. Prepare the income statement, statement of retained earnings, and balancesheet of Fast Apartment Locators Inc. after recording the transactions. UseExhibit 1-9 as a guide.

Solution to Review Problem1. Panel A: Details of Transactions

a. Smith invested $35,000 cash to acquire the common stock of the corporation.b. Purchased $350 in office supplies on account.c. Paid $30,000 to acquire land as a future building site.d. Earned service revenue and received cash of $1,900.e. Paid $100 on account.f. Paid for a personal vacation, which is not a transaction of the business.g. Paid cash expenses for rent, $400, and utilities, $100.h. Returned office supplies that cost $150.i. Declared and paid dividends of $1,200.



Office Accounts Common Retained Cash + Supplies + Land Payable

+Stock

+Earnings

(a) +35,000 +35,000 Owner investment(b) + 350 + 350(c) 30,000 +30,000(d) + 1,900 + 1,900 Service revenue(e) 100 100(f) Not a business transaction(g) 400 400 Rent expense

100 100 Utilities expense(h) 150 150(i) 1,200 1,200 DividendsBal. 5,100 200 30,000 100 35,000 200

35,300 35,300

=

AssetsCash................................................. $ 5,100Office supplies ............................... 200Land................................................. 30,000

Total assets ...................................... $35,300

LiabilitiesAccounts payable ..................... $ 100

ShareholdersEquityCommon stock .......................... 35, 000Retained earnings..................... 200

shareholders equity............. $35,300

Panel B: Analysis of Transactions

2. Financial Statements of Fast Apartment Locators Inc.

FAST APARTMENT LOCATORS INC.Income Statement

For the Month Ended July 31, 2002

Revenue:Service revenue .......................................................................... $1,900

Expenses:Rent expense ............................................................................... $400Utilities expense ......................................................................... 100

Total expenses......................................................................... 500Net Income.......................................................................................... $1,400

FAST APARTMENT LOCATORS INC.Statement of Retained Earnings

For the Month Ended July 31, 2002

Retained earnings, July 1, 2002............................................................................ $ 0Add: Net income for July ..................................................................................... 1,400

1,400Less: Dividends ..................................................................................................... 1,200Retained earningsl, July 31, 2002 ........................................................................ $200

FAST APARTMENT LOCATORS INC.Balance SheetJuly 31, 2002


1. Use accounting vocabulary for decision-making.Accounting is an information system for measuring, pro-cessing, and communicating financial information. As thelanguage of business, accounting helps a wide range ofdecision makers.

2. Apply accounting concepts and principles to analyzebusiness situations. Generally accepted accounting principles(GAAP) guide accountants in their work. The three basicforms of business organization are the proprietorship, thepartnership, and the corporation. Whatever the form, ac-countants use the entity concept to keep the businesss recordsseparate from other economic units. Other important guide-lines are the reliability principle, the cost principle, the going-concern concept, and the stable-monetary-unit concept.

3. Use the accounting equation to describe an organi-zations financial position. In its most common form, theaccounting equation is

Assets = Liabilities + Equity

For corporations, the accounting equation is

Assets = Liabilities + Shareholders Equity

4. Use the accounting equation to analyze business trans-actions. A transaction is an event that both affects the fi-nancial position of an entity and can be reliably recorded.Transactions affect a businesss assets, liabilities, and share-holders equity. Therefore transactions are analyzed in termsof their effect on the accounting equation.

5. Prepare and use the financial statements. The financialstatements communicate information for decision makingby an entitys managers, owners, creditors, by govern-ment agencies, and by other users. The income statementsummarizes the entitys operations in terms of revenuesearned and expenses incurred during a specific period.Total revenues minus total expenses equal net income.The statement of retained earnings reports the changes in re-tained earnings during the period. The balance sheet liststhe entitys assets, liabilities, and shareholders equity at aspecific time. The cash flow statement reports the cash com-ing in and the cash going out during the period.

6. Evaluate the performance of a business. High net in-come indicates success in business; net loss indicates alack of success in business.

Summary

Self-Study QuestionsTest your understanding of the chapter by marking thecorrect answer for each of the following questions:1. The organization that formulates generally accepted

accounting principles is (p. 5)a. Ontario Securities Commissionb. Public Acc

ch1,

Documents

accounting equation

accounting concepts

accounting works

accounting course willsharpen

various accounting terms

business financial activities

language of business

business decisionsaccounting