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When you are finished studying this chapter, you should be able to: 1. Define generallyaccepted accountingprinciplesandexplain why they arenecessary. 2. Explain the objective offinancial reporting and the qualities necessary achieve to this objective. 3. Identify the elementsof the financial statements and describetheir characteristics. 4. Define accrual accounting,explain how it differs from cashbasis accounting,and identify examplesof accrual accounting on actual financial statements. 5. Compute and explain the meaning of the current ratio. 6" Identify the risks and potential frauds related to financial accountingrecords, and explain the controls neededto ensuretheir accuracy.
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In April 2006,with just two weeksuntil the start of histrial, Computer AssociatesInternational'sformer CEO, Sanjay KumaL pleadedguilty to securities fraud and obstruction justice.Not of to only did Kumar engagein a conspiracy inflate the firm's 2000 revenue, alsoauthorized $3.2million payment he a and 2001sales of In to buy the silence potential witnesses. November2006,he to was sentenced 12 yearsin prisonand fined $8 million for his * part in the $2.2billionfraud. records, takingthe risk Why would a smartand wealthymanfalsifyaccounting peoplein power beginto feel invincible. prisonsentence? lt Sometimes of a long to and to individual havea strongsense ethicalbehavior of is importantfor every no to decision, matter how small.Too apply high moral standards everybusiness smalldecisions add up to one big crime. can often a numberof seemingly
L"{}.1 Def general accepted ine ly principles accounting and explain whytheyare necessary.
Net profit equalsall revenues minusall expenses.
I OF CH A P T E 2 . C H A R A C T E R I S T I C S A C C O U N T I N G N F O R M A T I O N R
EXHIBIT2.1 Tom's Wear, Inc. Income Statement For the Month Ended January 31, 2006
$ 900
. . . . . .. . . . . $ 360 50
t0m!sweal
4r5 $ 485
lnformation of CharacteristicsAccounting
What MakeslnformationUseful?
The most generaland the most important objective of financial reporting is to provide useful information for making decisions. What makes information useful? According to the FASB, the information must be relevant,reliable, comparable,and consistent. Relevant. For information to be relevant, it needsto be significant enough to influence businessdecisions.The information should help confirm or correct the users'expectations. No matter how significant the information is, however,it must be timely to be relevant.For example, the price of fuel is extremely important information to an airline such as Southwest or JetBlue, and a managerneedsthis information to make decisionsabout ticket prices. However, if the firm reports fuel prices only monthly, the information will not be timely enough to be relevant. To be relevant, information must be useful in predicting the future. Currently, the SEC requires firms to submit their financial information within 60 days of the end of the firm's fiscal year. Reliable, When information is reliable, you can dependon it and you can verify its accuracy. The information is completely independentof the person reporting it. To be reliable, the information in the financial statementsmust be a faithful representationof what it intends to convey,For example,Borders Group Inc. reported $4.04 billion in salesfor its fiscal year ended January 28,2006. This amount must be true and verifiable; otherwise, the information could be misleading to investors.As you learned in Chapter 1, it is part of the auditors' job to make sure Borders has the documentationto confum the accuracy of its salesamount.Anyone who examinesBorders' salesrecords should come up with the same amount. Comparable. In addition to being relevant and reliable, useful information possesses comparability. This meansinvestorswill be able to comparecorrespondingfinancial information between two similar companies-how one company's net income compareswith accountantsmust another company's net income. In putting together financial statements, allow for meaningful comparisons.Becausethere are often alternativeways to account for the sametransactionwithin GAAP, companiesmust disclosethe methodsthey select.This disclosure allows educatedinvestorsto adjust the reported amountsto make them comparable. For example, Searsmay account for its inventories by averagingthe cost of its purthe chases,whereasWal-Mart may use a method that assumes first items purchasedare the
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Relevance: Information that will provide a basis for forecasts of future firm performance by the CEO and CFO, among others. What's ahead for this company?
Reliability: Information that is neutral and verffiable Is the information independent ofthe specifc person who prepared it?
Comparability: Different companies use the same set of accounting rules. Does the information allow meaningful comparisons of two different companies?
Consistency: A company uses the same rules from year to year. Does the information allow meaningful comparisons of a company's performance at different points in time?
first items sold. As a requirementof GAAP, Searsand Wal-Man will disclosethesechoices in the notes to their financial statementsso that investorscan comparethe inventory information of the companies. Consistent. To be useful,accountinginformationmustbe consistent. Consistency the charis acteristicthat makesit possibleto track a company'sperformanceor financial condition from one year to the next. Only if a companyusesthe sameaccountingmethodsfrom period to period arewe ableto makemeaningfulcomparisons. example,total revenues Thrgetwere For for $51.3 billion for the fiscal year endedJanuary28,2006, and $46.7 billion for the fiscal year endedJanuary29,2005. Only when thesetwo numbersare basedon the samesetof accounting methodscan investorsdeterminewhy salesincreased. the increase If was caused partly or solely by the changein the way the companymeasured sales,then investorswould be misled about the company'sactualperformance. Financial statement userswant to rely on the firm's consistent applicationof accountingstandards. Exhibit 2.2 summaizesthe desiredqualitative characteristics accountinginformation must haveto be considered useful by the FASB.
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1. What is the purpose financial of statements? 2. What four characteristics explainwhat the FASB meansby "useful,, information? Assumptions Principles and Underlying Financial Reporting
The separate-entity assumptionmeansthat the firm'sfinancialrecords ano financialstatements are completely separate from those of the f irm'sowners The monetary-unit assumption means that the itemson the f inancial statements are measured monetaryunits in (dollarin the U.5.).
Financial information pertains to only the firm, not to any other parties such as the firm's owners.This distinction between the financial information of the firm and the hnancial information of other hrms or people is called the separate-entity assumption. It meansthat the financial statementsof a businessdo not include any information about the finances of individual owners or other companies.Look at the income statementin Exhibit 2.1, which summarizesthe company's revenuesand expenses. You will notice that the items on the financial statementsare expressedin amounts of money. This is called the monetary-unit assumption. When you observe that Tom's Wear had expensesof $415 during January 2006, you know that the amount includes only company expenses. SupposeTom took a vacation to Hawaii at a cost of $3,000. No part of that transaction would be part of Tom's Wear's hnancial reports becauseof the separate-entityassumption.
S OF 2 . C H A P TE R E LE ME N TS TH EF I N A N C I A L T A T E M E N T S
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At a minimum, firms preparenew financial statementsevery year. For internal use, financial statementsarepreparedmore frequently. The SEC requirespublicly traded frms to prepare a new set of financial statementseach quarler, which enablesusersto compare the company's performance from one quarter (every three months) to the next. Accountants divide the life of a businessinto time periods so they can preparereports about the company's performance during those time periods.This creationof time periods is called the time-period assumption. Although most companiesreport financial information every three months, only the annual financial information is audited. Most companiesuse the calendaryear as their fiscal year. Assets are recorded at their original cost to the company. This is known as the historical-cost principle. Accountants use cost becausethe cost of an assetis a reliable amount-it is unbiasedand verifiable. Accountantsassumea company will continue to refuture, unlessthey haveclear evidenceit will either close main in business the foreseeable for or go bankrupt. This is called the going-concern assumption. With this assumption,financial statementvalues are meaningful. Would the bank lend money to a frrm if the frm were future? Ifthe firm expectsto liquidate, the not going to continue operatingin the foreseeable lose their meaning. If a company is not a going concern, on the financial statements values would needto be liquidation valuesto be useful. the valueson the flnancial statements you and As you haveread aboutthe four financial statements the notesto the statements, have learnedabout the qualities of financial information and the assumptionsand principles and principles, that provide the foundation of financial reporting.Without theseassumptions analystscould not rely on the information to make decisions. managers,investors,and To complete the foundation for financial reporting and to enableyou to gain a full unyou will needto know derstandingof the information containedin the financial statements, A apply to the preparationof the statements. constraint in finanabout two constraintsthat limit or control imposed by GAAP. There are two constraints:matericial accounting is a ality and conservatism. in of Materialie refersto the sizeor significance an item or transaction relationto the company's overall financial performanceor financial position. An item is material if it is large For enoughto influenceinvestors'decisions. example,the cost of fueL the amountspaid to emleasingairplanesare all materialitems for JetBlueor Southployees,and the cost of buying or west Airlines. In contrast, an item is consideredimmaterial if it is too small to influence in investors.GAAP doesnot have to be strictly appliedto immaterial items (measured total). Airlines made an isolatederror and failed to recordthe revenue For example,suppose JetBlue JetBlue'stotal revenuewas over and usedin 2005. Because from your $350 ticket purchased year endedDecember31,2005, the companywould not needto cor$1.6 billion for its fiscal rect this single enor. The item is consideredimmaterial. (However,if there were lots of these errors,the total amountcould be material.) Conservatism refers to the choices accountantsmake when preparing the financial statements. When there is any question about how to accountfor a transaction,the accountant should selectthe treatmentthat will be least likely to overstateincome or overstateassets.Accountants believe it is better to understateincome or assetsthan it is to overstate either.For example,JetBlue'sDecember3I,2005, balancesheetshowstotal property and to equipmentof over $2.9 billion. GAAP requiresJetBlue to evaluatetheseassets make sure potential. revenue-generating they are not overstatedwith respectto their future
The time-periodassumption meansthat the life of a can business be divided into meaningfultime periodsfor financialreporting. principle The historical-cost are meansthat transactions recordedat actual cost. The going-concern assumptionmeansthat, unless there is obvious evidenceto the contrary,a firm is expected continue to operating in the foreseeable future.
{,"{}.3 ldentify the elementsof the an fi nanci al statements d descri be thei r characteristics.
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CHA P T EIR o e U AL tT tEo F A c c o U N T tN G FoR MA TtoN tN s Tom's Wear.We will take the secondmonth's transactionsand seehow they affect the accounting equationand the financial statements. Then, we will relatethe statements the qualto itative characteristics described by GAAP. At the beginning of the secondmonth, on February l,2006, Tom's Wear has a balance sheetthat is identical to the balancesheetdatedJanuary3 1, 2006. Recall that the company's assets, liabilities, and shareholder's equity balancesroll forward when the new period starts.
On account meanson credlt. The expression appliesto eithe r b uyingo r se llingon credit. Accounts payable are amountsthat a company owes its vendors. Theyare liab ilities nd a re sh own on a the balance sheet.
Prepaidinsurance the name is for insurance business a has purchasedbut not yet used. lt is an asset.
EXHIBIT2.3
Date February I
Tlansaction Tom's Wear purchases 200 Ashirts at $4 each. They are purchased on credit. Tom's Wear buys advertising for $150,paying $100 in cash and the remainder on account. The ad runs immediately. Tom's Wear purchases 3 months' worth of insurance for $150 cash, with the policy begiruring on the date of purchase. Tom's Wear sells 185 Tshirts for $10 each. 170 of these are sold for cash and the remainder on account. Tom's Wear declares and pays a dividend of $100.
Febmary 5
February 14
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The company's successcontinues with the sale of 185 more T-shirts at $10 each. Although Transaction4 showsthesesalesas a single transaction,they could havebeenindividual sales.They are groupedtogetherhere to make the presentationsimple. Of the 185 shirts s o l d ,l T 0 w e re s o l dforcashof$1,700(170shi rtsat$10each)and15w eresoldoncr edit f or Accounts receivableare $150 (15 shirts at $10 each).When a sale is made on credit, accounts receivable are the amountscustomers owe a amountsowed to the firm by customers.Accounts receivableare assets-things of value to companyfor goodsor services a business.This is the fourth transactionshown in Exhibit 2.4. Notice that the rest of this purchased credit. on transactionincludes the decrease inventory of $740 (185 shirts at $4 each) with a correin spondingexpense-cost of goodssold of $740-which decreases retainedearningsby $740. At the end of the secondmonth of business,Tom's Wear pays a dividend of $100 to its only stockholder,Tom. This transactionreducesassets-cash-by $100, and it reducesretained earningsby $100. This is the fifth transactionshown in Exh1bit2.4. The financial statements February can be preparedwith the information from these for transactions.However, there is still one more stepbefore accuratefinancial statementscan Adjusting the books meansto be prepared.This step is called adjusting the books. You need to review the amount that make changes the in hasbeenrecordedfor eachassetand eachclaim to make sureevery amountcorrectly reflects accountingrecords, the end at the financial situation of the company on the specific dateof the balancesheet-the last day of the period,just before the of the fiscal period (month, quarter,or year).After reviewing the transactions Tom's Wear for financialstatements are during the month, can you identify any amount that seemsincorrect to you? Start at the beprepared, make surethe to amountsreflectthe financial ginning of the accountingequation worksheetin Exhibit 2.4 andlook at each item that has conditionof the companyat beenrecorded. The assets cash,$6,695;accounts are receivable, $150; inventory, $100; and that date. prepaid insurance,$150. Are these amounts accurateat February 28,2006, the end of the secondmonth of Tom's Wear?Is any assetlikely to communicateincorrect information? Yes-prepaid insurance,as it currently appearsin the company's records, will not expresswhat it should. Becausethe balancesheetwill have the dateFebruary 28, 2006, Tom's Wear wants the amount of prepaid insuranceto be accurateat that date.What is the amount of the asset-insurance that is still unused-at the date of the balancesheet? The $ 150,paid on February14,appliedto 3 months.On February28,half amonth'sworth haspassed. So, approximately one-sixth (half a month's worth) of the prepaid insurancehas been used.An adjustmentmust be made to make sure the correct amount of prepaid insuranceis shown on the balancesheet.Like routine transactions,adjustmentsmust keep the accountingequation in balance.To record this adjustment in the accounting equation, subtract $25 (l/6 x $150) from the prepaid insurancecolumn, reducing the amount of prepaid insurance,and then reduceowner'sclaims by the same$25 amount.This reductionin the owner's claims is an expense-insurance expense-so it will be shown in the red-boxed area in the accounting equation worksheet.This adjustmentis shown as Al on the worksheetin Exhibit 2.4. The correct amount of the asset-the unusedportion-will be shown on the balance sheetat February28,2006, as $125. A review ofthe other items on the balance sheetdoes not reveal any other neededadjustments on this particular balance sheet date. In the next chapter, you will learn about other situationsrequiring adjustmentsbefore the financial statements can be prepared.For now, this adjustmentmakes the accounting records ready for the preparation of the financial statementsat the end of February. The income statement,preparedfirst, lists the revenuesand expensesfor the period; you can find thosein the red-boxed areain Exhibit 2.4. Allrevenues increaseretainedearnings; all expenses decrease retainedearnings.The only item that we regularly find under retained earningsthat is nor included on the income statementis a distribution to the owners, dividends in a corporation. GAAP saysthat distributions are not expenses. All of the items for the income statementare in the red-boxed area of the worksheet. We can simply take the amountsin the red box in the retained earningscolumns and group the transactionsinto revenuesand expensesto form an income statement.The salesrevenue,often simply calledsales,is $1,850. There are three types of expenses listed. One is the cost of goods sold-also known as cost of sales.Recall, this is the expenseassociatedwith selling somethingpurchasedfrom someone else.Tom'sWearhascost of goodssold of $740.The othertwo expenses $150 are for the advertisingand $25 for insurance.Be sureyou seeand understandthat the insurance expenseis not the amount Tom's Wear actually paid to the insurancecompany.Instead, it
S O C H A P T E2 . E L E M E N T S F T H E F I N A N C I A L T A T E M E N T S R
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EXHIBIT2.5 Tom's Wear,Inc. Income Statement For the Month Ended February 28,2006 lncome Statement for Tom's Wear
This is the income statementfor the secondmonth of businessfor Tom's Wear.
25
vt-D
$ 935
is the cost of the insurancethat was used during the period. The amount that has not been used as of February 28 remains on the balance sheetas an asset. of The net income for the period is $935-revenues of $1,850minus expenses $915. for the month of February. Check it out in Exhibit 2.5,the income statementforTom's Wear in equity is preparednext (shownin Exhibit 2.6). The statement changes shareholder's of equity during the year. in providesthe detailsof the changes shareholder's This statement equity columns of the The information for this statement is found in the shareholder's worksheetin Exhibit 2.4, shown in the yellow-boxed area.Tom's Wear beganthe month with $5,000 in contributed capital. No new stock was issued during the month. That means no new contributions were made during the month. Retained earnings began the retainedearnings,and the month with a balanceof $385. Net income of $935 increases retainedearnings.Becausewe have alreadypreparedthe individend of $100 decreases come statementto summarize what happenedin the red-boxed area in the retained earnings column, we do not needto list all of the individual items again.We just needto add net income as a single amount. The amount of retained earnings at the end of the period i s $ 1, 220( $385 + 93 5 - 1 0 0 ). Next, Tom's Wear preparesthe balance sheet.The balance sheet was really prepared as the transactionswere put in the accounting equation worksheet-but not in a way to communicatethe information most effectively.The transactionsneedto be summarizedand organizedto communicatethe information clearly and effectively. Each assetowned at February 28 is listed, along with the claims to those assets.Notice the similarity between the list of transactionson the worksheetin Exhibit 2.4 and the balance sheetin Exhlbit2.T .
EXHIBIT2.6 Tom's Wear,Inc. Statement of Changesin Shareholder's Equity For the Month Ended February 28,2006
Beginning common stock Common stock issued during the month Ending common stock Beginningretainedearnings Net income for the month Dividends declared Ending retained earnings Total shareholder's equity
. ....... .. ..
$ 5,000 0
$ 5,ooo
$ 385 935 (100)
r,220 $ 6,220
t0m'swGal
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EXHIBIT2.7
T o ta l a s s e ts
........ $7,070
$ 7,070
The full-disclosure principle meansthat the firm must disclose any circumstances and eventsthat would make a difference the users the to of financialstatements.
The assetsare listed at their amountson February 28,2006. There is $6,695 cash.(The details of how this number was calculated will be shown on the statementof cash flows.) Tom's Wear also has accountsreceivableof $150-the amount customersstill owe the company for T-shirts purchasedduring the month but the cashhas not been collected yet. There are 25 shirts left in the inventory, eachhaving cost $4, for a total of $100. The last asset prepaidinsurance, the amountshownis $125-the unused is and portion at February 28. The adjustmentreducedprepaid insuranceby $25 for the amount used up during the last half of February. There are two liabilities at February 28,2006-accounts payable of $800 and other payablesof $50. These amounts are still owed by Tom's Wear to creditors. The last item is the amount of shareholder's equity. Becausewe have alreadyprepared the statement changesin shareholder's of equity, we know that $5,000is the total contributed capital-in the form of stock-and $7,220 is the amount of retainedearnings.Together,the liabilities plus shareholder's equity add up to $7,070-the sameamount as the total assets. The statement cashflows (shown in Exhibit 2.8) showsevery cash collection and of every cash disbursementfor the month. Each cash transactionis classified as one of three types: operating, investing, or financing. To prepare this statement,you need to use the items from the transactionsin the cash column of the worksheet in Exhibit 2.4, shown boxed in green.For each cash amount, ask yourself if it pertains to operating activities, investing activities, or financing activities. The first cashamount in Exhibit2.4 is the payment of $100 in cashfor advertising;that was the second transaction. This $100 is an operatingcashflow because is a cashexpense it related to routine businessactivities. The next cash transactionis the $150 paid to the insurancecompany.The purchaseof insurance is an operating cash flow. Notice the statementof cash flows shows the cash paid-with no regard for when the insuranceis used. Transaction involvescashinflows, for a total of $1,700.This transaction 4 was a sale, which is an operating cash flow. Notice the cash in Transaction4 is $1,700, representing 170T-shirtssold for cash.Although 185 were actuallysold,the cashfor 15 ofthem hasnot been collected yet. In the statementof cash flows, every item must be cash only. The final cashtransactionis the distribution of $100 to the owner as dividends. This is classified as a financing cash flow becauseit relatesto how the businessis financed. Be sure you seethat the statementof cash flows includes every cash inflow and every cash outflow shown on the accounting equation worksheet.Also notice nothing else is included on this financial statement.The net amount is the changein the amount of cashduring the period. The bottom of the statementof cash flows adds the beginning cash balance of $5,345to the increase $1,350to get the endingcashbalanceof $6,695,shownon the of February 28,2006, balance sheet. Notes to the financial statements not included here for Tom's Wear,but you should are never forget that they are a crucial part of the financial statements. There is an accounting principle called the full-disclosure principle, which meansthat companiesshould disclose
O S C H A P T E2 . E L E M E N T S F T H E F I N A N C I A L T A T E M E N T S R
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EXHIBIT2.8 Tom's Wear, Inc. Statement of Cash Flows For the Month Ended February 28,2006 Statement of Cash Flows for Tom's Wear for February
The Statementof Cash Flows provides details about the changesto cash during the neriod. $ 1,700 (100) (150)
Cash from operating activities Cash collected from customers . . . . Cashpaidto advertising Cashpaidforinsurance Net cash from operations Cash from investing activities Cash from frnancing activities Cash paid for dMdends Net cash from financing Net increase in cash Add beginning cash balance Dnding cash balance
.....
$ 1,450 0
$ (100)
tom's wGal
..,.
any circumstancesand events that would make a difference to the users of the financial statements. Look at the notes in the financial statementsof Staplesin the appendix of the book. The notes are longer than the statements!As you gain an understandingof the comyou will seethe plexity of the choices accountantsmake in preparing financial statements, need for notes to give the financial statementusersinformation about those choices.
Assets
Looking at the balancesheetat February 28,2006, for Tom's Wear,Exhibit 2.7, you seeon the left the company's assets,also referred to as economic resources.According to GAAP, assetsare those items of value that belong to or are controlled by the company.They are on the balance sheet as a result of past transactions,but they do have value, which they will provide in the future when they will be used to help the businessproduce revenue. The first asseton Tom's Wear's balancesheetis cash.The amount hasbeen determined by past transactions,and the money has value becauseof what it can buy in the future. Other common assetsinclude accountsreceivable(amountsowed to the company by customers) and inventory (items purchasedfor sale).The last assetshown is prepaid insurance.This is the unusedportion of the insurance-it still has value on February 28. Assetsare listed on the balancesheetin order ofliquidity. Liquidity refers to how easily an assetcan be convertedinto cash.The assets that are expectedto be usedwithin a year are called current assets. The assets that will not be used within a year are called Look noncurrent assets,or long-term assets.So far, Tom's Wear has only current assets. at the balance sheet of Home Depot Inc. in Exhibit 2.9. The assetsection of the balance sheetshowsboth current and long-term assets. Assetsare one of three classificationsof items on the balancesheet.The other two classifications tell who-creditors or owners-has claim to these assets.Recall, the balance sheetis essentiallythe accounting equation: Assets = Liabilities * Shareholders' equity
Assetsare the economic resources owned or controlled by a company, resultingfrom oasttransactions.
Liquidityis a measure how of can be easilyan asset converted cash. to The more liquid an assetis,the more easilyit can be turned into cash. Current assetsare the assets the companyplansto turn into cashor useto generate revenuein the next fiscalvear. Noncurrent assets,or longthat term assets,are assets will lastfor more than a year.
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Jantaty29,
JanuaryS0,
2006
2005
Assets Currentassets:
Cash and cash equivalents Short-term investments Receivables,net Merchandise inventories
..........
506 1,659 1,499 10,076 533 14,273 6,932 12,325 6, 195 1, 191 I,404 390 28,437
Costin excess ofthe fairvalue ofnet assets acquired Otherassets Total assets
Liabilities and Stockholder's Equity Cument liabilities: Shor t - t er m de b t Accounts payable Accrued salaries and related expenses Salestaxespayable . . .. . Deferred revenue Income taxes payable Current installments of long-term debt Other accrued e4genses Total current liabilities Long-term debt, excluding current installments Other long-term liabilities Deferred income taxes
7,924 14,056 7,O73 L,207 843 427 31,530 6,629 24,901 348 3,286 .. 601 .... $ 44,482
5,7rr
22,726 369 r,394 258
$ 39,020
............
900 6,032 1,L76 488 L,767 388 6rB 1,647 12,901 2,672 977 1,023
Stockholder's Equity Common stock, par value $0.05;authorized: 10,000shares; issued 2,401 shares at January 29,2006 and 2,385 shares at January 30, 2005; outstanding 2,724shares at January 29, 2006and 2,185 shares at January 30, 2005 L20 Paid-in capital 7,287 Retained earnings 28,943 Accumulated other comprehensive income 409 (138) Unearned compensation Theasurystock, at cost,277 shares at January 29, 2006 and 200 shares at January 30, 2005 (9,7t2) Total stockholder's equity Total liabiHties and stockholder's equity 26,909 $ 44,482
...
$ 39,020
O S C H A P T E2 . E L E M E N T S F T H E F I N A N C I A L T A T E M E N T S R
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tiabilities
The January2,2006, balancesheet,shown in Exhibit 1.6, indicated that Tom's Wear owed $500 to Tom's mom. On February 28,2006, that is no longer the case.The debt was paid off in January.On February 28,2006, the only liabilities Tom's Wear has are accountspayable and other payables.Liabilities are amountsthat the businessowes. They are the claims of are creditors.Usually, theseclaims will be paid to creditorsin cash.Liabilities, like assets, the items on credit creresult of pastffansactions events.For example,a purchaseof inventory or atesa liability called accounts payable.The balancesheeton February28,2006 was prepared after the purchaseof the shirts but before Tom paid for them, so the balancesheetshowsthe cost ofthe shirts as accountspayable.Once incurred, a liability continuesas an obligation of the companyuntil the companypays for it. The accountspayableamountfor the T:shirts remains on the balancesheetuntil Tom pays the bill for the shirts.Often, liabilities involve interest-payment of an additional amount for the right to delay payment.When Tom's Wear repaid Tom's mom in January, paid $5 interestfor the use of her money. he Liabilities can also be cunent or noncurrent.If a liability will be settled with a current you can think about a current liasset,it is called a current tiability. For practical purposes, ability as a liability that will be paid off in the next year. Noncurrent liabilities, or longterm liabilities, will be paid off over a period longer than one year. Most balance sheets show a subtotalfor current assetsand a subtotalfor current liabilities. That format is called a classified balance sheet.Look at the balancesheetfor Home Depot, shown in Exhibit 2.9. Seeif you can find the subtotalsfor current assetsand current liabilities. This is a classified balance sheet becauseit has two classifications of assetsand liabilities-short term and lone term.
Liabilities obligations are the companyhas incurredto obtain the assets has it acouired.
Currentliabilities are l i a b i l i t i e sh e c o m p a n yw i l l t settle-pay off-in the next fiscalyear. Noncurrentliabilities, longor term liabilities,are liabilities t h a t w i l l t a k e l o n g e rt h a n a year to settle. A classifiedbalancesheet showsa subtotalfor many items,includingcurrentassets and current liabilities.
asset? anda long-term 1. What isthe difference a asset between current 2. What is a classified balance sheet? Shareholders' Equity
Shareholders'equity is the of is Shareholderst equity, sometimes called net assets, the owners'claims to the assets t n a m ef o r o w n e r s 'c l a i m so company.The first way is the company.There are two ways owners can createequity in a the assets the firm. lt of the capital is cash, but it by making capital contributions-contributed capital. Usually, includes both contributed could be equipment or other items of value. When Tom startedhis T-shitt business,he incapitaland retainedearnings. vested $5,000 of his own money. Sometimes this is called the owner's investment in the company.The term investmentmay be confused with investmentsthat the company itself Contributed capital, calledpaid-in makes with its extra cash. For example, General Motors may invest some of its extra cash sometimes capital,is the amount the in the stock of Google, which GeneralMotors would call an investment.To avoid that conownershave put into the fusion, we will refer to owners' investmentsin the firm as capital contributions. business. The secondway to createequity in a businessis to make a profit. (That is the preferred Tom's equity in the way.) When Tom's Wear sells a shirt, the profit from that shirt increases reduce shareholders'equity; company.Revenues expenses increaseshareholders'equity; and dividends, when declared,reduce shareholders'equity. on In corporations,the two types of equity are separated the balancesheet.The first is Retained earningsis capital contributed capital, also known as paid-in capital; the secondis retained earnings. In a sole proprietorship or partnership,both types of equity are together called capital. Separat- the companyhasearnedand has not been distributedas ing these amounts for corporationsprovides information for potential investorsabout how dividends. much the owners have actually investedin the corporation.
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assetsare listed in order of their liquidity-how easily they can be converted to cash. A monetary value is computedfor eachasset.Cash,for example,is the total amount of money in checking and savingsaccounts.The next assetcould be short-term investments,onesthe company can easily sell for cash at any time. The next asseton the balancesheetis usually accountsreceivable-the total amount that customersowe the company for credit sales.Inventory is another asset,measuredat its cost. We saw that Tom's Wear's balance sheetincluded the cost of the T-shirts still in the inventory on the balance sheetdate. Earlier you learnedtwo characteristicsof the way things are measuredfor the financial statements. First, they are measuredin monetary units. For us, that means dollars. For example, the actual number of T-shirts in the inventory is not shown on the balancesheet;only the cost of the inventory is shown. Second, the items on the financial statementsare recorded at historical cost-what the company paid for them. They are not recorded at the amount the company hopes to sell them for. Some assetscontinue to be shown at cost on the balancesheet,and others are revaluedto a more current amount for eachbalancesheet. You will learn the details of which assetsare revalued and which assetsare not revalued in the chaptersto come.
Recognizedrevenue is revenuethat has been recordedso that it will show up on the incomestatement. The revenue-recognition principlesays that revenue shouldbe recognized when it is earnedand collectionis reasonably assured.
The matching principle says that expenses shouldbe recognized-shownon the incomestatement-i n the sameperiod asthe revenue they helpedgenerate.
Recognizing Revenue and Expenses. When shouldrevenuebe included on an income statement?GAAP says when it is earned,that is when revenue is recognized-meaning that is when revenueis included on the income statement.When Tom delivers a shirt to a customer,Tom's Wear has earnedthe revenue.This is called the revenue-recognition principle. When one of Tom's friends sayshe is going to buy a T-shirt next week, no revenueis recognized.When an exchangeactually takes place, or when the earningsprocessis complete or "virtually complete," that is the time for revenuerecognition. When Tom's Wear and a customer exchangethe cash and the T-shirt, there is no doubt the transactionis complete. However, even when Tom's Wear only delivers the T-shirt and the customeragreesto pay for it later (the sale is on credit), the company will consider the earningsprocessvirtually complete.Tom's Wear has done its part, so the saleis included on the income statement. What about expenses? When an expenseis recognized dependson when the revenue that results from that expenseis recognized.Expensesare recognized-included on the income statement-when the revenuethey were incurred to generateis recognized.This is called the matching principle, and it is the basis of the income statement.Expensesare matched with the revenue they helped to generate.An example is the cost of goods sold. Only the cost of the T-shirts sold is recognized-included as an expenseon the income statement.The expenseis matched with the revenuefrom the sale of those shirts. The cost of the unsold T-shirts is not an expense-and will not be an expense-until those shirts are sold. An expenseis a cost that has beenusedto generaterevenue.If a cost hasbeenincurred but it has not beenusedup, it is classifiedas an assetuntil it is used.Prepaidinsurance is an exampleof a cost that is classifiedas an asset until it is used;and when it is used,it becomes lnsuranceexpense. Must the customer actually pay the company in cash before a sale can be counted as revenue?No. Notice that the salesof all the shirts areincluded in the salestotal, eventhough 15 of the shirts have not been paid for yet. When a customer purchasesan item on credit, the earnings processis consideredvirtually complete, even though the cash has not been collected. Similarly, a cost incurred in the generationofrevenue need not be paid to be included on the income statement.In calculating the revenue and exoensesfor an income
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Accounting information matters! really Mills Corporation, a shopping-mall real-estate investment practices, trust,disclosed the SEC that wasinvestigating accounting its inrevenue. analyst Banc Americas cluding waythe firm recognizes the An for of Securities downgraded shares "sell" Mills to status because announcement the suggested the firm overbooked revenue mayhaveunderstated and expenses. Whathappened? The price firm's share dropped 12%. by
2 o C H A P TE R E LE ME N TS TH EF I N A N C I A L T A T E M E N T S OF S statement,accountantsdo not follow the cash. Instead, they use the time when the "economic substance"of the transactionis complete. Accountants use the expressionsvirtually complete and economic substanceto describe the sameidea-that a transactiondoesnot need to be technically complete to recogrize the resulting revenue. If the transaction is substantially complete, the revenue is recognized. When Tom's Wear sells the T-shirts, delivering them and receiving the customers' promise to pay is consideredthe economic substance that transaction.Cash may of come before the transactionis complete or it may come afterward. This way of accounting for revenuesand expenses-using the economic substanceof the transactionto determine when to include it on the income statementinsteadof using the exchangeof cash-is called accrual accounting. When to recognizerevenueis easyfor somebusinesses extremely diffrcult for othand ers. There is a lot of disagreementamong accountantsabout the timing of revenuerecognition. They agree that revenue should be recognized when the revenue has actually been earnedand it is reasonableto assumethe customer will pay. That is, the transactionis virtually complete. But they often cannot agreeon exactly when that has happened.This is an important topic that is regularly debated in the financial community. Unfortunately, improper revenuerecognition has causedseriousproblems for many companies.Many of the accounting scandalswith the earningsreported by major corporationsin the last few years are related to revenuerecognition. Exhibit 2.10 summarizes principles, and constraintsof accounting the assumptions, information.
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Accrualaccountingrefersto the way we recognize revenues ano expenses, Accountantsdo not rely on the exchange cashto determine of the timing of revenue recognition. Firms recognize revenue when it is earnedand expenses when they are incurred-no matter when the cashis receivedor disbursed. Accrual accounting followsthe matchingprinciple.
EXFIIBIT 2.10
Principles:
F\rll-disclosure principle
Constraints:
Materiality
Conservatism
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Vour Turn2-s
Give an example of the matching principlefrom the income statement for Tom'sWear for February.
[.,.{}.;$ D efine ac c r ual c o u n ti n g , Accrual ac Accounting Basis e xplainhow it di ffe rsfro m in The term accrual basisaccountlngincludestwo kinds of transactions which the exchange ca s hbas is c oun ti n ga n d ac , of of cashdoesnot coincide with the economic substance the transaction.The revenuesand i dent if yex am ple s f a c c ru a l o expenses recognizedat a time other than the time when the cashis collectedor paid. are a c c ount ing ac tu a l on One kind of accrual basis transaction is an accrual and the other is a deferral. The fi n anc ial t at em e n ts . s is meaningof eachkind of accrualbasistransaction shownin Exhibit 2.11. When the actioncomesbeforethe cash ,itis an accrual.WhenTom'sWearmadea credit An accrual transactionis one To In sale,it was an accrualtransaction. accruemeansto "build up" or "accumulate." acin which the revenueis or eventhoughthe cashhasnot beenexcounting,we arebuildingup our sales our expenses earnedor the exoense is incurredbefore the exchanqe changed.The sale is completed first-merchandise is delivered to the customer-and the of cash. cash payment will come later. Instead of receiving the assetcash from the purchaser,the company records an asset called accounts receivable-meaning cash due from the purA deferral transaction is one Because Accounts receivableis the amount owed to the companyby customers. chaser. in which the exchange cash of part ofthe transactionfor recording the GAAP is basedon accrualaccounting,the necessary placebeforethe takes revenueis earnedor the revenueis the actual sale of goods or services,not the cashreceipt from the customers. expense incurred. When the dollars come before the action, it is called a defenal. When Tom's Wear paid purchase-as we all pay insurance premiumsup front, it for the insurance, was an advance not after the expiration date of the policy. But the amount paid for the insurance was not in until it was actuallyused.To defer something, commonlanguage, considered expense an meansto put it off-to delay or postponeit. In the languageof accounting,a deferral means that the company will postponerecognizing the expenseuntil the insuranceis actually used. When Tom's Wear paid the cashin advanceof the period coveredby the insurance,the company recorded the cash disbursement.In other words, Tom's Wear recorded it in the busiwas not recognizedwhen nessrecordsas cashthat had been spent.However,the expense the cashwas paid. It will be recognized-and remember,that meansincluded on the income statement-when the cost is actually used.
ffiH&{flffi$T { R.S
I AccrualAccounting :
AccrualAccounting
Accrual accounting involves both accrualsand deferrals. Action...* r First Dollars Later
C H A P T E2 . A C C R U A L S N D D E F E R R A L S R A
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2.'I2 : EXFIIBIT
1t1/06 Balance
12t31/06 Balance
12131107 Balance
12/31108 Balance
12t31/09 Balance
sneet \
l/
sheet \
ft
Income Statement for the Year Ended 12t31t07
sheet \
l/
Income Statement fortheYear Ended 12t31t08
sheer \
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sneet
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period of time. A company may construct weekly, monthly, quarterly, or annual hnancial Many companiespreparemonthly and quarterly financial statements;all comstatements. paniesprepare annual financial statements. The income statementfor a speciltc year gives the revenuesand expensesfor that year. It gives information about how the balance sheet has changedbetween the beginning of the year and the end of the year. The revenuesinreduceowners'claims.If the differencebetweenrevenues crease owners'claims;expenses is and expenses positive-if revenuesare greaterthan expenses-the company has a net inare come. Ifthe expenses greaterthan revenues,the companyhas a net loss. The net income or net loss is sometimescalled the bottom line.
Financ ial t at em e n ts s provide information about the risk relatedto i n v es t ing a c omp a n y . in W illy ou get a go o d re tu rn on your investment? How l o ng will it t ak e?
C H A P TE R A C C R U A LS D D E FE R R A LS 67 2 o AN Still, the information on thesetwo financial statements, matter how relevant to the no bank's evaluation, would not be enough. Another piece of the puzzle is the way the company managesits cash.A company may have little debt and lots of earning potential. However, if the company does not have enough cash, the loan payments cannot be made. Becausecashcollection is the bank's primary concern, the statementof cashflows provides additional information for the bank.
E X F I I E I2 . 1 3 T
Clean Sweep or Maids-R-Us Balance Sheet AtJanuary L,2007 Beginning Balance Sheet for Clean Sweep and Maids-R-Us
At the beginning of the month, both companieshave the same balancesheet. Assets Cash Supplies Totalassets Liabilities No tespa ya ble Owner's equity Owner, Capital Totalliabilities andowner'sequrff . ..... .. .. ..... 900 200 $1,100 $ $ 400
.....
700 $ 1,100
EXFIIBIT 2.14
BothCleanSweep and Maids-R-Us 1. Clean houses 10 for a fee of $75 perhouse.
Clean Sweep Maids-R-Us
Agreesto extendcredit to the customers. Fees will be collected after 30 days, Paysonly $100 of the loan plus $40 interest.
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* Balance Sheet
have earnedthe sameamount of revenue,so eachwill show $750 revenueon its income statementfor the month. Transaction 2: Each company makes a loan payment. Clean Sweep pays the entire amount of the note payable, $400, plus interestof $40. Maids-R-Us pays only $ 100 of principal on the note payable,plus interestof $40. The only expensein this transof action is the interestexpense $40. Both companieshaveincurred the sameamount of interestexpense,so eachwill show $40 interestexpenseon its income statement. The repaymentof the principal of a loan doesnot affect the income statement.
C H A P T E2 . A C C R U A L S N D D E F E R R A L S R A
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EXHIBIT2.16 Clean Sweep or Maids-R-Us Income Statement For the Month Ended January 31,2007 Income Statement for Clean Sweep and Maids-R-Us January for
Look back at Exhibit 2.15 to the accounting equation worksheet, where you will seethe transactionsin the red boxed atea are the same for both companies. That meanstheir income statementsare identical.
Adjustment: At the end of the period, each company will record supplies expenseof $ 175,leaving $25 as supplieson hand on the January3 1 balancesheet,Both income statements will show suppliesexpense $175. of We can construct an income statementfor each company from the numbersin the redboxed areain Exhibit 2.15. Revenues the month of JanuaryErmounted $750; expenses for to were $215; so net income was $535. This is the case for both companies,as shown in Exhibit 2.l6.Even though one company extendedcredit to its customersand the other collected cash for its services,the income statementsare identical. The income statementis only concernedwith revenuesearnedand expenses incurred, not with the timing of the related cash flows. The balancesheetat January31 for each company can be constructedby simply organizing the details of the ending balancesof the accounting equation for each company in Exhibit 2.15. For a sole proprietorship, all owner's equity-contributed and earned-is added together and called owner's capital. The two balance sheetsare shown in Exhibit 2.17. Notice the differences.Assets and liabilities are different for the two comoanies.but the owner's equity amounts are the same.
$ 1 ,2 1 0 zt)
$1,235
Capital,Brown .....
$ 1 ,2 3 5
Clean Sweep Statement of Cash Flows For the Month Ended January 31,2007
Maids-R-Us Statement of Cash Flows For the Month Ended January 31,2007
Cash from operating activities Cash collected from customers Cash paid for interest Net cash from operations Cash from investing activities Cash from financing activities Re pa yme nto f loan ...... Ne tca sh fromfin anc ing Ne tincrea se incas h
Cash from operating activities Cash paid for interest Net cash from operations Cash from investing activities
$ (40) 0
(100) ....... .. ... .
.....
(100) $ (140)
It is important to understandwhy both companieshavethe sameamount of owner's equity. Both had beginning equity of $700 plus net income for the month of $535, for a total of $1,235.That is the number you find on the January 31 balance sheetfor owner's equity. does not affect owner's equity. The timing of cash receipts and disbursements Finally, look at the statementof cash flows. As you have seen,the cash receipts and disbursementsfor the two companies were not the same. This shows up clearly on the statementof cash flows. The cash flow statementfor each company shows all the cash received and all the cash disbursed for the month. The cash flow statementsare shown in Exhibit 2.18.
differ recognized the income on statement how the revenues 1. Explain shown on the statementof cashflows. from the revenues 20o/o which is in revenue, of earns$50,000 sales a 2. Suppose company will be shown on the pe' providedon acount. How muchrevenue How muchwill be shown on the period's riod'sincomestatement? will be included the in of statement cashflows?How muchrevenue balance sheet? total on the end-of-the-period retained earnings Statements of Putting lt All Together-the Objectives Financial
Financial information should be useful. What makesit useful is the way the transactionsof the businessare organizedinto the four basic financial statements:
C H A P T E2 . A C C R U A L S N D D E F E R R A L S R A
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. Take advantage purchase of discounts special and offers. o Plan purchases, equipment repairs, replacements. and . Beprepared anyfinancing mayneed pefor you in riodsof cashshortages-short-term creditlines, small loans, long-term or debt. Fora newor growing business, accurate flow cash projections makethe difference can between success andfarlure. an ongoing For good business, cash budgetingcan makethe difference between moving forwardandstanding still. How do you prepare cashflow projectionT a According the Women Business to preparing s Center, a projectionlike preparing cash is a budget balancing and yourcheckbook the same you at time,First, estimate yourcash inflows. primarily sales. Cash generated is by But in manybusinesses, of the sales on acsome are (charge count accounts, term payments, layaway, and tradecredit). you mustestimate So whenthosecredit will sales turn intoactual cash inflows. you Then, estiyou mate thecash all disbursements need make to and whenyouneed make to them. The goal of cash budgeting to alwayshave is yourbusiness enough cash keep to running smoothly. lf it turnsout that you havemorecashthan you need, then you mustfigureout how bestto usethat extra cash-howto invest Thatisa cash it. flow problem that youdefinitely want!
. Makesure you have enough cash purchase to sufficient inventory planned for sales.
The ongoing life of a businessis broken into discreteperiods so that performancecan be evaluatedfor a specific period. For our cleaning businessexamples,the period is a month. Income is measuredin a way that capturesthe economic substance earning revof enue and incurring expenses; is not basedon cashcollectionsand cashdisbursements. it Notice, the net incomes for Maids-R-Us and Clean Sweep for January are exactly the same,in spite of the differencesin when the cashis collected and disbursed.Those timing differencesare reflected on the balancesheetby the differencesin cash and both receivables and payables; and differences are also shown on the statement of cash flows-the statement that provides the details of the timing of cash receipts and
72
have been designedto be relevant,reliable, consisThe four statements disbursements. tent, and comparable. In addition to these qualities, accounting information relies on the basic assumptions and principles we discussedearlier, shown in Exhibit 2.10. We can relate each of the assumptions and principles to the financial statementsof Maids-R-Us. . The separate-entity assumptionmeansthat only the businesstransactionsof Maids-RUs are shown in the financial statements-none of the owner's personal transactions are included. . The going-concernassumptionmeanswe may assumethat Maids-R-Us is an ongoing, viable business.According to GAAP, if it were not ongoing, the company would need to have all its assetsappraisedand listed at liquidation value. . The monetary-unit assumptionmeanseverything shown on the financial statementsis measuredin monetary units, here dollars. . The historical-cost principle meansthe items on the financial statementsare valued at cost. For example, the supplies on the balance sheetare not valued at what they might be worth if resold or at the current cost, which might be higher than the amount that Maids-R-Us paid for them. They are valued at the price Maids-R-Us paid when they were purchased. . The revenue-recognitionprinciple means the revenue on the income statementhas been earned.The related cash may not have been collected, but the work of earning it has been completed and collection of the receivablesis reasonablyassured. . The matching principle meansrelatedrevenuesand expenses should be on the sameincome statement.Only the supplies that are used to earn the revenueduring the period The unusedsuppliesare reported on the balancesheet are countedas suppliesexpense. until they are actually used. Accrual accounting is an accounting system in which the measurementof income is not Instead,revenueis included in the calculabasedon cashreceipts and cash disbursements. are tion of income when it is earned,and expenses included as they are matchedto revenue. Timing differences between the economic substanceof a transaction and the related cash flows do not affect income. That is why both companieshave the same net income even though the timing of the cash flows is different.
C H A P T E2 . A C C R U A L S N D D E F E R R A L S R A
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EXHtBtT2.19 Polo Ralph Lauren Consolidated Balance Sheets BalanceSheet of Polo Ralph Lauren Corporation
Compare the balance sheetof PoIo to that of Tom's Wear. See how many similarities you can find.
April2, 2005
(Dollars in thousmds, except share data)
............
$ 350,485$
352,335
455,682 44r,724 430,082 373,170 74,821 2t,565 102,693 99,357 1,413,763 l,2g7,r5r 487,894 409,74L 35,973 65,542 558,858 341,603 46,991 17,640 183,190 L76,875 $ 2,726,669 $ 2,297,552
$ 184,394 $ 188,919 72,L48 77,736 1,82t 365,868 236,724 622,4t0 505,200 290,960 r37,59r 277,345 99,560
Stockholders' Equity Common stock Class A, par value $0.01per share; 500,000,000 shares authorized: 64,016,034 and 61,498,183 shares issued and outstanding 652 Class B, par value $0.01per share; 100,000,000 shares authorized: 43,280,02I shares issued and outstandinA 433 Additional paid-in-capital 664,279 Retained earnings 1,090,310 Theasurystock, Class A, at cost (4,177,600and 4,145,800shares) (80,027) Accumulated other comprehensive income 29,973 Unearnedcompensation (2g,gL2) .. Total stockholders' equity 1,6?5,?08 Totalliabilitiesandstockholders'equity ....... $ 2,726,669
g._?zelw_
Seeaccom4tanging Notesto Consolid,ated Financi,alStatem,ents. Also, there are two balance sheetsshown, which you will recall are called comparative balance sheets.Take notice of the dates of the balance sheets.This financial statement shows the financial position of the company at a single point in time. For Polo Ralph Lauren Corporation, the last day of the fiscal year is the Saturdaynearestto March 3 1, information disclosed in the notes to the financial staremenrs.
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{,.s.5
C om put eand ex p l a i nth e meaningof t he c u rre n t ratio.
Currentratio is a liquidity ratio that measures firm's a abilityto meet its short-term obligations.
r".t)"6
ldentify the risksand potential frauds relatedto financ ialac c ou n ti n g records, and explainthe controlsneededto ensure their accuracy.
C H A P T E 2 . B U S I N E S S I S K .C O N T R O L A N D E T H I C S R R ,
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EXHIBIT2.20
Controls
I Fix the errors!
1 l
Example of a control: Use passwords so that only authorized users can enter data in the accounting system.
Example of a control: Reconcile the company bank statement each month with the accounting records.
Example ofa control: Have the company accounta.nt review the accounting records and make corrections at the end of each month.
76
I I I I
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Associates International hasbeenin the news Inc.) knownasComputer CA (previously guilty plea years. recent was Kumar's for several A development former CEO Sanjay for in for Newfifraudandobstruction justice 2006.Unfortunately CA,thereis more. of to woes,according IAe Wall Street S, are nancial accounting Journol(June2006), the "holes internal The in controls." firmsaccounting system allegedly result of allowed people geta commission a single from sale. multiple to
Detective Controls. Detective controls are those that help a company find errors. For example, at the end of every work day, a cashierat Targetwill count the money,ATM receipts, and credit card receipts in his or her drawer and comparethe total to the total salesentered in the computer.This control will help Target find errors in its salesand receipts. Once the errors are found, they must be corrected. Corrective Controls. Corrective controls are policies and proceduresthat correct any errors that have been discovered.Tiargethas a policy for handling cash shortages-perhaps the cashier must make up any shortage. As you learn more about accounting, you will see examples of preventive, detective, and corrective controls. Keep in mind that to be effective, a systemof internal control must rely on the people who perform the duties assignedto them. An internal control system is only as effective as the people who executeit. Human error, collusion-two or more people working togetherto circumvent a policy or procedure-and changing conditions can all weaken a system of internal control.
C H A P T E2 . C H A P T E R U M M A R Y P R O B L E M S R S
77
lnstructions
1. Set up an accounting equation worksheet like the one in Exhibit2.4 and record each transaction on the worksheet. (Record the equipment purchaseas an assetand ignore the fact that the equipment was probably used during the year.We will get to that topic on in a later chapter. Also, ignore interestexpense the bank note.) 2. Prcparethe four basic financial statementsfrom the worksheet. Solution (dollarsin millions)
Liabilities
Contributed Capital
Retained
E*r,lnfl:
' ';,
Cash I
Supplies
Accounts Notes r Common tt Payable Payable r Stock - Revenues Expenses Dividends I I 250 850
2
o
(3001
6
800 (480
7
8
(51
440 950 = Assets $1,410 20 20 850 250 800 (505)
(5)
Check:
From the accounting equation worksheet, you can prepare the hnancial statements.Start In with the income statement. The red squareindicatesthe revenuesand expenses. this case, it is a very condensedincome statement.That is, the company would have many types of revenueaccountsand many more expenseaccountsin its internal recordkeeping:
Contributed Capital: Beginningbalance,common stock Common stock issued Ending balance,common stock RetainedEamings: Beginningbalance + Net income - Dividends Ending balance TotalShareholders'Equity
.....
$540
The balance sheet is the next statementthat you prepare. Notice that revenues,expenses,and dividends arenot shown on the balancesheet.Those amountshavebeen folded into the retained earningsbalance.
Assets Cash . Supplies Property, plant, & equipment Total assets Liabilities & Shareholders' Equity Liabilities Accounts payable Note payable Shareholders' equity Contributed capital Retainedeamings Total liabilities and shareholders' equity
The $ 440 .--------+ change in cash from the begirming of the year 20 (0 in this example) to the 950 amount on the year-end 1,410 $ balancesheet ($a40)will be explainedbythe statement of cash flows.
20 850
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T C H A P TE R 2C H A P TES U M M A R Y P R O B L E M S R Finally, you preparethe statementof cashflows. To do this, go down the list of transactions in the cashcolumn of the worksheetand identify eachas cashfrom operatingactivities, cash from investing activities, or cash from financing activities. . All cashcollected from customersand all cashpaid for the expenses run the day-toto day operationsof the firm are cashflows from operations.For SW2, theseare (4) cash paid for operating expenses,(6) cash collected from customers,and (7) cash paid to employeesfor salaries. . All cashpaid for land and equipment (assets that last longer than a year) are cashflows from investing activities. For SW2, these are (3) purchaseof land and (5) purchaseof equipment. . All cashusedto finance the business-from owners and long-term creditors-are cash flows from financing activities. For SW2, theseare (1) issueof stock, (2) receipt of proceedsfrom loan, and (9) payment of dividends to shareholders. Notice that Transaction 8, purchasesupplies on account, does not affect the statementof cash flows. Why not? No cash is involved in the transaction.When the cash is paid in the next yea.r, will be an operating cash flow. it
SW2 Company Statement of Cash Flows For the Period Ended June 30
( in mi l l i ons )
Cash from operating activities: Cashcolle c t edf r om c us t om er s Cash paid for operating expenses Cash paid to employees Cash from investing activities: Cash paid for land Cash paid for equipment Cash from financing activities: Cash from common stock issued Cash proceeds from loan Cash paid for dividends Increase in cash Add beginning cash balance Ending cash balance
....,...
$ 295
(e50)
" " '" " " " I r This is the r cashbalance 440 r found on the l 6 $ 440 *l balance 1,095
st l ccl ,.
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(p.6s)
balance sheet Classified (p.61) 61) Contributed capital(p. (p. Current assets 59) (p. liabilities 61) Current Current rut\o(p.74) (p.64) Deferral
(p . s 2 )
Time-period assumption (p. 53)
(p.sz)
YourTurn2-2
is L. The purposeof financial statements to provide information useful for decisionmaking. 2. Useful information is relevant, reliable, comparable,and consistent.
YourTurn2-3
Prepaid insuranceis an assetuntil the time to which the policy applies has expired. Then, it becomesan expense.
Your Turn2-4
1. A current assetis one that is expectedto be convertedto cash or used in the next year. A long-term assetis one that is expectedto last longer than a year. 2. A classified balance sheetis one that has subtotalsfor both current assetsand current liabilities.
YourTurn 2-5
The cost of the T-shirts An exampleof the matchingprinciple is cost of goodssold with sales. as sold is put on the sameincome statement the salesrevenuefrom the saleof thoseshirts.
YourTurn2-6
The difference between cash basis and accrual basis accounting is the timing of recognizCashbasis accountingrecognizesrevenuewhen the cashis coling revenuesand expenses. when cashis disbursed.In accrual accounting,revenuesarerecognized lected and expenses in the period in which they are earned (by the completion of the work) and expensesare matched to the revenuesthey help create.
YourTurn2-7
1. On the income statement,the revenuesearnedare shown. (That is called recognizing the revenue.)On the statementof cash flows, only the amount of cash collected from customersis included.
C H A P TE R MU LTIP LE -C H OIC E S TIONS 81 2 . QU E 2. If a company earns $50,000 worth of revenue, then all of that will be recognizedincluded on the income statement.The amount of cash collected is given as 80%, so $40,000 would be shown on the statementof cash flows as cash collected from customers. The entire amount, $50,000, will be in the retained earningsbalance because the retained earninss increaseis the amount that is on the income statement.
Questions
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. L8. 19. 20. What is GAAP? Name the four characteristicsthat help make accounting information useful. What is the separate-entity assumption? a be Why would the going-concem assumption importantto a bank giving a business loan? Explain materiality and give an example of both a material and an immaterial item. What are the four basic financial statements? Which financial statementpertains to a single moment in time? What is a current asset? What is a current liability? What are the two ways that equity is generatedin a business? What doesthe income statementreport about a hrm? Name the types of accountsthat appearon the income statement. What is the purpose of the statementof cash flows? How are the cash flows categorized? What is the signifrcanceof classifying cash flows into thesecategories? What is the full-disclosure principle? What doesrecognizerevenuemean in accounting? What is the matching principle? What is an accrual?What is a deferral? Must a company collect the money from a sale before the sale can be recognized? What is the cost of goodssold? Explain the differencebetweencashbasisaccountingand accrualbasisaccounting. How is the curuentratio computed?What does it tell us about a company? Define internal control and explain why it is important.
Multiple-Choice Questions
1. Ifrevenue exceeds expenses a given period, for a. Total assetsfor the period will decrease. b. Cash for the period will increase. c. The income statement will report net income. d. Liabilities for the period will decrease. 2. The matching principle is best describedas the processof a. Matching assetsto liabilities and owners' equity. revenue. b. Recognizinga cost asan expense the periodin which it is usedto generate in c. Matching cashcollectionsto revenue. d. Matching income to owners'equity. 3. Which of the following would never appearon a company's income statement? a. Prepaid insurance b. Cost of goodssold c. Interest expense d. Salesrevenue 4. Which of the following statementsis consistentwith accrual basis accounting? a. Revenuesare recordedwhen cash is received. b. Expensesare recorded when cash is paid. c. Expensesare recorded in a different period than the related revenue. d. Revenuesare recorded when earnedand expenses matched with the revenues. are 5. Salesrevenueis most often recognizedin the period in which a. The customer agreesto purchasethe merchandise. b. The seller agreesto sell the merchandiseto the customer at a specifredprice. c. The seller collects cash from the customer. d. The seller delivers the merchandiseto the customer.
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CHA P T E]R O Q U AL IT IE SFAC C OU N T IN G FOR MA TION O IN 6. Which of the following is an example of a financing cash outflow? a. Borrowing money from a bank by signing a long-term note payable b. Financingthe purchase a new factory by issuingnew shares stock of of c. Paying a cash dividend to stockholders 7. How are financial assetsreoorted in the balancesheet? a. Chronologically
r: ,
3 #iilJ3?l#rheir riquidity
d. In the order oftheir relative values 8. Which of the following financial statementelementsare found on the balance sheet? a. Insuranceexpense b. Retained earnings c. Salesrevenue d. All of the above 9. A company'scurrentratio is 1.85.You can safelyconcludethat a. The companyis a good investment. b. The company will have no trouble paying its current obligations. c. The company has a short-term problem related to paying its bills. d. The company has a long-term problem related to meetingsits obligations. 10. Which of the following is not a type of internal control? a. Preventive b. Corrective c. Collusion d. Detective
ShortExercises
Give the accountingprinciple, assumption, SE2-1. Qualitativecharacteristics. constraint, or qualitative characteristicthat is most applicable to each of the following: (LO 1,2) a. Airlines check fuel prices daily to make decisionsabout ticket pricing. b. Personal transactions ofthe owner are separate from business transactions. c. The firm usesthe samedepreciationmethod from period to period. SE2-2. Basic accounting principles and assumptions.Give the accounting principle, assumption, constraint,or qualitative characteristicthat is most applicable to each of the foll o w i n g :(L O 1 ,2 ,3) a. Equipmentis recordedas an assetand expensed over the periodsin which it is used. b. The company preparesfinancial statementsquarterly. c. When rent is purchased advance, is recordedas an asset. in it d. Assetssuchas inventory are valuedin dollars,not units, for the financial statements. SE2-3. Basic accountingprinciples. For each of the following, give the accountingprinci(LO 1,2,3) ple or assumption that is bestdescribed: a. Carlene's Sweet Shop reports revenuewhen it is earnedinsteadof when the cash is collected. b. The land on the balance sheetof Tia's Cotton Fabrics Inc. is valued at what it cost, even though it is worth much more. c. Designer Flowers recognizesdepreciationexpensefor a delivery van over 7 years, the period in which the van is used to help generaterevenuefor the company. d. The owner of Munoz Plumbing thought that it would help the company's balance sheetto include as an assetsome land she and her husbandpersonally own. The accountantrejected this idea. SE2-4. Qualitative characteristics.For each of the following items, explain what it means. Why are these characteristicsimportant? (LO 2) a. Relevant b. Reliable
. C H A P T E R 2 S H O R TE X E R C I S E S
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c. Comparable d. Consistent For eachitem that follows, tell whether it is an SE2-5. Elementsof thefinancial statements. asset,a liability, or a shareholders'equity item. (LO 3) a. Computer b. Prepaid rent c. Retainedearninss d. Notes payable e. Accounts receivable f. Common stock g. Accounts payable h. Cash i. Inventory SE2-6. Elements of thefinancial statements.For each of the following items, give the financial statementon which it would appear.(Hint: some items will appearon more than (LO 3) one financial statement.) Cash Salesrevenue Cost of goodssold Equipment Long-term debt Common stock Accounts receivable Net cash from operations Retainedearnings Net income
SE2-7. Revenuerecognition. SupposeMotor Trend Analysis Inc. performed servicesfor a client on accounton February09, 2008. Motor Trend chargedthe client $3,050.The client paid for half of the serviceson February29,2008. The remaining balancewas paid on for March 5, 2008. How did thesetransactionsaffect Motor Trend's financial statements the month of February and for the balance sheetendedFebruary 29,2008? (LO 3, 4) SE2-8.Accrual accountingversuscashbasisaccounting.Hazel& EugleniaGroceryInc. purchasedinventory in June 2008 for $100,000cashto sell in June and July. The companysold merchandise cost $60,000in Juneand the remainderin July.What is the cost of goodssold that for Juneand for July 2008 if Hazel & EugleniausesGAAP? What is the cost of goodssold for Juneand for July 2008if Hazel & Eugleniausescashbasisaccounting?(LO a) SE2-9. Cash versus credit sales. Suppose two companies are identical except for their credit policy. One company allows cashsalesonly, whereasthe other sells for cashor credit. for Supposethe two companieshavethe samesalesrevenueand expenses the year.The only difference between the two is that the first company has no outstanding accounts(receivable), whereasthe secondhas quite a few still outstandingat year-end.Of the four basic financial statements,which one or ones will be different between these two companies? Explain how and why they are different.(LO 3,4) SE2-10. Computeand explain current ratio. Given the following information, compute the current ratio for the two years shown. Explain the trend in the ratio for both years and what you think it means.(LO 5) F r om balanc e h e e ta t s Currentassets Cur r entliabili ti e s
SE2-11. Identify businessrisks and controls. For each ofthe controls given, tell whether it is primarily a preventivecontrol, a detectivecontrol, or a colrective control. (LO 6) Retro Clothing Inc. has an online purchasesystemthat automatically inserts the total price of each item a customer orders.
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CHA P T E/R o QU AL IT IE S A C C O U N T IN G FOR MA TION IN OF The teller double-checksthe account number on the loan payment before applying payment. External auditors are hired to audit the year-endfinancial statements.
Exercises-Set A
E2-lL. GAAP and the income statement One of your friends starteda businessin 2008. At the end of the first year, December 31, 2008, he preparedthe following income statement. Give three examples from the statementthat indicate the statementwas not prepared accordingto GAAP. (LO 1,3) Sales Inventory purchases Rent for 2008 and 2009 Cash on hand Due from customers Net income
E2-24. Relevanceand reliability. Your car has broken down, so you have decided to look for a replacement.You find an advertisementon the Internet for a used Lexus. When you contact the owner, this is what you find: (LO 2) 1. 2. 3. 4. The car is a 2005 model. The owner sayshe used the car only for driving to and from work. The odometerreadingis 68,759miles. The owner saysthat he had the oil changed every3,000to 5,000miles sincehe bought the car new. 5. The owner saysthis is the best car he has ever owned. 6. The owner will provide a maintenancerecord preparedby a licensed mechanic.
Evaluate each item from the preceding list in terms of its relevanceto the decision about whether to buy this car. Then, evaluateeach item with respectto its reliability. What additional documentationor supporting evidencewould you want for your decision? E2-3A. Elements of the financial statements.The following accounts and balanceswere of taken from the financial statements Brand Names at a Discount Inc. For each item, identify the financial statement(s)on which the item would appear.Then, identify eachbalance a sheetitem as an asset, liability, or a shareholders'equity account.(LO 3) Van Interest receivable Cash Short-term notes payable Net cash from operating activities Building Common stock Retained earnings Net cash from investing activities Interest payable Long-term mortgage payable Salariespayable Net cash from frnancing activities
$s0,000 32,500
78,000 15,875 28,000 31,853 75,000 100,000 40,000 650 85,000 t,3t5 10,000
E2-44. Net income and retained earnings. Marge's SeafoodMarket Inc. reported the following (incomplete) information in its records for 2007: (LO 3) Net income $ 15,000 Sales 105,000 Beginningbalance-retainedearnings 30,000 Cost of goodssold 60,000 Dividendspaid 2,000
CHAPTER2. EXERCISES 85
a. If the salesrevenuegiven is the only revenuefor the year, what were the expensesfor the year other than cost of goods sold? b. What does the beginning balanceof $30,000 for retained earningsmean?Is this useful information for potential investors? c. What is the balanceof retained earnings at the end of 2001? Listed are elementsof the financial statements E2-5A. Elementsof thefinancial statements. discussed this chapter.Match eachelementwith the descriptions(useeachas many times in (LO 3) as necessary). a. Assets b. Liabilities c. Shareholders'equity d. Revenues e. Expenses 1. 2. 3. 4. 5. 6. 7. 8. 9, 1.0. 11. Debts of the company Economic resourceswith future benefit Inflows of assetsfrom delivering or producing goods or services Things of value a company owns ofan entity that remains after deductThe residual interestin the assets ing its liabilities The difference between what the company has and what the company owes The owner's interest in the company Outflows or using up of assetsfrom delivering or producing goods ano servlces Costs that have no future value The amount the company owes Sales
E2-6A. Balance sheetand income statementtransactions.Unisource Company startedthe year with $2,000in cashand common stock.During 2010,the UnisourceCompanyearned receiv$4,600 of revenueon account.The companycollected$4,200 cashfrom accounts paid $2,850 cash for operating expenses. Enter the transactionsinto the accountable and (LO 3,4) ing equation. a. What happenedto total assets(increaseor decreaseand by how much)? b. What is the cashbalanceon December3L,2010? on c. What is the total shareholders'equity December3I,20lO? d. What is net income for the year? E2-7A. Income statementpreporation. Use the following to prepare an income statement for CrenshawConsultants Inc. for the year endedJune30, 2010. (LO 3) Servicerevenues Rent expense Salaryexpense Other operating expenses Administrativeexpenses 554.000 1,000 6,000 24,000 8,500
E2-8A. Classifiedbalance sheetpreparation. The f< December31.2011. financial statements Health i of lions.) Preparea classified balance sheetas of Decem Propertyand equipment Commonstock Long-terminvestments Short-terminvestments Cash Accountsreceivable Inventories $4,776 1 ,9 8 0 3,218 1,689 1,24O 1,200 1 ,1 3 4 Accou 1,200 O th e r noncurrentl i abi l i ti es 10,348 Retainedearnings 554 Other current assets 2,487 Other noncurrentassets Currentportion of long-termdebt 340 870 L o n g - term debt
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E2-9A.. Current ratio. Use the balance sheet you prepared in E2-8A to compute Health Trainers' cuffent ratio at December 31, 20ll. What does it indicate? (LO 5) E2-10A. Current ratio. The following data was taken from the 2008 and 2007 financial statementsof Fancy Fish Stores Inc. Calculate the current ratio for each year. What happenedto the company's liquidity from2007 to 2008? (LO 5) Currentassets Total assets C u rre n tl i a bi l i ti es T o ta l l i a b i li ti es Total shareholders' equity 2008 256,485 433,202 104,195 180,455 252,736 2007 265,960 405,974 101,929 182,093 224,881
E2-11A. Identifi businessrisks and controls. Give two examples of controls that you believe would minimize the risk of errors in the accountins records of SearsInc. (LO 6)
Exercises-Set B
E?-IB. GAAP and the balance sheet.One of your friends starteda businessin 2008. At the end of the first year, December 31, 2008, he prepared the following balance sheet. Give three examplesfrom the statementthat indicate the statementwas not preparedaccording to GAAP. (LO 1,3) Assets Cash Revenues Total assets $ 2,000 1,000 $ 3,000 Li abi l i ti es Notespayable Expenses Total l i abi l i ti es Commonstock Total l i abi l i ti es & sharehol ders' equi ty
$ 1,ooo
1,000 2,000 1,500
$ 3,soo
E2-28. Relevanceand reliability. You have decidedto open a restaurant,so you look around in your area to seeif an establishedrestaurantis for sale.You find an advertisementin the newspaperfor a local sandwich shop for sale.When you contact the owner, this is what you find: (LO 2) 1. The restauranthas been open for 10 years. 2, The owner saysowning the sandwich shop is a lot of fun. 3. The sandwich shop has increasedprofits each year, and the owner can provide financial records. 4. The sandwichshoplocationis downtown. 5. The owner saysthe building housing the restaurant has beenremodeledand brought into compliancewith all codesand regulationsin the past year, and he can provide documentation. 6. The owner saysthe red carpet is the most beautiful carpet ever made. Evaluate each item from the preceding list in terms of its relevanceto the decision about whether to buy this restaurant.Then, evaluateeachitem with respectto its reliability. What additional documentationor supporting evidencewould you want for your decision? E2-38. Elements of the financial statements.The following accounts and balanceswere taken from the financial statementsof Quality ProductsInc. For each item, identify the financial statement(s)on which the item would appear.Then, identify each balance sheet item as an asset, liability, or a shareholders'equity a account.(LO 3) Equipment Accounts receivable Cash Short-term notes payable
C H A P T E2 . E X E R C I S E S 8 7 R
1 :.1 ]".
'l lt"ttl'
Net cash from investing activities Land Common stock Retained earnings Net cash from financins activities Accounts payable Long-term mortgage payable Interest payable Net cash from operating activities
89,300
32,r00
54,000
, sr)n
34,350
F-2-4B.Net income and retained earnings. Manny's Cuban Bistro Inc. reported the following (incomplete) information in its records for 2009: (LO 3) Net income Sales Beginning balance-retained earnings Cost of goodssold Dividendspaid $ 17,850 75,000 20,000 40,000 3,500
a. If the salesrevenuegiven is the only revenuefor the year, what were the expenses the year other than cost ofgoods sold? for b. What does the beginning balanceof $20,000 for retained earningsmean?Is this useful information for potential investors? c. What is the balanceof retained earnings at the end of 2009? Listed are elementsof the financial statements E2-5B. Elementsof thefinancial statements. discussedin this chapter.Match eachelementwith the descriptions(useeachas many times (LO 3) as necessary). A, ASSetS b. Liabilities c. Shareholders' equity d. Revenues e. Expenses f. Retainedearninss g. Common stock l. 2. 3. 4. 5. 6.
1
Note signedwith a bank Rent paid a year in advance Items that make up net income that appearon the income statement Items that appearon the balance sheet A shareof ownership in a corporation Equity that results from doing businessand is kept in the company rather than paid out to stockholders Shareholders'interest in the company Costs of the dailv ooerationsof a business Salariesowed to employees Cost of inventory when it is sold Revenuereceived for servicesnot yet provided Interest received on notes receivable
E2-68. Balance sheetand income statementtransactions.Pet CaterersInc. startedthe year with earned$6,500of revenueon $3,500in cashand common stock.During 2012,the Pet Caterers account.The company collected $5,900 cashfrom accountsreceivableand paid $3, 115 cashfor operatingexpenses. Enter the ffansactions into the accountingequation.QO 3,4) a. What happenedto total assets(increaseor decreaseand by how much)? b. What is the cashbalanceon December3l,2Ol2? c. What is the total shareholders'equity on December 3I,2012? d. What is net income for the year?
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F.2-7B.. Income statement prepardtion. Use the following to preparean income statement for Michael & Trina's Dazzlinglandscape ServiceInc. for the year endedJune30, 2009. (LO 3) Service revenue Rent expense Salary expense Other operating expenses Insuranceexpense
$22,500 1,500
1 ))5
9,850 2,500
E2-88. ClassiJiedbalance sheet preparation. The following items were taken from the December 3I, 2012, f,rnancialstatementsof Calorie Counter Food StoresInc. (Al1 dollars are in thousands.) Preparea classifiedbalancesheetas of December31,2012. (LO 3) L a n da n d b u i l di ng C o m m o ns t ock $S ,A OO Accountspayable 2,104 Other noncurrentl i abi l i ti es Long-terminvestments 2,200 R etai ned earni ngs Other current assets Other noncurrentassets Currentportion of long-termdebt Long-termdebt 1,300 1,140 1,195 5,073 1, 311 6, 450 556 2,300 203 820
E2-98. Current ratio. Use the balance sheet you prepared in E2-88 to compute Calorie CounterFood Stores'currentratio at December31,2012. What doesit indicate?(LO 5) E2-108. Current ratio.The following data was taken from the 2010 and 2009 f,rnancial statements Kitten CaboodleInc. Calculatethe current ratio for eachyear.What happened of to the company's liquidity from 2009 to 2010? (LO 5) Currentassets Total assets C u rre n tl i a b i l i ti es T o ta l l i a b i l i ti es Total shareholders' equity
E2-llB.Identify businessrisksand controls. Give two examplesof controls that you believe would minimize the risk of errors in the accountingrecords of Home Depot Inc. (LO 6) Problems-Set A Pz-lA. Relationshipsbetween financial statementitems. Use the following information for USA Movers Inc. for the yearendedJune30, 2009,to answerthe following questions. Assume that the shareholdersmade no new contributions to the company during the year. (LO 3) 1. 2. 3. 4. 5. 6. 7. Revenues the year endedJune30, 2009 = $350 for Net income for the year endedJune30, 2009 : $l 10 Beginningbalance(June30, 2008, balance)in retainedearnings: $140 Ending balance (June 30, 2009, balance) in retained earnings : $200 Total liabilities and shareholders'equity June 30,2009 : $600 at Total liabilities at June30, 2008 : $60 Total liabilities at June 30. 2009 : $50
Required
a. What were the USA Movers'total expenses during the year endedJune 30,2009? b. What was the amount of the dividends declaredduring the year endedJune 30, 2009? c. What is the total that owners investedin the USA Movers as of June 30,2009? d. What were total assets the company'sJune30, 2008, balancesheet? on
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P2'2A. Analyzing transactions. Results Advertising Inc. enteredinto the following transactions during 2008: (LO 3) 1. ResultsAdvertising Inc. startedas a corporation with a $6,500 cash contribution from the owners in exchangefor common stock. 2. Saleson accountamounted $4,100. to of accountsreceivableamountedto $3,900. 3. Cash collections policy. The for 4. On October 1, 2008,the companypaid $1,800in advance an insurance policy does not go into effect until 2009. Required Put eachof the transactionsin an accountingequation worksheet.Then, answerthe following questions: a. What is the amount of cash flow from operating activities for 2008? b. What amount of total liabilities would appearon the ResultsAdvertising December31,2008, balancesheet? c. What is the amount of contributed capital as of December 31, 2008? d. What amount of net income would appearon the income statementfor the year endedDecember31, 2008? P2-3A. Identify enors using GAAP; prepare a classified balance sheet; and calculate the current ratio. An inexperiencedaccountanthas put together a balance sheetforWings and Things Inc. The balances shown are at June 30,2011. (LO 1, 3, 5)
Assets
CurrentAssets: C as h Accountsreceivable L a nd Supplies Operatingexpenses Total CurrentAssets pay Sa lar ies able Bu ildings Equipm ent In t angible s et s as Total Noncurrentassets Total Assets $ 2 7 ,0 0 0 6,000 3 0 ,0 0 0 5 ,0 0 0 2,000 70,000 45,000 3 6 ,0 0 0 1 3 ,0 0 0 5,000 1 0 1 ,0 0 0 $ 1 7 1 ,0 0 0
and E qui ty Li abi l i ti es Current Liabilities: i P re p a i d nsurance Interestreceivable payabl e S a l a ri es In ta n gi bl e assets Accountspayable Total Current Liabilities Equity Shareholder's R e ta i n ed earni ngs C o m m onstock Short-termnote E T o ta lSharehol ders' qui ty T o ta lL i abi l i ti es and E qui ty
$ 169,000
Required
a. Identify the errors in the balance sheet. b. Using good form, preparea corrected,classified balance sheet. c. Calculate the current ratio using the corrected amountsfrom the balance sheet preparedin b. What does this ratio measure?Discuss the implications of Wings and Things' current ratio. d. Explain why it is important to properly follow GAAP when preparing financial statements. P2-4A. Analyzing transactions and preparing financial statements.Given the following (LO 3) transactions, 1,2008, 1. AnisehMaximousopenedFreshPastryBakerybycontributing$15,000onApril in exchangefor common stock. 2. Fresh Pastry borrowed $10,500 from the bank on April 1. The note ts a l-year, l27o note, with both principal and interest to be repaid on March 31,2009. 3. Aniseh paid $1,500 cash to rent equipment for the shop for the first month.
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4. Aniseh paid $655 cash for the utility bill for the lrst month. 5. Fresh Pastry was a hit and earned$7,500 in revenuethe first month, all cash. 6. Aniseh hired a friend to be the customerservice specialistfor the pastry shop and paid $475 cash in salary expensefor the first month. 7 . The businesspaid distributions to owners in the amount of $ 1,000 for the first month. 8. At the end of the month, $105 of interest payable is due on the note ftom #2.
Required
a. Show how each transactionaffects the accounting equation. b. Preparethe four basic financial statementsfor the month of April. (The balance sheetat April 30.) c. Give one additionalpiece of information relatedto the transactions that could be recordedin an information systemfor a purposeother than the financial statements. P2-54. Analyze transactions from the accounting equation; prepare the four financial statements;and calculate the current ratio. The following accounting equation worksheet showsthe transactions BlairstoneConsulting& Advising Inc. for the hrst month of busifor ness,April 2009. (LO 3, 5)
Cash
$3,000 't1,000 15,000 2,500 10,000 (8,000) 1,200 (3,400) (3,1 0o) 8,000 15,000 11,000
$3,ooo
Commonstock
2 3
4
f
7 8 9
(1,2oo)
(3,400) (3,1 00) Expense
10
(s0o)
(s00)
D i vi d ends
Required
a. AnaTyze each transactionin the accounting equation worksheet and describethe underlying exchangethat resulted in each entry. b. Has the company been profitable this month? Explain. c. Preparean income statementfor the month endedApril 30, 2009. d. Preparea statementof shareholders'equity for the month endedApril 30, 2009. e. Preparea statementof cash flows for the month endedApril 30, 2009. f. Preparea balance sheetat April 30, 2009. g. Calculate the current ratio at April 30. What does this ratio measure? P2-64. Analyzing transactionsand preparing financial statements.Kristin and Jenny Harrison graduated from the Aveda Institute at the end of June in 2010. They decided to withdraw $80,000eachfrom their trust fund to open a day spa,'A Day In Your Dreams"
t' . ...tt:;'..1 r
CHApTER . pROBLEMS 2
91
1r ', :'f.rr,;
Inc. in exchangefor 5,000 sharesof common stock. The hrm signed a note with Uncle Damien for an additional $65,000. Kristin and Jenny formed A Day In Your Dreams Inc. on July 1, 2010. The businessused availablefunds to purchasesome land with a newly remodeled building for $215,000 and spa equipment for $20,000. The businessalso bought a computersystemon accountfrom DELL Inc. for $40,000,with payment due at the beginning of the following year. (LO 3, 5) . During the first year of business,A Day In Your Dreams eamed $150,000 in service revenue,but collectedonly $125,000;the remaining $25,000was due early the next year. . Salaryexpenses the year were $35,000,of which $30,000was paid in cashduring for the year; the remaining $5,000 was due the first day of the next year. . The company paid operating expenses $30,000 in cash during the year. of . The company sent a check during the last month of the year for $6,500 for interest expensedue on the loan from Uncle Damren. . The company invested$15,000 of cashin short-term investmentsat the end of the year. . A Day In Your Dreams declared and paid dividends of $3,500 during the year.
Required
a. Show how each transactionaffects the accounting equation. b. Preparethe four basic financial statementsfor the year endedJune 30, 2011. (The balancesheet June30, 2011.) at c. Calculatethe current ratio at June30, 2011.What doesthis ratio measure? Discuss the implications of A Day In Your Dreams' current ratio.
Problems-Set B
P2-18. Relationshipsbetweenfinancial statementitems.Use the following information for Multicultural Travel Inc. for the year endedDecember31,2010, to answerthe questions. Assume that the shareholders made no new contributions to the company during the year.
(Lo 3)
1. 2. 3. 4. 5. 6. 7. Revenues the year endedDecember31, 2010 : $850 for Net income for the year endedDecember31,2010: $370 Beginningbalance(December31,2009, balance)in retainedearnings: $280 Ending balance(December3I,2010, balance)in retainedearnings= $360 Total liabilities and shareholders' equity at December31,2010 : $725 Total liabilities at December31, 2009 : $80 Total liabilities at December31. 2010 : $40
Required
during the year ended a. What were Multicultural Travel's total expenses December31,2010? during the year endedDecember 3 1, 2010? b. What was paid to shareholders c. What is the total that owners invested in the Multicultural Travel as of December31,2010? d. What were total assets Multicultural Travel'sDecember31,2009, balancesheet? on P2-28. Analyzing transactions.International News Herald Inc. enteredinto the following transactions during 2010: (LO 3) 1. International News Herald Inc. started as a corporation with a $'7,250cash contribution from the owners in exchangefor common stock. to 2. Newspaper sales,all on account,amounted $8,900. to amounted $4,750. 3. Cashcollectionsof accounts receivable 4. On November 1, 2010, the company paid $3,000 in advancefor an insurancepolicy that doesnot go into effect until 2011. 5. The company paid dividends of $400.
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Required Put eachof the transactionsin an accountingequation worksheet.Then, answerthe following questions: a. What is the amount of net cashfrom financins activities for the vear ended December 3I,2010? would appearon the December31,2010, balancesheet? b. What amountof total assets c. What amount of net income would appearon the income statementfor the year endedDecember3I, 20lO? d. What is the amount of retained earnings as of December 31,2010? P2-3B. Identifu ercors using GAAP; prepare a classified balance sheet; and calculate the current ratio. An inexperiencedaccountanthas put together a balancesheetfor Art Objects Inc. The balances shownare at September 30,2009. (LO 1, 3, 5) Assets CurrentAssets: P re p a i d n s u rance i Cash Land Other current assets Interestreceivable Total current assets Accountspayable Buildings E q u i p me n t Intangibleassets Total noncurrentassets Total Assets $ 30,000 6,000 28,000 5,000 2,000 71,000 42,000 36,000 18,000 6,000 102,000 $ 173,000 Li abi l i ti es and E qui ty C urrentLi abi l i ti es: Accountsreceivable Other long-termassets payabl e S al ari es Intangi bl e assets Accountspayable Total currentl i abi l i ti es Shareholder's Equity R etai ned earni ngs C ommonstock Short-termnote Total shareholders'equity Total Liabilities and Equity
Required
a. Identify the errors in the balance sheet. b. Using good form, preparea corrected,classified balancesheet. c. Calculate the current ratio using the correctedamounts from the balance sheet preparedin b. What doesthis ratio measure? Discussthe implicationsof Art Objects' current ratio. d. Explain why it is important to properly follow GAAP when preparing financial statements. P2-48. Analyzing transactions and preparing financial statements.Given the following (LO 3) transactions, 1. Leticia Shettlestarteda business, Exotic Travel Planners, contributing$5,000 on by July 1, 2010,in exchange common stock. for 2. The company borrowed $3,000 from the bank in July. The note is a l-yea4 l}Vo note, with both principal and interestto be repaidon June 30,2011. 3. The companyearned$1,085in cashrevenueduring July. 4. The company paid operating expenses $725 for the month of July. of 5. The company made distributions to owners in the amount of $55 in July. 6. At the end of July, $25 of interest payable is due on the note from #2. Required a. Show how each transactionaffects the accounting equation. b. Preparethe four basic financial statements the month of July (balancesheetat for J u l y 3 1 ). c. Give one additional piece of information related to the ffansactionsthat could be recordedin an information systemfor a purposeother than the financial statements.
C H A P T E2 . P R O B L E M S R
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P2-58. Analyze transactions from the accounting equation; prepare the four financial statements;and calculate the current ratio. The following accounting equation worksheet shows the transactionsfor Jackie Knight's Furniture Repairs, a corporation, for the first monthof business November2007.(LO 4,5,1)
Assets
Accounts re c e i v a b l e Supplies
Cash 1
2 3
(s,000)
(s,000)
Operating expenses
1,500
8,000
6 7 8 9
10
(200)
(200) Dividends
Required
a. Analyze each transactionin the accounting equation worksheet and describethe underlying exchangethat resulted in each entry. b. Has the company been prof,ttablethis month? Explain. c. Preparean income statementfor the month ended November 30'2007. equity for the month endedNovember30,2007. d. Preparea statement shareholders' of e. Preparea statementof cash flows for the month endedNovembet 30,2001 . f. Preparea balance sheetat November 30,2007 . g. Calculatethe currentratio at November30,2007.What doesthis ratio measure? Jackie, Chris, and P2-68. Analyzing transactionsand preparing financial statenxents. Cindy started their own consulting firm. They contributed $30,000 each in exchangefor note 3,000 sharesof common stock and borrowed another$60,000by signing a 1O-year with Tallahassee Capital City Bank. They formed We Do It All Consulting Inc. on January I,2009. The business used availablefunds to purchasesome land with an office building for $105,000 and office equipment and furniture for $25,000. The businessalso bought a computer system on account from Gateway Inc. for $21,500; payment was due at the beginning of the following year. (LO 3, 5) . During the first year of business,We Do It A11Consulting earned$185,000 in service revenuebut had collectedonly $163,000;the remaining $22,000was due early the next yea.r. . Salary expenses the year were $55,000,of which the companypaid $45,000 in cash for during the year; the remaining $10,000 was due the first day of the next year.
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CHA pT EIR o e U AL tT tEo F Ac c o u N T tN G FoR MA TtoN s tN . The company paid operating expenses $27,500 in cash during of the year. . Interest expensefor the year was $3,500 but was not due until the note matured. ' The company invested$ 18,000of cashin a certifrcateof deposit at the end of the year. ' we Do It All consulting declaredand paid dividends of $4,g00 during the year. Required a. Show how each transactionaffects the accounting equation. b. Preparethe four basic financial statements the year endedDecember 31, for 2009. (The balancesheet December31,2009.) at c. Calculate the current ratio at December 3l , 2009. What does this ratio measure? Discuss the implications of we Do It All consulting's current ratio.
l!l!,6%
jjl_],?s!
FSA2-2. Selectedinformation from the comparativebalancesheetsfor SearsHoldings Corporation are presentedhere. Although some accountsa"re listed, all of the current assets not and currentliabilities are given. (LO 3, 4,9)
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C H A P TE R2 . FIN A N C IA L S TA TE ME N T A N A LY S IS
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Cash Accountsreceivable Inventory Other current assets plant, and equipment Property, Accountspayable O t her c ur r entl i a b i l i ti e s Long-termdebt Total shareholders' equity
at January26,2005 at January28,2006 (dol l ars n mi l l i ons) i q,qqo $3,43s $ 8 11 9,068 888 9,823 3,458 6,892 8 ,6 12 1 1 ,6 11 646 3,281 179 315 927 1,154 2,101 4,469
Required
a. Provide the following values at the end ofeach given ftscal year. 1. Currentassets 2. Current liabilities 3. Currentratio b. Based on your answersin part a, discussthe changein liquidity between the two years. FSA2-3. A condensedstatementof cash flows for Apple Computer Inc. for the year ended given afterthe statement. 24,2005, is shownhere.Use it to answerthe questions September (L0 5) Apple ComputerInc. Statement of Cash Flows For the year ended September24,2005 (i n mi l l i ons) Cas h and c as he q u i v a l e n tsb e g i n n i n go f th e y ear , Cashgeneratedby operating activities Investing cashflows: Purchase short-terminvestments of Proceeds from maturitiesof short-terminvestments Proceeds from sales short-terminvestments of Purchase property,plant, and equipment of O t her Cashgeneratedby (usedfor) investingactivities F inanc ing as hfl o w s : c Proceeds from issuance common stock of (usedfor) financingactivities Cashgeneratedby (decrease) cashand cashequivalents Increase in Cashand cashequivalents, end of the year 543 (1,470) 8,609 $ 2,969
2,535
522
$jr491
Required
a. Did Apple purchaseany property, plant, or equipment during the year? b. If you were to examine Apple's balance sheetat September24, 2005, what would be the amount for cash and cash equivalents? c. Was cash generatedfrom operationsor used by operations?By what amount? d. Did Apple receive any new contributions from owners during the year? How can you tell?
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Ethics
Ken Joneswants to start a small businessand has askedhis uncle to lend him $10,000. He has prepareda businessplan and some financial statements that indicate the businesscould be very profitable. Ken is afraid his uncle will want some ownershipin the company for his investment, but Ken does not want to share what he believes will be a hugely successful company.What are the ethical issuesKen must face as he preparesto presenthis business plan to his uncle? Do you think he should try to emphasizethe risks of ownership to his uncle to convince him it would be preferable to be a creditor? Why or why not?
Group Assignment
Look at the four basicfinancialstatements Tom'sWearin Exhibits 2.5,2.6,2.i , arld2.8. for Work togetherto find numbersthat show the links betweenthe various financial statements. Then, write a brief explanation of how the statementsrelate to each other.