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In Chopter1, you leorned o business thot oddsvolueto mokeo profit Youleorned thotbusiness tronsoctions be clossified operoting, investing, finoncing. or con os The fourbosicfinonciol of ln stotements-the income stotement, stotement chonqes the shoreholders' equily, bolonce the sheet, ond thestotement coshflows-provide of informotion cboutthese business processes

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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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I CHAPTER o Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N I O

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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.

Making for Information Decision


After Tom sold his first batch of T-shirts, he had some decisionsto make. The biggest one was whether or not to continue in business.What he neededto know to evaluatethat decision was whether or not the company made a profit in January.Net profit is the amount left after all expenses deductedfrom all revenues. are For Tom's Wear, the accountingperiod is the first month of doing business,January 1 through January31. Information about the month's operationsis summarizedon the income The revenues the period amounted for statement-one of the four basic financial statements. were to $900; that is the total amountthe companyearnedwhen it sold 90 shirts.The expenses the cost ofthe T-shirtssold, the cost ofthe advertising,and the interestpaid on the loan from Tom's mom. The cost of the 90 T:shirts sold was $360, advertisingexpensewas $50, and the cost of borrowing the money-interest expense-was $5. When those expenses,totaling $415, are deductedfrom the salesrevenueof $900, the remaining $485 is net profit. Tom's Wear addedvalueby ordering shirtswith the speciallogo andproviding them to Tom's friends at a convenienttime and place.And Tom's Wear achievedits goal-to make a profit. in On the income statement Exhibit 2.l,you will see$485 shown as net income, another name for profit. The term profit can be applied to a single sale,a group of sales,or all the transactionsfor a period of time of businessactivity, whereasnet income is a more specific term for describing a company's entire profit for a specific time period. The company madea grossprofit of $540 on the saleof 90 t-shirts,and Tom's Wear'snet income for his f,rrstmonth of businessactivity was $485. Financial reporting provides information for decision making. An income statement, like the one shown for Tom's Wear, is one source of information. When the secondmonth of businessactivity is complete, Tom will prepare another income statementand will be To able to comparethe two statements. make such a comparisonmeaningful, Tom needsto use the same rules for preparing the two statements.If Tom wanted to compare his company's performance to the performance of another T-shirt company, he would need to be sure that the other company was using the samerules to prepareits income statement.For frnancial information to be useful for evaluatingthe performanceof a businessacrosstime or for comparing two different companies,the samerules must be used consistently. accountAs you learnedin Chapter1, thereis a setofguidelines calledgenerallyaccepted ing principles (GAAP) that a company must follow when preparing its financial statements, Theseguidelines-usually known as accountingprincipleswhich help ensureconsistency. A if throughcommon usage. principle was acceptable it was used were historically developed Todaythe processof establishing GAAP is more forand acknowledged most accountants. by mal, with the SEC and the FASB responsible for setting accounting standards.

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

for Income Statement Wearfor January Tom's


This is a simple income statement for one month of business.

Revenue Sa]es . Expenses Co sto fgo od ssold . . Advertising expense

$ 900
. . . . . .. . . . . $ 360 50

t0m!sweal
4r5 $ 485

:: ffiil#:3] ::: ::::::::: :::::::: ::::::: :::::::=::: ,


standfor? 1. What doesGAAP reporting? for needed financial 2. Why areguidelines

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[,.{}.2 of Explain objective the and reporting the financial qualities to necessary achieve objective. this

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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CHA pT EIR o e U AL tT tEo F A c c o u N T IN G FoR MA TtoN tN s

EXHIBIT2.2 Qualitative Characteristics of Accounting Information


:1

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

53

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.

Statements Elements the Financial of


As you learned in Chapter 1, a complete set of financial statementsincludes the: 1. Income statement 2. Balance sheet(sometimescalled the statementof ftnancial position) 3. Statementof changesin shareholders'equity (also called the statementof changesin owners'equity) 4. Statementof cashflows 5. Notes to the financial statements To GAAP describethe individual items that are included in the financial statements. learn the secondmonth of businessfor we what is shown on eachfinancial statement. will look at

{,"{}.3 ldentify the elementsof the an fi nanci al statements d descri be thei r characteristics.

54

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.

Transactions the Second for Month of Business


The transactions Tom's Wear'ssecondmonth of business shownin Exhibit 2.3.The for are first transaction in February is the purchaseof 200 T-shirts, costing $4 each. Last month, Tom's Wear paid cashfor the purchaseof the T-shirts. This month, the company buys them on credit, also known as on account. This meansTom's Wear will pay for them later. The purchaseincreasesthe company's assets-$8O0 worth of T:shirts-and the $800 claim belongs to the vendor. When a company owes a vendoq accounts payable are the amounts the company owes.This is the first traasactionshown in Exhibit 2.4,where the transactions are presentedin the accounting equation worksheet. Next, Tom hires a company to advertisehis businessimmediately.This cost is $150 for a service.Tom's Wear pays $100 when the service is provided, so the company still owes payment.However,in this transaction, $50. Like the first transaction,this one also postpones Tom's Wear has incurred an expense.In the first transaction-when the inventory was purchased-Tom's Wear gained an asset.The cost of the shirts will become an expensewhen the shirts are sold. In contrast,the work done related to the advertisingis complete, and that signalsan expense.(The timing of recognizing expenses be tricky; the next chapterwill can discusstiming in detail.)The $150 expense, like all expenses, reducesthe owner'sclaims to the assets the firm. Assetsdecrease $100,the cashpaid for the advertising; of by and the remaining $50 increasescreditors' claims-liabilities-because it will be paid later. It is shown as other payablesbecauseaccountspayableis generally reservedfor amountsa firm owes its vendors. This is the secondtransaction shown in Exhibit 2.4. Notice that the expenseis recorded even though all of the cash has not yet been paid. grows,Tom decideshis companyneedssomeinsurance. As his business Tom's Wear pays $150 for 3 months' worth of coverage,beginning February 14. When a company pays for something in advance, the item purchased is something of future value to the company.Becausesuch an item provides future value, it is classifiedas an asset.Items purchased advance in may seemlike unusualassets, and often havethe wordprepaid with them to provide information about what sort of assetsthey are. Common prepaid items are insurance,rent, and supplies.In this case,Tom's Wear has purchasedan assetcalled prepaid insurance. Cash is decreased $150, and the new asset-prepaid insuranceby is increased $150. Notice that insuranceexpense by has not beenrecorded.Until someof the insuranceis used up-and it can be used up only from one point in time to a subsequent point in time-there is no expense. This is anothercaseof the cashflow being different than the expense.

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.

Transactions Tom's for Wearfor February

Febmary 5

February 14

February 23

February 28

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55

CHAPTER o Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 O I

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

57

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.

Revenue Sales Expenses


Cost of goods sold Advertising expense Insurance expense T otale xp en se s ..... Net income

..... $ 1' 850 740


lbu

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

Statement Changes of Equity in Shareholder's for Tom's Wear for February


of The Statement Changesin Shareholder'sEquity shows how all of the equity accountshave changedduring the month.

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

58

CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 O I

EXHIBIT2.7

Balance Sheetfor Tom's Wearat February 28


The balance sheetat February 28 has incorporated the new retained earningsbalance.

Tom's Wear,Inc. Balance Sheet At February 28,2006


Assets
Cas h Accounts receivable Inventory Prepaidinsurance ...... $6,695 150 100 .. 125 .. Liabilities and Shareholder's Eouitv Accounts payable Otherpayables .... Common stock Retained earnings Total liabilities and shareholder's equlty

$ 800 50 5,000 r,220


.

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

59

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

(100) $ 1,350 5,345 $ 6,695

..,.

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.

Explain. ls prepaid insurance expense an asset? or an

Your Turn 2-3


"''l'il't',' j$in'* tir..u,,lt u"lll't

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.

60

CHAPTER r Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N I O I

EXHIBIT2.9 ComparativeBalance Sheets for The Home Depot


This is a recent balance sheet taken from the Home Depot's annual reoort.

The Home Depot,Inc. and Subsidiaries Consolidated Balance Sheets

anxounts i,n mi,llions, ercept per share d,ata

Jantaty29,

JanuaryS0,

2006

2005

Assets Currentassets:
Cash and cash equivalents Short-term investments Receivables,net Merchandise inventories

..........

Other current assets Totalcurrentassets .


Property and equipment, at cost: Land Buildings F\rmiture, fixtures, and equipment ..... Leasehold improvements Construction in progress Capital leases Less accumulated depreciation and amoftization Net property and equipment Notes receivable ...

793 L4 2,896 11,401 742 15,346

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

5,766 1,055 4r2 7,546 161 11

1,504 r0,455 2,L48 87r 1,388

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

119 6,650 23,962 227 (108) (6,692)

...

$ 39,020

SeeaccompanEing Notes to Consolid,atedFi,nancial Statenxents.

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

61

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

Your Turn 2-4


'i i 'r

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.

Measurement Recognition Financial in Statements and


We will now take a closer look at someof the featuresof the balancesheetand income statement. Recall, the balancesheetis simply the accountingequation:Assets = Liabilities * Shareholders' equity. The three elements are major categories,each divided into subcategories. Measuring Assets. We will starl with assets. The most well-known assetis cash. It is listed frst on the balancesheet.As you will notice on Home Depot's balancesheet,all other

Capitalisthe combined contributedcaoitaland earnedcaoital-retained earnings-of a sole proprietorship partnership. or

62

CHAPTER o Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N I O I

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

I I I I
tr--

'hewsfhsA
7
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.

63

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

Assumptions, Principles, Constraints Financial and of Reporting Assumptions:


Time-period assumption Separate-entity assumptron Monetary-unit assumption Going-concern assumption The life of a business can be divided into artiflcial time periods for financial reporting. Financial statements of a flrm contain financial information about only that firm. Only items that can be measured in monetary units are included in the flnancial statements. A company wiII remain in business for the foreseeable future. Assets are recorded at cost. Revenue is recognized when it is earned and collection is reasonably assured. Expenses are recognized in the same period as the revenue they helped generate. A company should provide information about any circumstances and events that would make a difference to the users of the financial statements Materiality refers to the size or significance of an item or transaction on the company's financial statements. When there is any question about how to account for a transaction, the accountant should select the treatment that will be least likely to overstate income or overstate assets.

Principles:

Historical-cost principle Revenue-recognition principle Matching principle

F\rll-disclosure principle

Constraints:
Materiality

Conservatism

64

I CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 O

F,.fli,ie*+f,J,#.,Ff $T+1ffi &14;l$:"lF{F'runq.Hlf#$',q$


inWhen to recognizerevenue-record it so that it appearson the period'S come statement-is one of the most difficult judgmentsa companymust leadersby RevenueRecognition.com make. A 2005 study of 400 business found that more than half of atl public Data Corporation International and as have changedtheir revenuerecognitionpolicies a resultof companies modelsthat accountfor more But it is changingbusiness Sarbanes-Oxley. than any other singlefactor.New in changes revenuerecognitionpolicies involvingbundledproducts and serbusiness modelscan be quite complex, revenuecan vicesdeliveredover long periodsof time. When to recognize be diff icultto determine.

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.

Accruals Deferrals and

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

65

CashBasis Versus AccrualBasis Accounting


There is another type of accounting called cash basis accounting-revenue is recognized only when the cashis collected, and expenses recordedonly when the cashis paid. This are is not a generally acceptedmethod of accounting according to the FASB and the SEC. Using the exchangeof cash as the signal for recognizing revenue and expensedoes not communicate the performance of the business in a way that allows us to evaluate its achievements. The cash flows are important, but alone they do not provide enough information for decisionmakers.This doesnot stop somebusinesses from using it as the basis of their own accounting records. Remember, some businessesare not required to follow GAAP. For example, doctors who are sole proprietors may use cash basis accounting in their businesses. This meansthey recognize only the cash they receive as revenue.If they provide servicesto someonewho has not yet paid for those servicesat the time an income statementis prepared,they would not include the fee not yet received as revenuefor that income statement.That is not GAAP. If the doctors were following GAAP, they would count it as revenueand as a receivable(accountsreceivable).
Cashbasisaccounting is a systembasedon the exchange of cash.In this system, revenueis recognized only when cashis collected. and an expense recognized is only when cashis disbursed. This is not an acceotable method of accountingunder GAAP.

Accounting Periods and Cutofflssues


Why does it matter-for accounting purposes-if there is a difference between the time when the goods or services are exchanged-the economic substanceof the transactionand the time when the cash related to that transactionis received or disbursed?If a company makes a sale on credit and the cashis collected later, why does it matter when the sale is recognized-included as revenue on the income statement?Studying Tom's Wear will help you seethe answers thesequestions. to When Tom beganhis business 2006, he chosethe calendaryear as his company's in fiscal year. Each of his annual income statementswill cover the period from January 1 to December 31 of a specific year. It is important that what appearson the income statement for a specific year is only the revenueearnedduring those 12 months and only the expenses incurred to generatethat revenue.What is included as a saleduring the period?Accountants have decided to use the exchangeof goods and services,not the cash exchange,to define when a sale has taken place. Expensesare matched with revenues,also without regard to when the cash is exchanged.This makes the financial statements all companiesthat folof low GAAP consistent and comparable. Exhibit 2.12 showsthe relationshipbetweenthe balancesheetand the income statement and the time periodsinvolved.Recall,the balancesheetis a snapshot view of the assets,liabilities, and shareholders' equity on a specific date. For a company with a fiscal year-endon December 3 1, that is the date of the balance sheet.Remember,the end-of-theyear balance sheet for one year becomes the beginning-of-the-year balance sheet for the next year. When you are out celebrating New Year's Eve, nothing is happeningto the balancesheet. When Tom goesto sleepon December31,2006, the cashon the December31, 2006, balance sheet of Tom's Wear is exactly the amount of cash that the company will have on January l, 2007. So the final balancesheetfor one year simply rolls forward to the next year. Then, transactionsstart happening-exchanges take place. The revenuesand expenses for the period of time are shown on the income statement.The income statementcovers a

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 \

71

sneet

The BalanceSheet and Income Statement


Every balance sheetpresentsthe assets, liabilities. and shareholders'equity a business of firm at a moment in time. The income statementdescribeswhat happenedbetweentwo balance sheetdates.

lncome Statement for the Year Ended 12131tO6

lncome Statement for the Year Ended 12131/09

56

I CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 O

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.

Your Turn 2-6


fllililrl,iut ffi i*,irr',

What is the differencebetween cashbasisand accrualbasisaccounting?

How lnvestors-Ownersand CreditorsInformation Accounting UseAccrual


Owners and creditors are both consideredinvestorsin a business.Both invest their money to make money, and they both take a risk in investing their money in the business.In this context, you can think of risk as the uncertainty associatedwith the amount of future returns and the timing of future returns. Some investmentsare riskier than others are. For example, when a bank makes a loan to a company, the banker evaluatesthe ability of the company to repay the loan amount-the principal-plus interest-the cost of borrowing the money. If the bank makes a loan to a company that does not do well enough to repay to the debt, the company may need to sell noncashassets raise cashto pay off the loan plus interestdue.When lending money,the bank must comparethe risk with the expectedreturn. Most often, the risk and return of an investmentchangevalue in the samedirectionwe say they are positively correlated.Positively correlatedmeansthey move in the samedirection-higher risk means higher expected return for taking the higher risk; lower risk meanslower expectedreturns. For higher investmentrisk, the potential for a higher return is neededto attract investors. Investing in a company as an owner is riskier than investing as a creditor. A creditor's claim to the assetsof a company has priority over an owner's claim. (Creditors have first claim to the assets.)If a company has just enough money either to pay its creditors or to make a distribution to its owner or owners,the creditors must be paid, and theyalways must be paidbefore anything-if there is anything left-is distributed to the owners.That transIatesinto lessrisk for a creditor.The owner's risk is that the companywill go out of business. However, the owner, who takes more risk, has the right to sharethe profit. So the risk for the owner is accompaniedby the potential for a higher return. A creditor, on the other hand, will never receive more than the amount of the loan, plus the amount of interest that is agreedon when the loan is made. Financial information is useful for someonedeciding whether or not to invest in a company. SupposeTom's Wear wanted to borrow money to expand.A bank would want to examine Tom's Wear's income statement,balancesheet,and the statementof cashflows. The reason is to evaluatepotential risk-the company's ability to make the required principal and interest payments. and who has claim to them. A bank loan The balancesheetshowsa company'sassets officer would use the information on the balance sheet to evaluate Tom's Wear's ability to repay the loan. He would want to be sure that the company did not have too many debts. The more debt a company has, the more cash it must generateto make the loan payments. The information on the balance sheetwould not be enough to assurethe bank loan officer that Tom's Wear would be able to repay the loan. Becausea loan is repaid over several months or years,information about the future earningpotential of the businessis important. Studying the past performance of a businesshelps predict its future performance. That makes the profit the company earned during the past year relevant to the banker. Details incured to generatethat revenuewould help the bank about the salesrevenueand expenses evaluatethe company's potential to generateenough cash to repay a loan.

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.

An Example lllustrate to the Information Financial Statements Provide


We will comparetwo companies,each starting its fiscal year with identical balancesheets. Then, during the first month of the year, they have very similar transactions.We will look at only a few of the transactions,and we will seethat their income statementsfor the first month are the same.As you study the example, try to figure out why their income statements are the same.Their ending balance sheetsand statementsof cash flows are not the same.Where do the differences show up in the financial statements? The two companiesare Clean Sweepand Maids-R-Us.Both are cleaningbusinesses and both are sole proprietorships.Judy Jonesowns Clean Sweep, and Betty Brown owns Maids-R-Us.On January1,2007, the two companies have identicalbalancesheets. Look at eachitem on the balancesheetin Exhibit 2.13 andbe sureyou know what it means.Do this beforeyou go on. Study each transactionand look at its effect on the accounting equation.Follow along usingExhibits2.14 and2.15. Transaction1; Each company earns $750 worth of revenue.Clean Sweep collects the cash,but Maids-R-Us extendscredit to its customers.Clean Sweeprecordsthe asset cash,whereasMaids-R-Usrecordsthe assetaccountsreceivable. Both companies

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

Collectsthe fees in cash at the time the services are rendered.

Agreesto extendcredit to the customers. Fees will be collected after 30 days, Paysonly $100 of the loan plus $40 interest.

Transactions January for 2OO7 Clean Sweep for and Maids-R-Us


Be sure to study how the transactionsare different for the two comoanies.

2. Makea loanpayment plusinterest. 3. Countth'e supplies on January3landfind$25 worthlefton hand.

Pays off the entire loan plus $40 interest

Both will make an adjustmentto show $175 worth of suppliesused.

68

I CH A P T ER O QUAL ITIE S F ACCO UNTI NG NFO RM ATIO N ] O

EXI{IBIT2.T5 Transactions Clean Sweep and Maids-R-Us for


The differencesin the transactionsbetween the two companiesare reflected in the accounting equation worksheet. Panel A: Clean Sweep

- Income Statement Panel B: Maids-R-Us

, Statement of Changesin Owner's Equity

* Balance Sheet

- Statement of Cash Flows

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.

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69

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.

Revenue Cleaning fees

$ 750 $ 175 40 215 $ 535

Expenses Supplies Interest


Total expenses Net income

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.

E XH tBtT .17 2 Balance Sheetfor Clean Sweepand Maids-R-Us January at 31,2007


The balance sheetsare not the same.The total assetsare different becauseClean Sweep paid $300 more than Maids-R-Us on the note payable. They have different assetsalso. Maids-R-Us has accountsreceivableof $750, revenueit earnedbut did not collect in January.

Clean Sweep Balance Sheet At January 3I,2007


Liabilities and Owner's Equity Cash Supplies Totalassets ...

Maids-R-Us Balance Sheet At January 3L,2007


Assets
Cash $ 760 Accounts receivable .. 750 Supplies z5 Totalassets ... $1,535 Liabilities and Owner's Equity Notespayable ...... $ 30 0

$ 1 ,2 1 0 zt)
$1,235

Capital,Jones .. .. . . $ 1,235 Total liabilities and owner'sequity . .. $ I,235

Capital,Brown .....

$ 1 ,2 3 5

Total liabilities and owner'sequity .. $1,535

I O CHAPTER o Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N I

EXHTBTT 2.18 Statementsof CashFlow for CIeanSweep and Maids-R-Us


The differencesin the cash transactionsresult in differencesin the statementsof cash flow.

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

$ 750 (40) $ 710 0


( 400) ....... .......... $

Cash from operating activities Cash paid for interest Net cash from operations Cash from investing activities

$ (40) 0
(100) ....... .. ... .

Cash from financing activities Repaymentofloan . Netcashfromfinancing (400)

.....

(100) $ (140)

Net increase (decrease) in cash 310

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.

Your Turn 2-7


Wm-mw" ffiww,wru

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:

1. The income statement


J

The statementof changesin owner's equity

3. The balance sheet 4. The statementof cash flows

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71

f"Jil: i,,l\il L-iL:35; i i)in,j'ilBusine SS i-q


Accounting Accrual ls hut Cash King ls
In this chapter, havelearned you that frnancial statements prepared an occruol are on basis, that does but not mean cashisnot important. Here whatTheMotis "The leyFool saidaboutcashin a June 2006article, ": Next Enron Cash king.Despite is whatsome business execs want you to believe, cash paysthe billsaccounting earnings not. do As a matter fact,cash of budgeting oneof the most is tmportant performs. starting activities company a The pointfor avoiding cash a crisis to develop compreis a hensive flow budget. you readaboutthe fallof cash lf you Enron, will learn thatthe company not have did a cash flowbudget. Enron simply out of cash, its ran and problems the SEC with driedup theirlines credits of withtheirbanks. Smart business owners develop annual even or multiyear cash flow projections make to sure theycanmeet ongoing business needs. Business owners prepare also and use historicql flow statements gainan uncash to derstanding about where of thecash all came fromand where the cash all went. Byestimating cashinflows your you and outflows,
L dII

. 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

IN O CHAPTER . Q UALI TI ES F ACCO UNTI NG F O R M A T I O N 2

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.

Financial Statements RealCompany


Even though Tom's Wear is a small, start-up company, its financial statementsinclude the same types of financial statement items as large, well-established corporations. When Tom's Wear sold shirts to customerson credit, the balance sheet showed accountsreceivable. Look at the balance sheetof Polo Ralph Lauren Corporation, shown in Exhibit 2.19. In the assetsection,Polo Ralph Lauren Corporation's balancesheetshowsaccountsreceivable of $455,682,000at April 2, 2005, its fiscal year-end.Customersowe Polo Ralph Lauren Corporation this amount for products and servicesthe companyprovided to its customers on credit. on Can you find anotherasset the balancesheetthat reflectsthe useof accrual,ratherthan In the cunent assetsection,the balancesheetlists prepaid expenses cashbasis,accounting? Although the details of Polo Ra$h Lauren Corporation'sprepaidexpenses of $102,693,000. the included items will be similar to prepaidinsuranceor prepaidrent-items are not shown, the company has paid for but has not used yet. On the other side ofthe balancesheet,Polo This represents what the Ralph Lauren Corporation has accountspayable of $184,394,000. for inventory items the company has purchasedbut has not yet paid for. firm owes to vendors Check out the other things you learned in this and the previous chapter about the balance sheet.First, it balances-assets : liabilities * shareholders'equity. Polo Ralph Lauren Corporation has a classified balance sheet. Current assets are shown first, with a subtotal; and current liabilities are also shown with a subtotal. Look at the stockholders' equity section. There is common stock and additional paid-in capital-both contributed capital amounts.Then, the balance sheetshowsretained earnings,the amount of equity the have earned(less dividends) by Polo Ralph Lauren Corporation's operations. shareholders

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73

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)

April 3, 2004 (As restated, seeNote 2)

Assets Current assets: C as handc as he q u i v a l e n ts ..... Accountsreceivable, of allowances net of


and.$97,292 $111,042 Inventories Deferred tax assets . Prepaid expenses and other Total current assets Property and equipment, net Deferred tax assets Goodwill, net Intangibles, net Other assets Total assets Liabilities and Stocldrolders' Equity Current liabilities: Accounts payable Income tax payable Defe rred taxliab ilit ies . . . . . . . Accrued expenses and other Total current liabilities Long-term debt Other noncurrent liabilities Commitments and contingencies (Note 14)

............

$ 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

620 433 563,457 921,602 (78,975) 23,104 (r4,794) r,4L5,447

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.

74

I O CHAPTER . Q UALI TI ES F ACCO UNTI N G N F O R M A T I O N 2

{,.s.5
C om put eand ex p l a i nth e meaningof t he c u rre n t ratio.

Analysis Ratio YourKnowledge: Applying


Every businessmust pay its bills. Suppliers, in particular, want to evaluate a company's ability to meet its current obligations. Simply looking at how much cash a company has doesnot provide enough information. Using ratios often provides additional insights. A financial ratio is a comparison of different amounts on the financial statements.Severalratios measurethe short-term liquidity of a company.The most common is the current ratio, which accountantscompute by dividing the total amount of current assetsby the total amount of current liabilities. The ratio gives information about a company's ability to fund its current operationsin the short run. Using the current ratio, investorscan comparethe liquidity of one company to that of other companiesof different types and sizes.Recall that liquidity is a measureof how into cash to pay its debts as they come due. easily a company can turn its current assets This information would be important to a supplier considering extending credit to a company. The current ratio also provides information about the liquidity of a company over time. Look at the balancesheetfor Home Depot in Exhibit 2.9. The currentratio atJanuary29, 2006, was million : 1.19 million + $12,901 $15,346 The current assetsat January 30,2005, totaled $14,273 million, and the current liabilities were $10,455 million. So the current ratio at January 30, 2005, was million : 1.37 million + $10,455 $14,273 Another way to think about the current ratio is to say that Home Depot had, at January with which to pay off each$1.00 of its currentliabilities. 30, 2005, $1.37 of cunent assets Can you seewhy companiesoften strive to have a current ratio of 1 or greater?That would mean a firm has enough current assetsto pay off its current liabilities. When using ratio analysis,it is often interestingto comparea firm's ratios to thoseof a competitor in the same industry.Lowe's, for example,had a currentratio of 7.34 at February3,2006, ar,d1.22at slightly while Home Depot's has January28,2005. The firm's currentratio has increased ratio hasbeen above 1 for the pasttwo However, for both companies,the current decreased. years. Looking at the current ratio for two consecutiveyears gives some information about Home.Depot or Lowe's, but you would need much more information to reach any conclusions. As you learn more about financial statements,you will learn additional ratios and severalways to analyzea company's financial statements. You might be surprisedto know that some firms actually try to keep their current ratio a below I.If a firm generates greatdeal of cash,it may know that it will generatesufficient cash to pay its current liabilities as they come due. Darden Restaurants,owners of Olive Garden,Red Lobster, and Smokey Bones, had a current ratio of 0.39 at May 29,2005. Here's what Darden's managementhad to say about the current ratio in the firm's annual report: Cash flows generated from operating activities provide us with a significant of sourceof liquidity, which we use to financethe purchases land, buildings and equipment and to repurchasesharesof our common stock. Since substantially all our sales are for cash and cash equivalents and accounts payable are generally due in five to 30 days, we are able to carry current liabilities in excess of culTentassets.

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.

and Risk, Business Control, Ethics


Now that we have discussedthe general characteristicsof accounting information and the we information shown on the four basic financial statements, will take a look at how companiesmake surethe information in those statementsis reliable.

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 ,

75

lnternal Controls-Definition and Objectives


Internal controls are the policies and proceduresthe managersof a hrm use to protect the f,rrm'sassetsand to ensurethe accuracyand reliability of the firm's accountingrecords.Internal controls a"re company's rules to help it keep its assetssafe and to make sure its fia nancial records are accurate.By adheringto those rules, a firm minimizes the risks of being in business.Theserules are called internal controls becausethey are put in place and controlled within the company.Controls imposed from outsidethe firm-laws and regulations, for example-are not internal controls becausethey are not rules that originated within the company.
Internal controls are a policies company's and proceduresto protect the assets the firm and to of ensurethe accuracy and reliabilityof the accounting records.

Special InternalControllssues Related Financial to Statements


Accountants are particularly concernedwith the financial statements. Whether you are involved in preparing them or using them to make decisions,you must have confrdencethat the information in them is accurateand reliable. When you see cash on a company's balance sheet,you should be confrdentthis is actually the amount of cash the company had on the balance sheetdate. The salesshown on the income statementshould be salesthat have been completed-goods delivered to the customers. Inaccurateinformation createsenormousproblems. The SEC has been especially concerned with the information contained in financial statements.For example, recently the SEC filed chargesagainstComputron for improperly recording more than $9 million in revenue on its financial statementscontained in its reports to the SEC. Improperly recorded revenuewas the focus of a recent SEC investigationof the Mexican unit of Xerox Corp. Xerox officials in Mexico failed to setup appropriateallowancesfor bad debts and improperly classified sales,leases,and rentals, violating GAAP. The causescited were (1) failure (of the Mexican executives)to adhereto Xerox's corporatepolicies and procedures,and (2) inadequateinternal controls. Exhibit 2.20 summarizesthree types of controls a company can use to minimize the risk oferrors in the accounting system:preventivecontrols, detectivecontrols, and corrective controls. Preventive Controls. Thesetypes of controlshelp preventerrors in an accountingsystem. When you order somethingfrom Amazon.com, the company gives you more than one chanceto review and confirm your order. The computer program is designedto automatically insert the price of eachitem you order.Theseare controls that Amazon hasput in place to help prevent errors from entering its accounting system.

EXHIBIT2.20

Types Internal of Controls


A company's accounting information system consistsof three major types of controls: ones that prevent enors, ones that detect errors, and ones that corTectelTors.

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

CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 I O

I I I I

'hewsf&sA
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.

Points Summary Chapter


To make the financial statementsuseful, we need to understand the rules and the choicesused to constructthem. Theserules are called Generally Accepted Accounting Principles (GAAP). Accounting according to GAAP is accrual based.That meansthat revenuesare recognized when they are earned,not when the cash is collected. Costs are matched to revenuesso that they are recognized-put on the income statementas expenses-at the sametime as the revenuesthey helped generate. Accrual accounting consistsof two types of transactions-accruals and deferrals-in which the exchangeof cash takes place at a different time than the exchangeof goods or servlces. With accruals,the action takes place before the exchange of cash. An example is a credit sale.The saleis recorded,but the cashwill be collected later. Remember,accrue meansto "build up." When Tom's Wear makes a sale on account, the company builds up sales,even though the cashhas not been collected yet. With deferrals,the dollars are exchangedbefore the action occurs.An example is payWhen Tom's Wear paid for the insurancein advance,that ing for somethingin advance. was a deferral. Remember, defer means to "postpone." When Tom's Wear purchases insurancein advance,prepaid insurance,the companypostponesrecognition ofthe expense.The action, in this case,is the passingof the time to which the insuranceapplies. Adjustments are made before financial statements prepared.The amountsrecorded are throughout the year may need to be adjusted to make sure they accuratelyreflect the assets, liabilities, shareholders'equity,revenues,and expenses the date ofthe stateon ments. How we actually adjust the amounts to correctly reflect the financial position of a company dependson how we keep track of our businesstransactions.

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

Problems Chapter Summary


The following transactionstook place during the first year of businessfor SW2 Company. (Dollars given are in millions. Use the numbers as shown, but make a note on your statements that the dollars are in millions.) The firm's year end is June 30. 1. 2. 3. 4. 5. 6. 7. 8. 9. Issued SW2 stock (receivedcontributions from owners) in the amount of $250 Borrowed $850 from a local bank with a 6-year note (ignore interest expense) Purchasedland for 5650 cash Paid $25 for operatingexpenses Purchased new equipmentfor cashof $300 Collected $800 from customersfor servicesprovided Paid salariesto employeesof $480 Purchased suppliesfor $20 on account,to be usedin the coming year Paid dividends to new shareholders $5 of

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)

Assets Property, Plant,& Equipment

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

250 850 (650) (25) 650

2
o

(25) 300 800 (480) 20 20


(5)

(3001
6

800 (480

7
8

(51
440 950 = Assets $1,410 20 20 850 250 800 (505)

(5)

Check:

Liabilities + SH Equity = $1,410

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:

SW2 Company Income Statement For the Period Ended June 30


( in mi l l i ons )

Re ve nu e Expenses Net income

... $800 505

The next statement y tice how net income is ut

SW2Compan; in Statementof Changes Shar For the Period Ended


( in m i l l i ons ) ,

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.

SW2 Company Balance Sheet At June 30


( in m illion s )

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

250 290 $ 1,410

These amounts came from the staternent of changesin shareholders' equity.

78

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

....,...

$800 (25) (480) (650) (300) 250 850 (5)

$ 295

(e50)

" " '" " " " I r This is the r cashbalance 440 r found on the l 6 $ 440 *l balance 1,095
st l ccl ,.

80

I CHAPTER o Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N I O

2 KeyTerms Chapter for


Accountspayable(p. 54) Accounts receivable(p. 56) Accrual(p.64) Accrual accounting (p 63) Adjusting the books (p. 56) Assets(p. 59) Capital (p. 61) Cashbasisaccounting Equity (p. 61) principle Full-disclosure (p.s8) assumption Coi ng-concern (p. 53) principle Historical-cost (p.s3) Internalcontrols(p. 75) Liabilities (p. 61) Liquidity (p 59) (p. Long-term assets 59) Long-term liabilities (p. 61) Matching principle (p. 62) Monetary-unit assumption Net profrt (p. 50) (p. Noncurrentassets 59) Noncur:rentliabilities (p.61) On account(p. 54) Paid-in capital (p. 61) Prepaid insurance(p. 54) Recognizedrevenue(p. 62) Retainedearnings(p. 61t Revenue-recognition principle (p.62) Separate-entity assumption

(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)

TURN Answers YOUR to Questions


2 Chapter YourTurn2-1
1. GAAP standsfor generally acceptedaccountingprinciples. 2. Guidelines are neededto ensurethe usefulnessof the information so that a firm's performance can be comparedfrom period to period and comparedto other firms'performances.

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.

: . I. . ,, ,' , , ,' ' ,',, ' ..

82

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

83

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

06/30/2008 s0,000 $1 $100,000

0613012009 $180,000 $17s,000

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.

84

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

$2,700 (1,s00) (e7s) 8,650 1,400 $10,275

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

86

CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 O I

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

$231,300 52,300 51,890 23,200

:l' :i: " :,,:.:.:t,

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

45,200 100,000 75,000


45.980

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

8. 9. 10. 11. 12.

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?

88

CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T I O N 2 O I

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

Sh o rt-te rmi nvestments 1,370 Cash Ac c o u n ts cei vabl e re In v e n to ri es

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

201 0 230,875 386,1 82 110,850 165,432 220,750

2009 256,294 363,170 107,895 167,670 195,s00

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

C H A P T E2 . P R O B L E M S R

89

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

2,000 s,000 8,000 39,000 3,000 57,000 40,000 62,000 10,000


112,000

$ 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.

90

CHAPTER o Q UALI TI ES Ac c oUNTI NG I N F o R M A T I o N ] oF

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

Assets Accounts Supplies receivable

Li abi l i ti es Accounts payabl e Notes payabl e (5-year)

S harehol ders' quit y E Contributed capi tal Retained earnings

$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

2,500 Revenue 10,000 Revenue

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.

92

CHAPTER . Q UALI TI ES F ACCO UNTI NG F O R M A T I O N 2 IN O

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

2,000 5,000 8,000 3s,000 4,000 54,000

52,000 47,000 20,000 119,000 $ 173,000

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

93

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

Li abi l i ti es Accounts payabl e Long-term notes payabl e

S harehol ders' E qui ty C ommon stock Retained earni n gs

Cash 1

$2,000 4,000 4,000

$2,000 stock Common

2 3

(s,000)

(s,000)
Operating expenses

1,500

8,000

1,500 Service revenue 8,000 Service revenue 4,000 4,000 (400)

6 7 8 9

6,000 (400) (3,1 00)

(5,ooo) (3,1 oo)


S al ar y expense

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.

94

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.

Financial Statement Analysis


FSA2-1. The balancesheets TootsieRoll IndustriesInc. are shownhere.(Lo 3, 5) for Assets Cash Investments Receivables Inventory Other current assets N e t p ro p ertypl ant & equi pment Other noncurrentassets Total assets L i a b i l i ti e s Bank loan (short-term) Accountspayable payabl e D i v i d e n ds A c c ru e dl i abi l i ti es Incometaxespayable T o ta lc urrentl i abi l i ti es N o n c u rrent i abi l i ti es I T o ta l l i a b i l i ti es C o n tri b u ted capi tal R e ta i n e d earni ngs O th e r s h a re hol ders' equi ty accounts, net* T o ta l l i a b i l i t i es and sharehol ders' equi ty 32,001 17,482 4,263 44,969 14,941 113,656 82,635 196,291 463,1 08 164,236 (s,939) 617,405 $ 813,6e6 * T h i si s a n i te m you w i l l l earnabout i n a l ater chapter. Required a. b. c. d. What were the total current assetsat December 31, 2004? 2005? How are the assetsordered on the balance sheet? What were the total current liabilities at December 31,2004? 2005? calculate the currentratio at December31,2004 and December31, 2005.what information do thesenumbersprovide? 6,333 19,3 1 5 3,6 59 44,722 8,288 82,317 159,2s7 241,574 434,047 149,055 31-D ec-05 31-D ec- 04 (i n thousands) $ 91,336 s4,892 33,524 55,032 11 12 ,7 178,750 388,340 $ S O,geg 32,369 37,457 58,777 7,1 01 178,750 440,310

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)

:.,,,,:l:,]]. I.:

C H A P TE R2 . FIN A N C IA L S TA TE ME N T A N A LY S IS

95

..,' :.,.1... :' ;," :,' ;' :' ,;

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

585 (260) (21)


(2,556)

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?

96

CHAPTER . Q UALI TI ES F ACCO UNTI NG N F O R M A T T O N 2 O I

Critical Thinking Problems


Risk and Controls Look at the information in the Staplesannual report in appendix in addition to the financial statements. What kinds of risks does Staplesface?Use the information in the annualreport and your own experienceto answer this question.

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.

InternetExercise: MSNMoneyand Merck


MSN Money offers information aboutcompanies,industries,people,andrelatednewsitems. For researchinga company,this Web site is a good place to startgatheringbasic information. Pleasego to the www.prenhall.com/reimersWeb site. Go to Chapter 2 anduse the Internet Exercise company link. Or try http://moneycentral.msn.com. lB2-l.Inthe Symbol box, enter MRK for Merck and Co. Inc. a. What type of company is Merck? b. List three products manufacturedby Merck. lE2-2. Click on FinancialStatements. a. For the most recent year list the amountsreported for sales,cost of goods sold, and total net income. Does the amount reported for revenuerepresentcash received from customersduring the year? If not, what does it represent? What does the amount reported for cost of goods sold represent?Is Merck a profitable company?How can you tell? b. For the most recent year list the amountsreported for total assets, total liabilities, and total shareholders'equity. Does the accounting equation hold true? Are assetsprimarily financed with liabilities or shareholders'equity? c. Does Merck use accrual-based cash-based or accounting?How can you tell? Pleasenote: Internet Web sites are constantly being updated.Therefore, if the information is not found where indicated, pleaseexplore the Web site further to find the information.

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