Chapter 2 · PDF fileUse the cash basis of accounting to analyze, record, and summarize...

2LEARNING OBJECTIVES

OBJECTIVE 1Describe the basic elements of a financial accounting

information system.

OBJECTIVE 2Describe the cash and accrual bases of accounting.

OBJECTIVE 3Use the cash basis of accounting to analyze, record,

and summarize transactions for a corporation’sfirst period of operations.

OBJECTIVE 4Use the cash basis of accounting to prepare financial

statements for the first period of operations.

OBJECTIVE 5Use the cash basis of accounting for recording

transactions and preparing financial statementsfor a second period of operations.

OBJECTIVE 6Describe the advantages and disadvantages of the

cash basis of accounting.

OBJECTIVE 7Describe and illustrate how vertical analysis can be

used to analyze and evaluate a company’sperformance.

Chapter 2

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In Chapter 1 we introduced you to the nature of businesses and the basic

concepts of financial statements. Financial statements are critical to the proper

functioning of free-market economy. Disclosure such as that provided by financial

statements is termed financial transparency. Financial transparency encourages

individuals to invest in businesses in which they have no direct control or ability

to monitor.

For example, would you be willing to invest in the stock of Lucent Technologies,

Microsoft, Amazon.com, or Intel without an ability to monitor the economic

performance of the company and its management? No, you wouldn’t. However,

financial statements provide you the transparency necessary to monitor the

performance of these companies and, thus, provide you an incentive to invest

in their stocks. Likewise, financial institutions such as First Union, J.P. Morgan

Chase, TIAA-CREF, Bank One Corporation, and state pension and mutual

funds demand financial transparency before they are willing to loan funds to

businesses.

In this chapter, we continue our discussion of financial statements and their role

in enhancing financial transparency. We begin by describing the basic elements

of a financial accounting system that will enable the preparation of financial

statements. We then distinguish types of accounting systems and illustrate the

simplest form of an accounting system based on a cash basis. In doing so, this

chapter serves as a foundation for our later discussions of modern-day accounting

systems and financial reporting. However, throughout this discussion and the

remainder of this text, you should not forget that a primary benefit of financial

reporting is its role in facilitating the functioning of a free-market economy.

The Cash Basis of Accounting

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Elements of an Accounting SystemA financial accounting system is designed to produce financial statements. You shouldrecall from Chapter 1 that the basic financial statements are the income statement,retained earnings statement, balance sheet, and statement of cash flows. So what arethe basic elements of an accounting system that enable the preparation of thesestatements?

The basic elements of a financial accounting system include (1) a set of rules fordetermining what, when, and the amount that should be recorded for economicevents, (2) a framework for preparing financial statements, and (3) one or more con-trols to determine whether errors could have arisen in the recording process. Thesebasic elements are found in all financial accounting systems—from those of a localretailer or hardware store to Microsoft, General Motors, Boeing, and William J.Wrigley Jr. Company.

RulesThe set of rules for determining what, when, and the amount that should be recordedfor economic events is derived from the eight concepts we discussed in Chapter 1. Inaddition, the set of rules depends on whether the business uses the cash basis or theaccrual basis of accounting. We describe and illustrate the set of rules for the cash ba-sis of accounting in this chapter. The set of rules for the accrual basis of accountingare described and illustrated in Chapter 3.

FrameworkThe accounting equation provides a framework for recording and summarizing eco-nomic events and preparing financial statements. You should recall from Chapter 1that the accounting equation is expressed as follows:

Assets � Liabilities � Stockholders’ Equity

Using this equation, accounting systems are designed to record and summarize theeffects of economic events on each element of the equation. That is, an economicevent is analyzed in terms of its effect on assets, liabilities, or stockholders’ equity.

A transaction is an economic event that under generally accepted accountingprinciples affects an element of the accounting equation and, therefore, must berecorded. A transaction could affect only one, two, or all three elements of the ac-counting equation. For example, equipment purchased for cash affects only assets.That is, one asset (equipment) increases while another asset (cash) decreases. If, onthe other hand, the equipment is purchased on credit, both assets (equipment) andliabilities (accounts or notes payable) increase.

By keeping a running total of the effects of transactions on each element, the equa-tion also provides a framework for summarizing the overall effects of a series of trans-actions. For example, by keeping a record of increases and decreases in cash, the netchange in cash for a period can be determined. Likewise, by keeping a record of sales,the total sales for the period can be determined.

Using the accounting equation as the framework for recording and summarizingtransactions also facilitates preparing financial statements. This is so because the ac-counting equation represents all of the balance sheet elements and, thus, the financialcondition of a company at a point in time. Changes in financial condition can be

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OBJECT IVE 1Describe the basicelements of a financialaccountinginformation system.

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measured by analyzing changes in two balance sheets for two periods of time. Bydoing so, the income statement, retained earnings statement, and statement of cashflows can be prepared. These relationships are illustrated here for an annual ac-counting period ending on December 31, 2004.

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ControlsUsing the accounting equation as a framework for designing an accounting system pro-vides the control that, after recording transactions, total assets must equal total liabili-ties plus total stockholders’ equity. If at the end of the period the equality does not hold,an error has occurred in either recording or summarizing transactions. For example, ifa $10,000 purchase of equipment for cash is incorrectly recorded as an increase in bothequipment and cash, the total assets will exceed the total liabilities and stockholders’equity by $20,000 at the end of the period. Likewise, if equipment was increased by$10,000 but cash was not decreased by $10,000, the total assets will exceed total liabili-ties and stockholders’ equity by $10,000 at the end of the period. In both cases, the in-equality of the equation indicates that an error has occurred in the recording process.

Before the financial statements are prepared, errors should be discovered and cor-rected. However, the equality of the equation at the end of the period doesn’t neces-sarily mean that no errors have occurred. For example, assume that a businesspurchased $10,000 of equipment on credit and recorded the transaction as an increasein equipment of $10,000. However, instead of increasing the liabilities by $10,000, thetransaction was recorded as a $10,000 decrease in cash. In this case, the accountingequation still balances, even though cash and liabilities are understated by $10,000.For this reason, accounting systems are designed with additional controls for record-ing and summarizing transactions. We discuss these controls in later chapters.

Cash and Accrual Bases of AccountingAn accounting system is based on either the cash basis or the accrual basis of ac-counting. The accrual basis is used by large businesses and is required of publiclyheld corporations, such as Amazon.com and Wm. J. Wrigley Jr. Company. The cashbasis of accounting is often used by individuals and small businesses.1 For example,

OBJECTIVE 2Describe the cash andaccrual bases ofaccounting.

1Some businesses use a modified-cash or tax basis of accounting. These bases of accounting arecovered in advanced accounting texts.

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you probably use a cash basis because your checkbook is your primary accountingrecord. You keep track of your deposits (cash receipts) and checks (cash payments).Periodically, the bank sends you a statement that you use to verify the accuracy ofyour record keeping.

Both the cash and accrual bases of accounting use the business entity, cost, goingconcern, objectivity, unit of measure, adequate disclosure, and accounting periodconcepts discussed in Chapter 1. As we discuss in the following paragraphs, the pri-mary difference between the cash and accrual bases of accounting involves the match-ing concept.

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F acing a slumping market for sugared

chewing gum, such as Juicy Fruit and

Doublemint, Wm. J. Wrigley Jr. Company is

reinventing itself with a strategy to expand its

product lines and introduce new chewing

gum applications. Wrigley’s new products

include sugarless breath mints and more

powerful flavored mint chewing gum, such

as Extra Polar Ice. In addition, Wrigley is

experimenting with health care applications

of chewing gum. Its Health Care Division

has already developed Surpass, an antacid

chewing gum to compete with Rolaids and

Mylanta. In addition, Wrigley is experiment-

ing with a cold-relief chewing gum and a

gum that would provide dental benefits, such

as whitening teeth and reducing plaque.

Given that the U.S. population is aging, the

company figures that people might prefer

chewing gum to taking pills for sore throats,

colds, or the flu. The effects of these new

strategic initiatives will ultimately be re-

flected in Wrigley’s financial statements.

Source: Adapted from David Barboza, “A Young HeirHas New Plans at Old Company,” The New York Times,August 28, 2001.

Got the Flu? Why Not Chew Some Gum?

B U S I N E S S S T R A T E G Y

Using the Cash Basis of AccountingUnder the cash basis of accounting, a business records only transactions involvingincreases or decreases of its cash. To illustrate, assume that a real estate agency sells a$300,000 piece of property on December 28, 2003. In selling the property, the agencyearns a commission of 8% of the selling price. However, the agency does not receivethe $24,000 commission check from the attorney until January 3, 2004. Under thecash basis, the real estate agency will not record the commission (revenue) until Jan-uary 3, 2004.

Under the cash basis, expenses are recorded only when cash is paid. For example,a December cellular phone bill that is paid in January would be recorded as a Janu-ary expense, not a December expense. Thus, under the cash basis, the matching con-cept does not determine when expenses are recorded. That is, expenses are recordedwhen paid in cash, not necessarily in the period when the revenue is earned.

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Using the Accrual Basis of AccountingUnder the accrual basis of accounting, revenue is recorded as it is earned regardless ofwhen cash is received. To illustrate using the preceding example, the real estate agencyrecords the commissions (revenue) of $24,000 as earned on December 28, 2003, eventhough the check (cash) is not received until January 3, 2004. Once revenue has beenearned and recorded, any expenses that have been incurred in generating the revenueare recorded and thus matched against that revenue. For example, a December cellularphone bill would be recorded in December as an increase in expenses and liabilities,even though it is not paid until January. In this way, the December phone expense ismatched against the revenue it helped generate in December.

Summary of Differences between the Cash and Accrual Bases of AccountingExhibit 1 summarizes the basic differences in recording revenue and expenses underthe cash and accrual bases of accounting.

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EXHIBIT 1Cash versus AccrualAccounting

Cash Basis Accrual BasisRevenue is recorded When cash is received When revenue is earned

Expense is recorded When cash is paid When expense is incurred ingenerating revenue

In the remainder of this chapter, we illustrate recording transactions and prepar-ing financial statements using the cash basis of accounting. We illustrate the accrualbasis of accounting in Chapter 3. Because the cash basis is simpler, it allows us to bet-ter focus on how the accounting equation is used as the framework for accountingsystems. In addition, a thorough understanding of the cash basis should enhance yourunderstanding of the accrual basis. In turn, this understanding will facilitate your abil-ity to analyze and interpret the financial statements of publicly held corporations pre-pared under the accrual basis.

Using the Cash Basis for a Corporation’sFirst Period of OperationsUsing the accounting equation as our basic framework, we illustrate the recording oftransactions under the cash basis of accounting. We assume that on September 1,2003, Lee Landry, M.D., organizes a professional corporation to practice general med-icine. The business is to be known as Family Health Care, P.C. We describe eachtransaction or group of similar transactions during September, the first month ofoperations. We then describe how the accounting equation can be used to analyze theeffects of the transactions on the financial condition of the business. We begin withDr. Landry’s investment to establish the business.

OBJECTIVE 3Use the cash basis ofaccounting to analyze,record, and summarizetransactions for acorporation’s firstperiod of operations.

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Transaction a. Dr. Landry deposits $6,000 in a bank account in the name of Fam-ily Health Care, P.C., in return for shares of stock in the corporation. We refer tostock issued to the owner(s) (stockholder[s]) such as Lee Landry as capital stock. Theeffect of this transaction is to increase the asset (cash), on the left side of the equa-tion, by $6,000. Increases are recorded as positive numbers; decreases are recorded asnegative numbers. Thus, the $6,000 deposit is recorded as a positive addition to Cash.To balance the equation, the stockholders’ equity (capital stock) on the right side ofthe equation is increased by the same amount. This $6,000 is recorded as a positiveaddition to Capital Stock. The effect of this transaction on Family Health Care’s ac-counting equation follows.

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Assets � Stockholders’ EquityCapital

Cash � Stocka. 6,000 6,000 Investment

Note that the equation relates only to the business, Family Health Care, P.C. LeeLandry’s personal assets (such as a home or a personal bank account) and personalliabilities are excluded from the equation. The business is treated as a separate entity,with cash of $6,000 and stockholders’ equity of $6,000.

Transaction b. Family HealthCare’s next transaction is to borrow$10,000 from First National Bank tofinance its operations. To borrow the$10,000, Lee Landry had to pledgepersonal assets as security for the loanand sign a note payable in the nameof Family Health Care. The notepayable is a liability or a claim on as-sets that Family Health Care mustsatisfy (pay) in the future. In addi-

tion, the note payable requires the payment of interest of $100 per month until thenote is due in full on September 30, 2009. At the end of September, we will recordthe payment of $100 of interest.

The items in the equation prior to the borrowing transaction and the effect of theborrowing transaction are shown next. The new amounts or balances of the items arealso shown.

Unethical practices can occurin promoting the issuance ofstock to stockholders. It isconsidered fraudulent to hideknown risks from potentialstockholders, use stock pro-ceeds for purposes other than

indicated, or sell counterfeitshares. For example, two peo-ple pleaded guilty for fraudu-lently selling $15 million ofphony shares of MindArrowSystems, Inc. stock.

E T H I C S I N A C T I O N

Assets � Liabilities � Stockholders’ EquityNotes Capital

Cash � Payable � Stocka. 6,000 6,000b. 10,000 10,000 Loan from bankBal. 16,000 10,000 6,000

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Observe how this transaction changed the mix of assets and liabilities but did notchange Family Health Care’s stockholders’ equity. That is, assets minus liabilities stillequal stockholders’ equity of $6,000.

Transaction c. Next, Family Health Care buys land for $12,000 cash. The land islocated near a new suburban hospital that is under construction. Lee Landry plans torent office space and equipment for several months. When the hospital is completed,Family Health Care will build on the land.

The purchase of the land changes the makeup of the assets, but it does not changethe total assets. The effect of this transaction on the accounting equation follows.

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Assets � Liabilities � Stockholders’ EquityNotes Capital

Cash � Land � Payable � StockBal. 16,000 10,000 6,000c. �12,000 12,000 Purchase of landBal. 4,000 12,000 10,000 6,000

Transactions (b) and (c) have not improved the stockholders’ equity of FamilyHealth Care. They have simply changed the mix of assets and increased the liability,notes payable. However, the objective of businesses is to improve stockholders’ equitythrough operations.

How do businesses improve stockholders’ equity? By earning revenues in excessof expenses. Revenues increase stockholders’ equity through the business operations,and expenses decrease stockholders’ equity. When revenues for a period exceed theexpenses used to earn the revenues, the financial condition of the business will haveimproved. This improvement in financial condition results in an increase in thestockholders’ equity of the business. Likewise, if the expenses exceed the revenues fora period of time, the stockholders’ equity of the business will decrease. For this rea-son, transactions involving revenues and expenses are recorded as part of stockhold-ers’ equity in the accounting equation. In the following paragraphs, we illustrate therecording of revenue and expense transactions for Family Health Care.

Transaction d. During the firstmonth of operations, Family HealthCare earns patient fees of $5,500, re-ceiving the amount in cash. Thesetransactions increase Cash and Stock-holders’ Equity by $5,500, as follows.

To boost earnings prior to theend of a reporting period,managers sometimes engagein the questionable practice of“channel stuffing.” Channelstuffing enhances revenue(accrual basis) by persuadinga distributor to take additional

products. The practice back-fired for Lucent Technologies,which had to take back $452million of equipment fromdistributors and reverse thisamount of previously recog-nized revenue.

E T H I C S I N A C T I O N

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Unlike transactions (b) and (c), the stockholders’ equity of Family Health Carehas increased by $5,500 as a result of this transaction. You should note that the in-crease in stockholders’ equity from revenue is listed in the equation under RetainedEarnings. Retained earnings is the stockholders’ equity created by the business oper-ations (revenues less expenses). Transactions affecting earnings are kept separate fromtransactions related to stockholders’ investments (capital stock). This is useful inpreparing reports to owners and creditors and in satisfying some states’ legal re-quirements that we will discuss later in the text.

Transaction e. For Family Health Care, the expenses paid during the month wereas follows: wages, $1,125; rent, $950; utilities, $450; interest, $100; miscellaneous,$275. Miscellaneous expenses include small amounts paid for such items as postagedue and newspaper and magazine purchases. This group of expense transactions re-duces cash and stockholders’ equity, as shown below.

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Assets � Liabilities � Stockholders’ EquityNotes Capital Retained

Cash � Land � Payable � Stock � EarningsBal. 4,000 12,000 10,000 6,000d. 5,500 5,500 Fees earnedBal. 9,500 12,000 10,000 6,000 5,500


Cash � Land � Payable � Stock � EarningsBal. 9,500 12,000 10,000 6,000 5,500e. �2,900 �1,125 Wages expense

�950 Rent expense�450 Utilities expense�100 Interest expense�275 Misc. exp.

Bal. 6,600 12,000 10,000 6,000 2,600

Transaction f. At the end of the month, Family Health Care pays $1,500 to itsstockholder (Dr. Lee Landry) as dividends. Dividends are distributions of businessearnings to stockholders. Dividend payments reduce cash and stockholders’ equity.The effect of this transaction is shown as follows:


Cash � Land � Payable � Stock � EarningsBal. 6,600 12,000 10,000 6,000 2,600f. �1,500 �1,500 DividendsBal. 5,100 12,000 10,000 6,000 1,100

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You should be careful not to confuse dividends with expenses. Dividends do notrepresent assets consumed or services used in the process of earning revenues. Thedecrease in stockholders’ equity from dividends is listed in the equation under Re-tained Earnings. This is done because dividends are considered a distribution of earn-ings to the owner(s).

The transactions of Family Health Care are summarized as follows in Exhibit 2.The transactions are identified by letter, and the balance of each item is shown aftereach transaction.

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Cash � Land � Payable � Stock � Earningsa. 6,000 6,000 Investmentb. 10,000 10,000 Loan from bankBal. 16,000 10,000 6,000c. �12,000 12,000 Purchase of landBal. 4,000 12,000 10,000 6,000d. 5,500 5,500 Fees earnedBal. 9,500 12,000 10,000 6,000 5,500e. �2,900 �1,125 Wages expense

�950 Rent expense�450 Utilities expense�100 Interest expense�275 Miscellaneous exp.

Bal. 6,600 12,000 10,000 6,000 2,600f. �1,500 �1,500 DividendsBal. 5,100 12,000 10,000 6,000 1,100

EXHIBIT 2 Family Health Care Summary of Transactions for September

In reviewing the preceding illustration, you should note the following, which apply toall types of businesses:

1. The effect of every transaction is an increase or a decrease in one or more of theaccounting equation elements.

2. The two sides of the accounting equation are always equal.3. The stockholders’ equity is increased by amounts invested by stockholders

(capital stock). In addition, stockholders’ equity (retained earnings) is in-creased by revenues and decreased by expenses. Finally, stockholders’ equity(retained earnings) is decreased by dividends distributed to stockholders. Theeffect of these four types of transactions on stockholders’ equity is illustratedin Exhibit 3.

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Financial Statements for a Corporation’sFirst Period of OperationsIn Exhibit 2, the September transactions for Family Health Care are listed in the or-der that they occurred. This exhibit, however, is not very user friendly in that it doesnot group and summarize similar transactions together. As we described and illus-trated in Chapter 1, the accounting reports that provide this summarized informationare the financial statements.

The September financial statements for Family Health Care are illustrated in Ex-hibit 4. The data for the statements were taken from the transactions summary shownin Exhibit 2. You should note that each financial statement is identified by the nameof the business, the title of the statement, and the date or period of time.

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EXHIBIT 3Effects of Transactionson Stockholders’ Equity

OBJECTIVE 4Use the cash basis ofaccounting to preparefinancial statementsfor the first period ofoperations.

EXHIBIT 4Family Health CareFinancial Statements forSeptember

FAMILY HEALTH CARE, P.C.Income Statement

For the Month Ended September 30, 2003Fees earned $5,500Operating expenses:

Wages expense $1,125Rent expense 950Utilities expense 450Interest expense 100Miscellaneous expenses 275

Total operating expenses 2,900Net income $2,600

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EXHIBIT 4Concluded

FAMILY HEALTH CARE, P.C.Retained Earnings Statement

For the Month Ended September 30, 2003Net income for September $2,600Less dividends 1,500Retained earnings, September 30, 2003 $1,100

FAMILY HEALTH CARE, P.C.Balance Sheet

September 30, 2003Assets

Cash $ 5,100Land 12,000Total assets $17,100

LiabilitiesNotes payable $10,000

Stockholders’ EquityCapital stock $6,000Retained earnings 1,100 7,100Total liabilities and stockholders’ equity $17,100

FAMILY HEALTH CARE, P.C.Statement of Cash Flows

For the Month Ended September 30, 2003Cash flows from operating activities:

Cash received from customers $ 5,500Deduct cash payments for expenses 2,900Net cash flow from operating activities $ 2,600

Cash flows from investing activities:Cash payments for acquisition of land $(12,000)

Cash flows from financing activities:Cash received from sale of cap. stock $ 6,000Cash received from notes payable 10,000 $16,000Deduct cash dividends 1,500Net cash flow from financing activities 14,500

Net increase in cash $ 5,100September 1, 2003, cash balance 0September 30, 2003, cash balance $ 5,100

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Income StatementAs shown in Exhibit 4, the income statement for Family Health Care reports feesearned of $5,500, total operating expenses of $2,900, and net income of $2,600. The$5,500 of fees earned was taken from the Retained Earnings column of Exhibit 2.Likewise, the expenses were summarized from the Retained Earnings column of Ex-hibit 2 and reported under the heading Operating Expenses. The expenses were listedin order of size, beginning with the largest expense. Miscellaneous expense is usuallyshown as the last item, regardless of the amount. The total operating expenses werethen subtracted from the fees earned to arrive at the net income of $2,600. The effectof this net income is to increase retained earnings and stockholders’ equity.

Retained Earnings StatementSince Family Health Care has been in operation for only one month, it has no re-tained earnings at the beginning of September. The ending September balance is thechange in retained earnings that results from net income and dividends. This change,$1,100, will be the beginning balance for October.

Balance SheetThe amounts of Family Health Care’s assets, liabilities, and stockholders’ equity at theend of September appear on the last line of the summary of transactions. With theaddition of a heading, the balance sheet is prepared as shown in Exhibit 4.

In the Liabilities section of Family Health Care’s balance sheet, notes payable isthe only liability. When there are two or more categories of liabilities, each should belisted and the total amount of liabilities reported. As with assets, liabilities should bepresented in the order that they will be paid in cash. Thus, the notes payable due in2009 will be listed after the obligations that are due in shorter time periods.

For Family Health Care, the September 30, 2003, stockholders’ equity consists of$6,000 of capital stock and retained earnings of $1,100. The retained earnings amountis taken from the retained earnings statement.

Statement of Cash FlowsFamily Health Care’s statement of cash flows for September shows that cash increasedfrom a zero balance at the beginning of the month to $5,100 at the end of the month.This $5,100 increase in cash was the result of cash flows from operating activities of$2,600. Family Health Care also reported net income of $2,600 for September. Underthe cash basis of accounting, the net income and the cash flows from operating ac-tivities are the same. Under the accrual basis of accounting, this is normally not true.2

In addition to cash inflows of $2,600 from operating activities, Family Health Carespent $12,000 of cash for investing activities involving the purchase of land. This cashoutflow related to investing activities was financed by an additional investment of$6,000 by Dr. Landry and $10,000 borrowed through a note payable at First NationalBank. Family Health Care also distributed $1,500 in cash dividends during September.

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2In Chapter 3, we discuss why net income and cash flows from operating activities differ underthe accrual basis of accounting.

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Using the Cash Basis for the SecondPeriod of OperationsTo reinforce your understanding of recording transactions and preparing financialstatements under the cash basis, we continue with Family Health Care’s Octobertransactions. During October, Family Health Care entered into the following trans-actions:

a. Received fees of $6,400 in cash.b. Paid expenses in cash, as follows: wages, $1,370; rent, $950; utilities, $540; in-

terest, $100; miscellaneous, $220.c. Paid dividends of $1,000 in cash.

The preceding October transactions have been analyzed and entered into a sum-mary of transactions for October, as shown in Exhibit 5. You should note that thesummary of transactions for October begins with the ending balances as of Septem-ber 30, 2003.

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OBJECT IVE 5Use the cash basis ofaccounting forrecording transactionsand preparingfinancial statementsfor a second period ofoperations.

Assets � Liabilities � Stockholders’ EquityCash � Land � Notes � Capital � Retained

Payable Stock EarningsBal. 5,100 12,000 10,000 6,000 1,100a. 6,400 6,400 Fees earnedBal. 11,500 12,000 10,000 6,000 7,500b. �3,180 �1,370 Wages expense

�950 Rent expense�540 Utilities expense�100 Interest expense�220 Miscellaneous exp.

Bal. 8,320 12,000 10,000 6,000 4,320c. �1,000 �1,000 DividendsBal. 7,320 12,000 10,000 6,000 3,320

EXHIBIT 5 Family Health Care Summary of Transactions for October

Family Health Care’s financial statements for October are shown in Exhibit 6.These statements were prepared from the summary of transactions in Exhibit 5.

The income statement for October reports net income of $3,220. This is an in-crease of $620, or 23.8% ($620/2,600), from September’s net income of $2,600. Thisincrease in net income was due to fees increasing from $5,500 to $6,400, a $900, or16.4% ($900/$5,500), increase from September. At the same time, total operating ex-penses increased only $280, or 9.7% ($280/$2,900). This suggests that Family HealthCare’s operations are profitable and expanding.

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The retained earnings statement reports an increase in retained earnings of $2,220.This increase is the result of net income ($3,220) less the dividends ($1,000) paid toDr. Landry.

The balance sheet shows that total assets increased from $17,100 on September 30,2003, to $19,320 on October 31. This increase of $2,220 was due to an increase in cash

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EXHIBIT 6Family Health CareFinancial Statements for October

FAMILY HEALTH CARE, P.C.Income Statement

For the Month Ended October 31, 2003Fees earned $6,400Operating expenses:

Wages expense $1,370Rent expense 950Utilities expense 540Interest expense 100Miscellaneous expenses 220

Total operating expenses 3,180Net income $3,220

FAMILY HEALTH CARE, P.C.Retained Earnings Statement

For the Month Ended October 31, 2003Retained earnings, October 1, 2003 $1,100Net income for October $3,220Less dividends 1,000 2,220Retained earnings, October 31, 2003 $3,320

FAMILY HEALTH CARE, P.C.Balance Sheet

October 31, 2001Assets

Cash $ 7,320Land 12,000Total assets $19,320


Stockholders’ EquityCapital stock $6,000Retained earnings 3,320 9,320Total liabilities and stockholders’ equity $19,320

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from operations ($3,220) less the dividends ($1,000) that were paid to Dr. Landry.Total liabilities remained the same, but retained earnings and stockholders’ equity in-creased by $2,220.

The statement of cash flows shows a net cash receipt from operations ($3,220) anda cash payment for dividends ($1,000). Recall that under the cash basis, the net in-come is the same as the net cash flows from operations. The ending cash balance of$7,320 also appears on the October 31 balance sheet.

Advantages and Disadvantages of the Cash BasisThe primary advantage of the cash basis of accounting is its simplicity. As shown inthe illustrations for Family Health Care, it is relatively easy to use the cash basis torecord and summarize transactions. In addition, the financial statements are easy toprepare, and the net income from operations is the same as the cash flows from op-erating activities.

The primary disadvantage of the cash basis is that revenues and expenses are notalways properly matched on the income statement. This is so because revenues andexpenses are recorded only when cash is received or paid. As a result, an expense canbe reported in one period and its related revenue in another period, with the resultthat net income could be distorted. This is the primary reason that generally acceptedaccounting principles rely on the accrual basis of accounting. For this same reason,all publicly held corporations are required to use the accrual basis of accounting. If,on the other hand, cash receipts and payments are relatively stable and uniform overtime, net income under the cash basis can approximate net income under the accrualbasis. In such cases, the ease and simplicity of the cash basis could more than offsetthe additional costs of using the accrual basis. This is often the case for smaller busi-nesses and individuals.

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EXHIBIT 6Concluded

FAMILY HEALTH CARE, P.C.Statement of Cash Flows

For the Month Ended October 31, 2001Cash flows from operating activities:

Cash received from customers $ 6,400Deduct cash payments for expenses 3,180Net cash flow from operating activities $ 3,220

Cash flows from investing activities 0Cash flows from financing activities:

Deduct cash dividends (1,000)Net increase in cash $ 2,220October 1, 2003 cash balance 5,100October 31, 2001 cash balance $ 7,320

OBJECTIVE 6Describe theadvantages anddisadvantages of thecash basis ofaccounting.

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Vertical AnalysisThe basic financial statements illustrated in this and the preceding chapter are pri-mary sources of information that financial analysts and other stakeholders use in eval-uating a company’s performance. In Chapter 1, we illustrated horizontal analysis asone method of analyzing financial performance. Another method of analyzing com-parative financial statements is to compute percentages of each item within a state-ment to a total within the statement. These percentages can then be compared acrossyears. This type of analysis is called vertical analysis.

In vertical analysis of the balance sheet, each asset item is stated as a percentage ofthe total assets. Each liability and stockholders’ equity item is stated as a percentageof total liabilities and stockholders’ equity. To illustrate, Exhibit 7 shows comparativebalance sheets for Wm. J. Wrigley Jr. Company, using vertical analysis.3

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OBJECT IVE 7Describe and illustratehow vertical analysiscan be used toanalyze and evaluatea company’sperformance.

3These financial statements have been adapted based on Securities and Exchange Commission filings.

EXHIBIT 7 Comparative Balance Sheets Using Vertical Analysis: Wm. J. Wrigley Jr. Company

December 31, 2001 December 31, 2000Amount Amount

(thousands) Percent (thousands) PercentAssets

Cash and cash equivalents $ 307,785 17.4% $ 300,599 19.1%Short-term investments 25,450 1.4 29,301 1.9Accounts receivable 239,885 13.6 191,570 12.2Inventories 278,981 15.8 253,291 16.1Property, plant, and equipment 684,379 38.8 607,034 38.5Other assets 229,168 13.0 192,945 12.3Total assets $1,765,648 100.0% $1,574,740 100.0%

LiabilitiesAccounts payable $ 91,225 5.2% $ 73,129 4.6%Dividends payable 42,741 2.4 39,467 2.5Income and other taxes payable 68,467 3.9 60,976 3.9Long-term liabilities 157,127 8.9 153,633 9.8Other liabilities 129,891 7.4 114,638 7.3

Total liabilities $ 489,451 27.7% $ 441,843 28.1%

Stockholders’ equityTotal stockholders’ equity 1,276,197 72.3 1,132,897 71.9Total liabilities and stockholders’ equity $1,765,648 100.0% $1,574,740 100.0%

To simplify, the stockholders’ equity is shown as a single amount. A review of Ex-hibit 7 reveals no major changes in the makeup of Wrigley’s December 31 balancesheets for 2001 and 2000.

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In vertical analysis of the income statement, each item is stated as a percentage ofsales. To illustrate, Exhibit 8 shows comparative income statements of Wm. J. WrigleyJr. Company, using vertical analysis.

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EXHIBIT 8Comparative Income Statements Using Vertical Analysis Wm. J. Wrigley Jr. Company for Years Ending:

December 31, 2001 December 31, 2000Amount Amount

(thousands) Percent (thousands) PercentNet sales $2,429,646 100.0% $2,145,706 100.0%Cost of sales 997,054 41.1 904,266 42.1Gross profit $1,432,592 58.9% $1,241,440 57.9%Selling and administrative expenses 919,236 37.8 778,197 36.3Operating income $ 513,356 21.1% $ 463,243 21.6%Other income (expense) 14,010 0.6 16,069 0.7Income before income taxes $ 527,366 21.7% $ 479,312 22.3%Income taxes 164,380 6.8 150,370 7.0Net income $ 362,986 14.9% $ 328,942 15.3%

Exhibit 8 reveals a slight decline in overall net income from 2000 to 2001 from15.3% to 14.9% of sales. Gross profit improved from 57.9% to 58.9% of sales due tothe decrease in the cost of sales from 42.1% to 41.1%. This increase in gross profitwas offset by the increase in selling and administrative expenses from 36.3% to 37.8%of sales. As a result, operating income decreased from 21.6% to 21.1%. Other incomeand expense remained approximately the same while income taxes decreased as apercentage of sales from 7.0% to 6.8%. Further inquiry should be made as to whyselling and administrative expenses increased as percentage of sales. This increase inexpenses hurt what was otherwise a positive improvement in operating results.

Key Points1. Describe the basic elements of a financial ac-

counting information system.

The basic elements of a financial accounting systeminclude (1) a set of rules for determining what, when,and the amount that should be recorded for eco-nomic events, (2) a framework for facilitating prepa-ration of financial statements, and (3) one or morecontrols to determine whether errors may have arisenin the recording process.

2. Describe the cash and accrual bases of ac-counting.

Under the cash basis of accounting, a business recordsonly transactions involving increases or decreases ofits cash. Under the accrual basis of accounting, rev-enue is recorded as it is earned and expenses arerecorded when they generate revenue.

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3. Use the cash basis of accounting to analyze,record, and summarize transactions for acorporation’s first period of operations.

Using the accounting equation as a basic framework,September transactions for Family Health Care arerecorded using the cash basis of accounting. In doingso, (1) every transaction affects one or more elementsof the accounting equation, (2) the two sides of theaccounting equation are always equal, and (3) stock-holders’ equity is increased by issuing capital stockand revenues (retained earnings) and is decreased byexpenses (retained earnings) and dividends (retainedearnings).

4. Use the cash basis of accounting to prepare financial statements for the first period of operations.

The financial statements for Family Health Care forSeptember, its first period of operations, are shown inExhibit 4. Under the cash basis of accounting, the netincome and the cash flows from operating activitiesare the same as shown in Exhibit 4.

5. Use the cash basis of accounting for recordingtransactions and preparing financial state-ments for a second period of operations.

Using the accounting equation as a basic framework,October transactions for Family Health Care are

recorded and are summarized in Exhibit 5. The finan-cial statements for Family Health Care for October, itssecond period of operations, are shown in Exhibit 6.

6. Describe the advantages and disadvantages ofthe cash basis of accounting.

The primary advantage of the cash basis of accountingis its simplicity. In addition, the financial statementsare easy to prepare, and the net income from opera-tions is the same as the cash flows from operatingactivities. The primary disadvantage of the cash basisis that revenues and expenses are not always properlymatched on the income statement.

7. Describe and illustrate how vertical analysiscan be used to analyze and evaluate a com-pany’s performance.

Vertical analysis is a method of analyzing comparativefinancial statements in which percentages are com-puted for each item within a statement to a totalwithin the statement. In vertical analysis of the balancesheet, each asset item is stated at a percentage of thetotal assets. Each liability and stockholders’ equityitem is stated at a percentage of total liabilities andstockholders’ equity. In vertical analysis of the incomestatement, each item is stated as a percentage of sales.

GlossaryAccrual basis of accounting: A sys-tem of accounting in which revenue isrecorded as it is earned and expensesare recorded when they generaterevenue.

Cash basis of accounting: A systemof accounting in which only transac-tions involving increases or decreasesof the entity’s cash are recorded.

Financial accounting system: A sys-tem that includes (1) a set of rules for

determining what, when, and theamount that should be recorded foreconomic events, (2) a framework forfacilitating preparing financial state-ments, and (3) one or more controlsto determine whether errors couldhave arisen in the recording process.

Transaction: An economic event thatunder generally accepted accountingprinciples affects an element of theaccounting equation and, therefore,must be recorded.

Vertical analysis: A method of analyz-ing comparative financial statementsin which percentages are computedfor each item within a statement to atotal within the statement.

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Self-Study Questions(Answers appear at end of chapter.)

1. The purchase of land for $50,000 cash was incor-rectly recorded as an increase in land and a increasein notes payable. Which of the following statementsis correct?A. The accounting equation will not balance because

cash is overstated by $50,000.B. The accounting equation will not balance because

notes payable are overstated by $50,000.C. The accounting equation will not balance because

assets will exceed liabilities by $50,000.D. Even though a recording error has been made,

the accounting equation will balance.

2. The receipt of $8,000 of cash for fees earned wasrecorded by Langley Consulting as an increase incash of $8,000 and a decrease in retained earnings(revenues) of $8,000. What is the effect of this erroron the accounting equation?A. Total assets will exceed total liabilities and stock-

holders’ equity by $8,000.B. Total assets will be less than total liabilities and

stockholders’ equity by $8,000.C. Total assets will exceed total liabilities and stock-

holders’ equity by $16,000.D. The error will not affect the accounting equation.

3. Assume that a lawyer bills his clients $25,000 for feesearned on April 30, 2004. The lawyer collects $18,500of the billings during May and the remainder inJune. Under the cash basis of accounting, whenwould the lawyer record the revenue for fees earned?A. April, $25,000; May, $0; and June, $0.B. April, $0; May $18,500; and June, $7,500.C. April $18,500; May, $6,500; and June, $0D. April $0; May, $18,500; and June, $6,500.

4. Using the information in Question 3, when wouldthe lawyer record the revenue under the accrual basisof accounting?A. April, $25,000; May, $0; and June, $0.B. April, $0; May $18,500; and June, $7,500.C. April $18,500; May, $6,500; and June, $0D. April $0; May, $18,500; and June, $6,500.

5. Which of the following transactions changes only themix of assets but does not affect liabilities or stock-holders’ equity?A. Borrowed $40,000 from First National Bank.B. Purchased land for cash.C. Received $3,800 for fees earned.D. Paid $4,000 for office salaries.

Discussion Questions1. What are the basic elements of a financial accounting

system? Do these elements apply to all businessesfrom a local restaurant to General Motors? Explain.

2. Provide an example of a transaction that affects (a) only one element of the accounting equation, (b) two elements of the accounting equation, (c) three elements of the accounting equation.

3. For each of the following errors, indicate whether theerror would cause the accounting equation to be outof balance and, if so, indicate how it would be out ofbalance. (a) The purchase of land for $30,000 cashwas recorded as an increase in land of $30,000 and adecrease in cash of $3,000. (b) The receipt of $4,000for fees earned was recorded as an increase in cash of$4,000 and an increase in liabilities of $4,000. (c) Thepayment of wages of $2,750 was recorded as a de-

crease in cash of $2,750 and a decrease in retainedearnings (wages expense) of $2,570.

4. Why is the cash basis rather than the accrual basisoften used by individuals and small businesses?

5. Under the cash basis of accounting, what are twoprimary controls for determining the accuracy of abusiness’s or individual’s record keeping?

6. Assume that at the end of each month, Leister Con-sulting Services bills its clients for jobs completedduring the month. On October 31, 2004, Leisterbilled its clients $45,000 for fees earned on jobs com-pleted during October. During November, Leistercollected 80% of its fees billed on October 31 andcollected the remaining 20% during December. Whatwould be recorded by Leister as fees earned during

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October, November, and December under the cashbasis and the accrual basis of accounting?

7. As of January 31, 2004, Wyle Construction Inc. owedits employees $5,000 for wages. Because that day fallson a Saturday, Wyle did not pay its employees untilthe following Monday, February 2. Under the cashbasis, when would the wages expense of $5,000 berecorded? Explain.

8. Fathom Consulting Services acquired land three yearsago for $25,000. On September 30, Fathom signed anagreement to sell the land for $80,000. In accordancewith the sales agreement, the buyer transferred$80,000 to Fathom’s bank account on October 6.Fathom uses the cash basis of accounting. (a) Whenwould Fathom record the sale of the land? (b) Howare the elements of the accounting equation affectedby the sale?

9. How does the payment of dividends of $15,000 affectthe three elements of the accounting equation? Isnet income affected by the payment of dividends?Explain.

10. Assume that Margarita Consulting erroneouslyrecorded the payment of $7,500 of dividends assalary expense. (a) How does this error affect theequality of the accounting equation? (b) How doesthis error affect the income statement, retained earn-ings statement, balance sheet, and statement of cashflows?

11. Assume that Blitzkrieg Realty Inc. borrowed $25,000from First Union Bank and Trust. In recording the

transaction, Blitzkrieg erroneously recorded the re-ceipt of $25,000 as an increase in cash, $25,000, andan increase in fees earned, $25,000. (a) How doesthis error affect the equality of the accounting equa-tion? (b) How does this error affect the income state-ment, retained earnings statement, balance sheet, andstatement of cash flows?

12. Assume that as of January 1, 2004, Palmetto Consult-ing has total assets of $450,000 and total liabilitiesof $280,000. As of December 31, 2004, Palmetto hastotal liabilities of $300,000 and total stockholders’equity of $225,000. (a) What was Palmetto’s stock-holders’ equity as of December 31, 2003? (b) Assumethat Palmetto did not pay any dividends during2004. What was the amount of net income for 2004?

13. Using the January 1 and December 31, 2004, datagiven in Question 12, answer the following questions.(a) If Palmetto paid $18,000 of dividends during2004, what was the amount of net income for 2004?(b) Under the cash basis, will Palmetto’s cash flowsfrom operating activities be the same as its net income?

14. The primary disadvantage of the cash basis of account-ing is that revenues and expenses are not alwaysproperly matched on the income statement. Explain.

15. In Chapter 1, we described and illustrated horizontalanalysis. (a) What is the difference between horizon-tal and vertical analysis? (b) Can horizontal and ver-tical analysis be used together in analyzing acompany?

ExercisesDetermine the missing amount for each of the following:

Assets � Liabilities � Stockholders’ Equitya. ? � $30,500 � $ 50,000b. $360,000 � ? � 100,000c. 225,000 � 45,000 � ?

The assets and liabilities (in millions) of Walt Disney Company as of September 30, 2000,were as follows:

Assets $45,027Liabilities 20,927

a. Determine the stockholders’ equity of Walt Disney as of September 30, 2000.

EXERCISE 2-1Accounting equation

OBJECTIVE 1

✓ a. $80,500


OBJECTIVE 1

✓ a. $24,100

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b. If assets decreased by $1,328 and stockholders’ equity decreased by $1,428, what was theincrease or decrease in liabilities for the year ending September 30, 2001?

c. What were the total assets, liabilities, and stockholders’ equity as of September 30, 2001?d. Based on your answer to (c), does the accounting equation balance?

The assets and liabilities (in millions) of Campbell Soup Co. as of July 29, 2000, were asfollows:

Assets $5,196Liabilities 5,059

a. Determine the stockholders’ equity of Campbell Soup as of July 29, 2000.b. If assets increased by $731 and liabilities increased by $1,115, what was the increase or

decrease in stockholders’ equity for the year ending July 29, 2001?c. What were the total assets, liabilities, and stockholders’ equity as of July 29, 2001?d. Based on your answer to (c), does the accounting equation balance?

One item is omitted in each of the following summaries of balance sheet and income state-ment data (in millions) for General Motors and Coca-Cola as of December 31, 2001 and2000.

General Coca-Motors Cola

December 31, 2000:Assets $323,969 $ (e)Liabilities (a) (f )Stockholders’ equity (b) 9,316

Increase (decrease) in assets, liabilities, and stockholders’ equity during 2001:

Assets $ (20,869) (g)Liabilities (31,437) $ (467)Stockholders’ equity 10,568 (h)

December 31, 2001:Assets $ (c) $22,417Liabilities 272,079 (i)Stockholders’ equity (d) 11,366

Determine the amounts of the missing items (a) through (i).

Jason Seagle is the sole stockholder and operator of Go-For-It, a motivational consultingbusiness. At the end of its accounting period, December 31, 2004, Go-For-It has assets of$325,000 and liabilities of $142,000. Using the accounting equation and considering eachcase independently, determine the following amounts:

a. Stockholders’ equity as of December 31, 2004.b. Stockholders’ equity as of December 31, 2005, assuming that assets increased by $84,000

and liabilities increased by $37,000 during 2005.c. Stockholders’ equity as of December 31, 2005, assuming that assets decreased by $8,000

and liabilities increased by $17,000 during 2005.d. Stockholders’ equity as of December 31, 2005, assuming that assets increased by $75,000

and liabilities decreased by $17,500 during 2005.(continued)

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OBJECTIVE 1

✓ a. $137


OBJECTIVE 1

✓ a. $303,516


OBJECTIVE 1

✓ b. $230,000

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e. Net income (or net loss) during 2005, assuming that as of December 31, 2005, assetswere $425,000, liabilities were $105,000, and there were no additional investments ordividends.

For Kroger Co., indicate whether the following transactions would (1) increase, (2) decrease,or (3) have no effect on stockholders’ equity.

a. Paid creditors.b. Made cash sale to customers.c. Paid interest expense.d. Purchased store equipment.e. Paid dividends.f. Purchased merchandise.g. Sold store equipment at a loss.h. Paid store rent.i. Paid taxes.j. Received interest income.

Describe how the following business transactions affect the three elements of the accountingequation.

a. Issued capital stock for cash.b. Purchased supplies for cash.c. Borrowed cash at local bank.d. Received cash for services performed.e. Paid for utilities used in the business.

a. A vacant lot acquired for $120,000, on which there is a balance owed of $40,000, is soldfor $210,000 in cash. What is the effect of the sale on the total amount of the seller’s(1) assets, (2) liabilities, and (3) stockholders’ equity?

b. After receiving the $210,000 cash in (a), the seller pays the $40,000 owed. What is theeffect of the payment on the total amount of the seller’s (1) assets, (2) liabilities, and(3) stockholders’ equity?

Indicate whether each of the following types of transactions will (a) increase stockholders’equity or (b) decrease stockholders’ equity:

1. Issued capital stock for cash.2. Received cash for fees earned.3. Paid cash for rent expense.4. Paid cash dividends.5. Paid cash for utilities expense.

The following selected transactions were completed by Speedy Delivery Service during May:

1. Received cash for capital stock, $25,000.2. Borrowed $15,000 from a local bank.3. Paid advertising expense, $800.4. Paid rent for May, $2,500.5. Received cash from customers, $7,250.6. Paid creditors, $500.

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EXERCISE 2-6Effect of transactions onstockholders’ equity

OBJECTIVES 1, 3, 4, 5

EXERCISE 2-7Effect of transactions onaccounting equation




✓ a. (1) assets increase$90,000

EXERCISE 2-9Effect of transactions onstockholders’ equity


EXERCISE 2-10Transactions


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7. Paid interest on note payable, $400.8. Purchased land for future building site by paying cash of $20,000.9. Paid a customer a $200 refund for an overcharge of services.

10. Paid cash dividends, $1,000.

Indicate the effect of each transaction on the accounting equation by listing the numbersidentifying the transactions, (1) through (10), in a vertical column, and inserting at the rightof each number the appropriate letter from the following list:

a. Increase in an asset, decrease in another asset.b. Increase in an asset, increase in a liability.c. Increase in an asset, increase in stockholders’ equity.d. Decrease in an asset, decrease in a liability.e. Decrease in an asset, decrease in stockholders’ equity.

David Saros operates his own catering service. Summary financial data for August are pre-sented in equation form as follows. Each line designated by a number indicates the effect ofa transaction on the equation. Each increase and decrease in stockholders’ equity, excepttransaction (4), affects net income.

Capital RetainedCash � Land � Liabilities � Stock � Earnings

Bal. 9,500 10,000 4,350 10,000 5,1501. �36,000 �36,0002. �15,000 �15,0003. �21,250 �21,2504. �1,500 �1,500Bal. 7,750 25,000 4,350 10,000 18,400

a. Describe each transaction.b. What is the amount of net decrease in cash during the month?c. What is the amount of net increase in retained earnings during the month?d. What is the amount of the net income for the month?e. How much of the net income for the month was retained in the business?f. What is the amount of net cash flows from operating activities?g. What is the amount of net cash flows from investing activities?h. What is the amount of net cash flows from financing activities?

The income statement of a corporation for the month of April indicates a net income of$42,000. During the same period, $50,000 in cash dividends were paid. Would it be correctto say that the business incurred a net loss of $8,000 during the month? Discuss.

Four different corporations, A, B, C, and D, show the same balance sheet data at the begin-ning and end of a year. These data, exclusive of the amount of stockholders’ equity, aresummarized as follows:

Total TotalAssets Liabilities

Beginning of the year $525,000 $220,000End of the year 970,000 425,000

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EXERCISE 2-11Nature of transactions


✓ b. $1,750

EXERCISE 2-12Net income and dividends

OBJECTIVES 4, 5

EXERCISE 2-13Net income andstockholders’ equity forfour businesses


✓ Company C: Netincome: $165,000

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On the basis of these data and the following additional information for the year, determinethe net income (or loss) of each company for the year. (Suggestion: First determine theamount of increase or decrease in stockholders’ equity during the year.)

Company A: No additional capital stock was issued, and no dividends were paid.Company B: No additional capital stock was issued, but dividends of $50,000 were paid.Company C: Capital stock of $75,000 was issued, but no dividends were paid.Company D: Capital stock of $75,000 was issued, and dividends of $50,000 were paid.

One item is omitted in each of the following summaries of balance sheet and income state-ment data for four different corporations, I, II, III, and IV.

I II III IVBeginning of the year:

Assets $400,000 $ 95,000 $100,000 (d)Liabilities 260,000 45,000 80,000 $150,000

End of the year:Assets 900,000 125,000 120,000 310,000Liabilities 500,000 35,000 105,000 170,000

During the year:Additional issue of capital stock (a) 22,000 10,000 50,000Dividends 40,000 8,000 (c) 75,000Revenue 250,000 (b) 175,000 140,000Expenses 180,000 52,000 177,000 160,000

Determine the amounts of the missing items, identifying them by letter. (Suggestion: Firstdetermine the amount of increase or decrease in stockholders’ equity during the year.)

Use the following data (in millions) for Campbell Soup Co. for the year ending July 29,2001, to answer the questions that follow the data.

Retained earnings July 29, 2000 $4,373Retained earnings July 29, 2001 4,651Net cash from operating activities 1,106Net decrease in cash 3

a. Determine the net increase or decrease in retained earnings during 2001.b. If dividends in 2001 are $371, what was the net income or loss for Campbell Soup for

the year ending July 29, 2001?c. Why doesn’t your answer in (b) agree with the net cash from operating activities of

$1,106 shown in the table?d. Why doesn’t the net cash from operating activities of $1,106 agree with the net decrease

in cash of $3?

Financial information related to Woods Interiors for September and October of 2004 is asfollows:

Sept. 30, 2004 Oct. 31, 2004Notes Payable $10,000 $15,000Land 17,000 25,000Capital Stock 6,000 9,000Retained Earnings ? ?Cash 18,000 27,000

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EXERCISE 2-14Missing amounts frombalance sheet andincome statement data


✓ a. $230,000

EXERCISE 2-15Net income, retainedearnings, and dividends

OBJECTIVES 4, 5

✓ a. $278 increase

EXERCISE 2-16Balance sheet, netincome, and cash flows

OBJECTIVES 4, 5

✓ b. $11,000

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a. Prepare balance sheets for Woods Interiors as of September 30 and as of October 31, 2004.b. Determine the amount of net income for October, assuming that dividends of $2,000

were paid.c. Determine the net cash flows from operating activities.d. Determine the net cash flows from investing activities.e. Determine the net cash flows for financing activities.f. Determine the net increase or decrease in cash.

After its first month of operations, the following amounts were taken from the accountingrecords of Mata Hari Realty Inc. as of April 30, 2004. Mata Hari Realty uses the cash basis ofaccounting.

Capital Stock $ 5,000Cash 10,750Dividends 2,000Interest Expense 1,000Land 18,500Miscellaneous Expense 1,250Notes Payable 15,000Rent Expense 3,000Retained Earnings 0Salaries Expense 4,500Sales Commissions 24,750Utilities Expense 3,750

Prepare an income statement for the month ending April 30, 2004.

Using the financial data shown in Exercise 2-17 for Mata Hari Realty Inc., prepare a retainedearnings statement for the month ending April 30, 2004.

Using the financial data shown in Exercise 2-17 for Mata Hari Realty Inc., prepare a balancesheet as of April 30, 2004.

Using the financial data shown in Exercise 2-17 for Mata Hari Realty Inc., prepare a state-ment of cash flows for the month ending April 30, 2004.

The following was adapted from the September 30, 2001, financial statements of LucentTechnologies Inc. Describe how each of the following transactions of Lucent Technologieswould affect the three elements of its accounting equation.

a. Paid dividends.b. Made cash sales.c. Received cash from issuing stock.d. Paid long-term debt.e. Received cash proceeds from selling a portion of manufacturing operations for a gain on

the sale.f. Received cash from the issuance of long-term debt. (continued)

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EXERCISE 2-17Income statement

OBJECTIVES 4, 5

✓ Net income: $11,250

EXERCISE 2-18Retained earningsstatement

OBJECTIVES 4, 5

EXERCISE 2-19Balance sheet

OBJECTIVES 4, 5

✓ Total assets: $29,250

EXERCISE 2-20Statement of cash flows

OBJECTIVES 4, 5



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g. Paid taxes.h. Paid research and development expenses for the current year.i. Paid employee pension expenses for the current year.j. Purchased machinery and equipment for cash.k. Paid officer salaries.l. Paid selling expenses.

Based on the financial transactions for Lucent Technologies Inc. shown in Exercise 2-21,indicate whether the transaction would be reported in the cash flows from operating, invest-ing, or financing section of the statement of cash flows.

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EXERCISE 2-22Statement of cash flows

OBJECTIVES 4, 5

ProblemsJay Marsh established an insurance agency on May 1, 2004, and completed the followingtransactions during May:

a. Opened a business bank account in the name of Frontier Insurance Inc. with a depositof $30,000 in exchange for capital stock.

b. Borrowed $10,000 by issuing a note payable.c. Received cash from fees earned, $8,100.d. Paid rent on office and equipment for the month, $1,000.e. Paid automobile expenses for month, $800, and miscellaneous expenses, $250.f. Paid office salaries, $1,500.g. Paid interest on the note payable, $75.h. Purchased land as a future building site, $15,000.i. Paid dividends, $2,000.

Instructions1. Indicate the effect of each transaction and the balances after each transaction, using the

following tabular headings:

PROBLEM 2 1Transactions andfinancial statements


✓ 3. Net income: $4,475

Assets � Liabilities � Stockholders’ EquityCash � Land � Notes Payable � Capital Stock � Retained Earnings

Explain the nature of each increase and decrease in stockholders’ equity by an appropriatenotation at the right of the amount.

2. Briefly explain why the stockholders’ investments and revenues increased stockholders’equity, and why dividends and expenses decreased stockholders’ equity.

3. Prepare an income statement and retained earnings statement for May.4. Prepare a balance sheet as of May 31, 2004.5. Prepare a statement of cash flows for May.

Scott Douma established Top-Notch Computer Services on July 1, 2004. The effect of eachtransaction and the balances after each transaction for July are as follows:

PROBLEM 2 2Cash basis financialstatements


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Instructions1. Prepare an income statement for the month ended July 31, 2004.2. Prepare a retained earnings statement for the month ended July 31, 2004.3. Prepare a balance sheet as of July 31, 2004.4. Prepare a statement of cash flows for the month ended July 31, 2004.

The following amounts were taken from the accounting records of Nutrition Services Inc. asof December 31, 2004. Nutrition Services began its operations on January 1, 2004, and usesthe cash basis of accounting.

Capital Stock $ 10,000Cash 27,500Dividends 5,000Fees Earned 229,500Interest Expense 1,200Land 75,000Miscellaneous Expense 6,800Notes Payable 15,000Rent Expense 24,000Retained Earnings 0Salaries Expense 65,000Taxes Expense 18,000Utilities Expense 32,000

Instructions1. Prepare an income statement for the year ending December 31, 2004.2. Prepare a retained earnings statement for the year ending December 31, 2004.3. Prepare a balance sheet as of December 31, 2004.4. Prepare a statement of cash flows for the year ending December 31, 2004.

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Cash � Land � Payable � Stock � Earningsa. �18,000 �18,000 Investmentb. �12,250 12,250 Fees earnedBal. 30,250 18,000 12,250c. �2,000 �2,000 Rent expenseBal. 28,250 18,000 10,250d. �10,000 �10,000Bal. 38,250 10,000 18,000 10,250e. �25,000 �25,000Bal. 13,250 25,000 10,000 18,000 10,250f. �1,150 �800 Auto expense

�350 Misc. expenseBal. 12,100 25,000 10,000 18,000 9,100g. �2,500 �2,500 Salaries expenseBal. 9,600 25,000 10,000 18,000 6,600h. �1,000 �1,000 DividendsBal. 8,600 25,000 10,000 18,000 5,600


OBJECTIVES 4, 5

✓ 1. Net income: $82,500

✓ 1. Net income: $6,600

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After its second year of operations, the following amounts were taken from the accountingrecords of Nutrition Services Inc. as of December 31, 2005. Nutrition Services began itsoperations on January 1, 2004 (see Problem 2-3A) and uses the cash basis of accounting.

Capital Stock $ 25,000Cash ?Dividends 15,000Fees Earned 254,100Interest Expense 1,600Land 140,000Miscellaneous Expense 7,000Notes Payable 20,000Rent Expense 28,000Retained Earnings (January 1, 2005) 77,500Salaries Expense 70,000Taxes Expense 20,000Utilities Expense 36,000

Instructions1. Prepare an income statement for the year ending December 31, 2005.2. Prepare a retained earnings statement for the year ending December 31, 2005.3. Prepare a balance sheet as of December 31, 2005.4. Prepare a statement of cash flows for the year ending December 31, 2005. (Hint: You

should compare the asset and liability amounts of December 31, 2005, with those ofDecember 31, 2004, to determine cash used in investing and financing activities. SeeProblem 2-3A for the December 31, 2004, balance sheet amounts.)

The financial statements at the end of Harvest Realty Inc.’s first month of operations follow.By analyzing the interrelationships between the financial statements, fill in the properamounts for (a) through (s).

HARVEST REALTY INC.Income Statement

For the Month Ended March 31, 2004Fees earned $ (a)Operating expenses:

Wages expense $3,680Rent expense 2,000Utilities expense (b)Interest expense 200Miscellaneous expenses 440

Total operating expenses 7,500Net income $ (c)

HARVEST REALTY INC.Retained Earnings Statement

For the Month Ended March 31, 2004Retained earnings, March 1, 2004 $ (d)Net income for March $5,500Less dividends (e) (f )Retained earnings, March 31, 2004 $ (g)

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OBJECTIVES 4, 5

✓ 1. Net income: $91,500

PROBLEM 2 5Missing amounts fromfinancial statements

OBJECTIVES 4, 5

✓ a. $13,000

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HARVEST REALTY INC.Balance Sheet

March 31, 2004Assets

Cash $ (h)Land 20,000Total assets $26,500


Stockholders’ EquityCapital stock $ (i)Retained earnings (j) (k)Total liabilities and stockholders’ equity $ (l)

HARVEST REALTY INC.Statement of Cash Flows

For the Month Ended March 31, 2004Cash flows from operating activities:

Cash received from customers $13,000Deduct cash payments for expenses 7,500Net cash flows from operating activities $ (m)

Cash flows from investing activities:Cash payment for purchase of land 20,000

Cash flows from financing activities:Cash received from sale of capital stock $10,000Cash received from notes payable (n) $ (o)Deduct cash dividends 1,000Net cash flows from financing activities (p)

Net increase in cash $ (q)March 1, 2004 cash balance (r)March 31, 2004 cash balance $ (s)

Spring Creek Realty Inc., organized July 1, 2004, is operated by Bob Gibbs. What errors canyou find in the following financial statements for Spring Creek Realty Inc., prepared after itsfirst month of operations?

SPRING CREEK REALTY INC.Income Statement

July 31, 2004Sales commissions $ 46,100Operating expenses:

Office salaries expense $ 8,150Rent expense 3,800Automobile expense 1,750Dividends 1,000Miscellaneous expense 775

Total operating expenses 15,475Net income $ 20,625

Bob GibbsRetained Earnings Statement

July 31, 2003Net income for the month 20,625Retained earnings, July 31, 2004 $ 20,625

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OBJECTIVES 4, 5

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Balance Sheet Inc.For the Month Ended July 31, 2004

AssetsCash $ 30,425Notes payable 10,000Total assets $ 40,425

LiabilitiesLand $ 20,200

Stockholders’ EquityCapital stock $10,000Retained earnings 20,625 30,625Total liabilities and stockholders’ equity $ 50,825

SPRING CREEK REALTY INC.Statement of Cash Flows

July 31, 2004Cash flows from operating activities:

Cash receipts from sales commissions $ 46,100Cash flows from investing activities:

Cash payments for land (20,200)Cash flows from financing activities:

Cash receipts from retained earnings 40,625Net increase in cash during year ending March 31, 2001 $ 66,525Cash as of July 1, 2004 0Cash as of July 31, 2004 $ 66,525

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ActivitiesAssume that you are considering developing a nationwide chain of women’s clothing stores.You have contacted a Houston-based firm that specializes in financing new business venturesand enterprises. Such firms, called venture capital firms, finance new businesses in exchangefor a percentage of the ownership.

1. In groups of four or five, discuss the different business strategies that you might use inyour venture.

2. For each strategy you list in (1), provide an example of a real-world business using thesame strategy.

3. What percentage of the ownership would you be willing to give the venture capital firmin exchange for its financing?

Megan Peroni and Shannon Haley both graduated from State University in May 2004. After graduation, Shannon took a job as a staff accountant in the Atlanta office of PricewaterhouseCoopers, an international public accounting firm. Megan began workingas a manager in Arrow Electronics, a wholesale computer hardware and software companybut left after only six months to start her own consulting business. The following conversationtook place between Megan and Shannon at their first annual alumni function:

Megan: Shannon, good to see you again.Shannon: Yes. It doesn’t seem like it’s been almost a year since we graduated.

Activity 2-1Business strategy

Activity 2-2Cash basis of accounting

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Megan: That’s for sure. It seems like only yesterday we were listening to that boring com-mencement speaker. I don’t even remember her name . . . Monica somebody. Are youstill working for PricewaterhouseCoopers?

Shannon: Yes, it’s been a great year. I’ve worked on thirteen companies; it’s been a fantasticlearning experience. Each client has a different culture, management team, strategy,problems, and personality. I’ve learned something new every day. How about you? Areyou still working for Arrow Electronics?

Megan: No, I quit after six months. My customers really didn’t know what they needed forcomputer systems . . . so . . . I quit and started a consulting business. I feel like I’m help-ing my customers more now than I did before. Besides, I like being my own boss.

Shannon: What’s the name of your business?Megan: I-Chor Consulting. It’s been amazing. I started with my savings of $10,000 six

months ago. My last bank statement showed I’ve got more than $120,000—“pure profit”of $110,000 in only six months.

Shannon: That’s unbelievable! If you ever need a CPA firm, keep us in mind.Megan: Sure. What are friends for anyway?

1. Comment on Megan’s statement that she’s earned $110,000 “pure profit” in only sixmonths.

2. Would the cash basis or the accrual basis of accounting be most appropriate for I-Chor?

Amazon.com, an Internet retailer, was incorporated in July 1994 and opened its virtualdoors on the Web in July 1995. On the statement of cash flows, would you expectAmazon.com’s net cash flows from operating, investing, and financing activities to be posi-tive or negative for 1996, 1997, and 1998? Use the following format for your answers, andbriefly explain your logic.

1998 1997 1996Net cash flows from operating activities positiveNet cash flows from investing activitiesNet cash flows from financing activities

Condensed financial statements for Wm. J. Wrigley Jr. Company for 2001 and 2000 areshown in Exhibits 7 and 8 of this chapter. Based upon these financial statements, answer thefollowing questions:

1. Using the accounting equation, Assets � Liabilities � Stockholders’ Equity, fill in theamounts for 2000. Express the amounts in thousands.

2. If during 2001 assets increased by $190,908 and liabilities increased by $47,608, determinethe increase or decrease in stockholders’ equity during 2001.

3. Based on your answers to (1) and (2), determine the total stockholders’ equity as ofDecember 31, 2001. Does this amount agree with Wrigley’s balance sheet shown inExhibit 7?

4. Based on Exhibit 7, what percentage of Wrigley’s total assets were financed by debt during2001? Assuming you are a long-term creditor of Wrigley, interpret this percentage interms of the chances that you will be repaid by Wrigley.

5. Assuming that in (4) you are a short-term creditor of Wrigley, would your interpretationand analysis of your chances of being repaid change?

The following balance sheets (in millions) were adapted from the December 31, 2001 and2000 financial statements of Boeing Co.:

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Activity 2-3Cash flows

Activity 2-4Accounting equation

Activity 2-5Vertical analysis

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December 31, 2001 December 31, 2000Assets

Cash $ 633 $ 1,010Receivables 15,554 12,478Inventories 6,920 6,852Property, plant, and equipment 8,459 8,814Intangible assets and goodwill 6,443 5,214Prepaid pension cost 5,838 4,845Other assets 4,496 3,464Total assets $48,343 $42,677

Liabilities and Stockholders’ EquityAccounts payable $13,872 $12,312Income taxes payable 909 1,866Notes and other liabilities 22,737 17,479Total liabilities $37,518 $31,657Stockholders’ equity 10,825 11,020Total liabilities and stockholders’ equity $48,343 $42,677

1. Prepare a comparative vertical analysis of the balance sheets for 2001 and 2000.2. Based on (1), what is your analysis of Boeing’s financial condition in 2001 as compared

to 2000?

The following income statement data (in thousands) for Dell Computer Corporation andGateway Inc. were taken from their recent annual reports:

Dell GatewayNet sales $31,888,000 $ 6,079,524Cost of goods sold 25,445,000 5,241,332Gross profit $ 6,443,000 $ 838,192Operating expenses 3,780,000 2,022,122Operating income (loss) $ 2,663,000 $(1,183,930)

1. Prepare a vertical analysis of Dell’s income statement.2. Prepare a vertical analysis of Gateway’s income statement.3. Based on (1) and (2), how does Dell compare to Gateway?

Yahoo.com’s Internet finance site provides summary financial information about publiccompanies, such as stock quotes, recent financial filings with the Securities and ExchangeCommission, and recent news stories. Go to Yahoo.com’s financial Web site (http://finance.yahoo.com/) and enter the stock symbol for Wm. J. Wrigley Jr. Company, WWY. Answerthe following questions concerning Wm. J. Wrigley Jr. Company by clicking on “Profile”and “Research.”

1. At what price did Wrigley’s stock last trade?2. What is the 52-week range of Wrigley’s stock?3. When was the last time Wrigley’s stock hit a 52-week high?4. Over the last six months, has there been any insider selling or buying of Wrigley’s stock?5. Who is the president of Wm. J. Wrigley Jr. Company?6. What was the salary of the president of Wm. J. Wrigley Jr. Company?7. What is the annual dividend of Wrigley’s stock?8. How many current broker recommendations are strong buy, buy, hold, sell, or strong

sell? What is the average of the broker recommendations?

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Activity 2-6Vertical analysis

Activity 2-7Financial information

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9. What is the earnings per share of stock for this year?10. What is the earnings per share estimate for next year?

The Business Section of the August 28, 2001, issue of The New York Times has an article byDavid Barboza, “A Young Heir Has New Plans at Old Company.” Read the article and answerthe following questions:

1. Is the article favorable, neutral, or unfavorable regarding future prospects for Wm. J.Wrigley Jr. Company?

2. Would you invest in Wm. J. Wrigley Jr. Company’s stock based on only this article? Ifnot, what additional information would you want?

3. Would it be a prudent investment strategy to rely on only published financial statementsin deciding to invest in a company’s stock?

4. What sources do you think financial analysts use in making investment decisions andrecommendations?

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Activity 2-8Analyzing financialinformation

Answers to Self-Study Questions1. D Even though a recording error has been made,the accounting equation will balance (answer D). How-ever, assets (cash) will be overstated by $50,000 and lia-bilities (notes payable) will be overstated by $50,000.Answer A is incorrect because although cash is overstatedby $50,000, the accounting equation will balance. AnswerB is incorrect because although notes payable are over-stated by $50,000, the accounting equation will balance.Answer C is incorrect because the accounting equationwill balance and assets will not exceed liabilities.

2. C Total assets will exceed total liabilities and stock-holders’ equity by $16,000. This happens because stock-holders’ equity (retained earnings) was decreased insteadof increased by $8,000. Thus, stockholders’ equity will beunderstated by a total of $16,000.

3. D Under the cash basis of accounting, revenues arerecorded when the cash is collected, not necessarily when

the fees are earned. Thus, no revenue would be recordedin April, $18,500 of revenue would be recorded in May,and $6,500 of revenue would be recorded in June (An-swer D).

4. A Under the accrual basis of accounting, revenuesare recorded when the fees are earned. Thus, $25,000 ofrevenue would be recorded in April and no revenuewould be recorded in May or June (Answer A).

5. B The purchase of land for cash changes only themix of assets but does not affect liabilities or stockhold-ers’ equity (Answer B). Borrowing cash from a bank(Answer A) increases assets and liabilities. Receiving cashfor fees earned (Answer C) increases cash and stockhold-ers’ equity (retained earnings). Paying office salaries (An-swer D) decreases cash and stockholders’ equity (retainedearnings).

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