CHAPTER 1
THE NATURE AND PURPOSE OF ACCOUNTING
Changes from Twelfth Edition
The chapter has been updated.
Approach
On the first day, the usual objective is to create interest in the subject, to set the scene, and to give an
overview of the course. The first part of the chapter does this. The second part of the chapter gives a fairly
specific introduction to the nature of financial accounting. Instructors probably may want to bring in
material from their own reading or experience to make the introductory points.
Cases
The cases are intended to get the student to start thinking like accountants and users of accounting
information, without knowledge of any of the techniques. Ribbons an’ Bows gives students an
opportunity to construct a simple set of financial statements. Kim Fuller can be used as a springboard
for any type of discussion: uses of information by various parties, the cost of record-keeping, or even the
development of a complete accounting system. Baron Coburg illustrates practically all of the basic
accounting concepts, without naming them. It is a difficult case, but enlightening, even for those with
some prior accounting training.
Problems
Problem 1-1
CHARLES COMPANY
BALANCE SHEET AS OF DECEMBER 31, ----.
Assets Liabilities and Owners’ Equity
Cash...................................................................................................................................................................................................................$ 12,000 Bank loan...........................................................................................................................................................................................................$ 40,000
Inventory ...........................................................................................................................................................................................................95,000 Owners’ Equity
Other assets .......................................................................................................................................................................................................13,000 Owners’ equity...............................................................................................................................................................................................80,000
Total assets ........................................................................................................................................................................................................$120,000
Total liabilities and owners’
equity .................................................................................................................................................................................................................$120,000
This problem can be used to explain certain accounting presentation conventions. For example, the use of
double lines to underscore a total, the position of the dollar sign at the top of a column of numbers, and
the dating of the balance sheet.
The purpose of this problem is to illustrate the equality of the basic accounting equation: assets equal
liabilities plus owners’ equity.
Problem 1-2
The missing numbers are:
Year 1
Noncurrent assets ....................................................................................................................................................................................$410,976
Noncurrent liabilities...............................................................................................................................................................................240,518
Year 2
Current assets ..........................................................................................................................................................................................$ 90,442
Total assets ..............................................................................................................................................................................................288,456
Noncurrent liabilities...............................................................................................................................................................................78,585
Year 3
Total assets ..............................................................................................................................................................................................$247,135
Current liabilities.....................................................................................................................................................................................15,583
Total liabilities and owners’ equity .........................................................................................................................................................247,135
Year 4
Current assets ..........................................................................................................................................................................................$ 69,090
Current liabilities.....................................................................................................................................................................................17,539
The basic accounting equation is
Assets = Liabilities + Owners’ equity
The instructor might want to explain how this equation is used (as it is in this problem) to calculate “plug”
numbers when managers construct projected balance sheets. The manager does not have to complete
every balance because the manager can plug certain balances.
The instructor may also draw attention to the other equations illustrated in the problem. These include:
Current assets + Noncurrent assets = Total assets
Current liabilities + Noncurrent liabilities = Total liabilities
Paid-in capital + Retained earnings = Owners’ equity.
Later in the course the instructor should explain that the additional paid-in capital account is a special
account to record the excess of capital received over par value in common stock issuances. At this stage
in the course it is better to simply use a descriptive term, like paid-in capital, to describe capital received
from stockholders. Also it avoids the use of the term common stock, which some students many not
understand.
Problem 1-3
The missing numbers are:
Year 1
Gross margin ...........................................................................................................................................................................................$9,000
Tax expense.............................................................................................................................................................................................1,120
Year 2
Sales.........................................................................................................................................................................................................$11,968
Profit before taxes ...................................................................................................................................................................................2,547
Year 3
Cost of goods sold ...................................................................................................................................................................................$2,886
Other expenses ........................................................................................................................................................................................6,296
Other accounting equations such as the following are also illustrated by this problem:
Gross margin = Sales - Cost of goods sold
Profit before taxes = Gross margin - Other expenses
Net income = Profit before taxes - Tax expense
The instructor may want to point out to the students that ratios are often used by managers to construct
projected financial statements. Year 4 is an example of this application.
In order to estimate Year 4, the key ratios to compute are:
Year 1 Year 2 Year 3 Average
Sales......................................................................................................................................................................................................... % % % %
Gross margin ........................................................................................................................................................................................... %
Profit before
taxes......................................................................................................................................................................................................... %
Net income .............................................................................................................................................................................................. %
Tax rate....................................................................................................................................................................................................
Year 4
Sales.........................................................................................................................................................................................................$10,000
Cost of goods sold ................................................................................................................................................................................... 2,500
Gross margin (75% of sales) ...................................................................................................................................................................$ 7,500
Other expenses ........................................................................................................................................................................................ 5,330
Profit before taxes (% of sales) ........................................................................................................................................................$ 2,170
Tax expense.............................................................................................................................................................................................870
Net income (13% of sales) ......................................................................................................................................................................$ 1,300
The basic accounting equation used is: Net income = Revenues – Expenses
Problem 1-4
The explanation of these 11 transactions is:
1. Owners invest $20,000 of equity capital in Acme Consulting.
2. Equipment costing $7,000 is purchased for $5,000 cash and an account payable of $2,000.
3. Supplies inventory costing $1,000 is bought for cash.
4. Salaries of $4,500 are paid in cash.
5. Revenues of $10,000 are earned, of which $5,000 has been recovered in cash. The remaining $5,000
is owed to the company by its customers.
6. Accounts payable of $1,500 are paid in cash.
7. Customers pay $1,000 of the $5,000 they owe the company.
8. Rent Expense of $750 is paid in cash.
9. Utilities of $500 are paid in cash.
$200 travel expense has been incurred but not yet paid.
inventory costing $200 are consumed.
ACME CONSULTING
BALANCE SHEET AS OF JULY 31, ----.
Assets Liabilities and Owners’ Equity
Cash .........................................................................................................................................................................................................$12,750 Accounts payable ....................................................................................................................................................................................$
700
Accounts receivable ................................................................................................................................................................................4,000
Supplies inventory...................................................................................................................................................................................
800
______
Current assets....................................................................................................................................................................................17,550 Current liabilities.....................................................................................................................................................................................700
Equipment ...............................................................................................................................................................................................
7,000
Owners’ equity ........................................................................................................................................................................................ 23,850
Total assets ..............................................................................................................................................................................................$24,550
Total liabilities
and owners’ equity ..................................................................................................................................................................................$24,550
ACME CONSULTING
INCOME STATEMENT JULY 1 - 31, ----.
Revenues .................................................................................................................................................................................................$10,000
Expenses 不包含 cost of good sales?
Salaries................................................................................................................................................................................................4,500
Rent.....................................................................................................................................................................................................750
Utilities ...............................................................................................................................................................................................500
Travel ..................................................................................................................................................................................................200
Supplies............................................................................................................................................................................................... 200 6,150
Net income.....................................................................................................................................................................................$ 3,850
ACME CONSULTING
CASH RECEIPTS AND DISBURSEMENTS, JULY 1 - 31, ----.
Receipts
Owners’ investment............................................................................................................................................................................$20,000
Cash sales ...........................................................................................................................................................................................5,000
Collection of accounts receivable....................................................................................................................................................... 1,000
Total receipts .................................................................................................................................................................................$26,000
Disbursements
Equipment purchase ...........................................................................................................................................................................$5,000
Supplies purchase ............................................................................................................................................................................... 1,000
Salaries paid .......................................................................................................................................................................................4,500
Payments to vendors...........................................................................................................................................................................1,500
Rent paid.............................................................................................................................................................................................750
Utilities paid ....................................................................................................................................................................................... 500
Total disbursements.......................................................................................................................................................................$13,250
Increase in cash..............................................................................................................................................................................$12,750
The change in this cash account includes the owners’ investment, which is not an income statement item.
The income statement includes revenues and expenses that have not yet been received in cash or paid in
cash. The cash paid to purchase the equipment is not reflected in the income statement. (It is probably
best if the instructor does not discuss depreciation at this point in the course.)
This problem illustrates several important points that managers should understand. These are:
a. Every transaction involves at least two accounts.
b. Net income is not equivalent to the net change in the cash account during an accounting period.
c. Cash is influenced by both balance sheet and income statement events.
d. The basic accounting equation (Assets = Liabilities + Owners’ equity) can be used to capture,
illustrate, and explain the accounting consequences of many (but not all) transactions and events that
involve a company.
The cash receipts - disbursements display is used since it would be premature to introduce the cash flow
statement display at this point in the course.
Problem 1-5
Cash +
Accounts
Receivable +
Supplies
Inventory + Equipment =
Accounts
Payable +
Owners’
Equity
1. +
$25,000
+
$25,000
Investment
2. -
500
-
500
Rent
3. +
$8,000
+
$8,000
4. -
500
+
$500
5. -
750
-
750
Advertising
6. -
3,000
-
3,000
Salaries
7. +
2,000
+
$8,000
+
10,000
Commissions
8. -
5,000
-
5,000
9. -
100
-
100
10. +
1,000
-
1,000
Expenses
BON VOYAGE TRAVEL
BALANCE SHEET AS OF JUNE 30, ----.
Assets Liabilities and Owners’ Equity
Cash .........................................................................................................................................................................................................$17,250 Accounts payable ....................................................................................................................................................................................$
4,000
Accounts receivable ................................................................................................................................................................................8,000 Current liabilities ................................................................................................................................................................................4,000
Supplies inventory...................................................................................................................................................................................400 Owners’ equity ........................................................................................................................................................................................29,650
Current assets .....................................................................................................................................................................................25,650
Equipment ...............................................................................................................................................................................................$
8,000
______
Total Assets ...................................................................................................................................................................................$33,650
Total liabilities
and owners’ equity.........................................................................................................................................................................$33,650
BON VOYAGE TRAVEL
INCOME STATEMENT JUNE 1-30, ----.
Commissions ...........................................................................................................................................................................................$10,000
Expenses..................................................................................................................................................................................................
Rent ....................................................................................................................................................................................................$500
Advertising .........................................................................................................................................................................................750
Salaries ...............................................................................................................................................................................................3,000
Supplies ..............................................................................................................................................................................................100
Misc. Expenses ...................................................................................................................................................................................1,000
5,350
Net Income ....................................................................................................................................................................................$ 4,650
BON VOYAGE TRAVEL
CASH RECEIPTS AND DISBURSEMENTS JUNE 1-30, ----.
Receipts
Owners’ investment ..........................................................................................................................................................................$25,000
Collection of commissions................................................................................................................................................................2,000
Total receipts ..............................................................................................................................................................................$27,000
Disbursements
Paid rent ............................................................................................................................................................................................$
500
Bought supplies.................................................................................................................................................................................500
Bought advertising............................................................................................................................................................................750
Paid salaries ......................................................................................................................................................................................3,000
Paid vendors......................................................................................................................................................................................5,000
Total disbursements....................................................................................................................................................................$ 9,750
Increase in cash..............................................................................................................................................................................$17,250
See Problem 1-4 for why change in cash account and the month’s income are not the same.
The problem’s purpose and lessons for managers are similar to those in Problem 1-4.
Case 1-1: Ribbons an’ Bows, Inc.
Note: This case is unchanged from the Twelfth Edition.
Approach
This is an introductory case and it should be taught as an introductory case. There will be plenty of
time in the course for the students to learn the correct form of financial statements and details of accounting
standards. In short, the instructor should be prepared to allow a variety of formats for the financial statements
and tolerate some “not quite correct” accounting.
The instructor may want to have students discuss Carmen’s March 31 statement, but the bulk of the
class should focus on the three case questions. Any discussion of the March 31 statement should deal with
the nature of the various accounts (. prepaid rent is rent paid in advance of using the property and it is an
asset because it has future economic benefits for the company, etc), rather than the format of the statement. It
is better to leave the beginning of the course’s instruction in financial statement formats to the assigned case
question discussions.
Comments on Information Gathered and Carmen’s Concerns
1. The three month sales total is the sum of the cash sales ($7,400) and credit sales ($320).
2. Cost of sales is derived from the following equation
Beginning merchandise inventory $3,300
Plus Purchases 2,900
Equals Total available merchandise $6,200
Less Ending merchandise inventory 4,100
Equals Cost of sales $2,100
3. Rent expense is $1,800 of $600 per month times three months. Paid in cash.
4. Part-time employee expenses ($1600) is the sum of cash paid ($1510) plus amount owed ($90).
5. Supplies expense ($80) is beginning supplies inventory ($100) less supplies inventory on hand on
March 31 ($20).
6. The prepaid advertising ($150) was run by the local paper on April 2. The benefit of the asset
expired so the asset became an expense.
7. The commercial sewing machine purchase led to an $1800 asset being recorded (a future benefit).
The asset’s benefit was partly consumed during May and June resulting in a $60 depreciation charge
($1800/ 5 years/ 12 months x 2 months – straight line depreciation.)
8. Some of the future benefits of the computer and related software asset were consumed during the three
month period. A $250 depreciation charge must be recognized ($2000/ 2/ 12/ x 3 – straight line
depreciation.)
9. Cash balance at the end of period lower than beginning balance. See Question 1 discussion.
month’s interest must be recorded on the cousins’ $10,000 loan. ($10,000 x .06 x 4/ 12).
Carmen has “rented” the cousins’ money for four months. (She forgot to include the March rent in
her March 31 balance sheet.)
depreciation is recorded on the cash register loaned by the local credit-card charge processor and
the furniture left by the former tenant. These “assets” were not recognized on the financial statement
because they were neither donated nor acquired in business transactions.
uncle’s legal work is neither an asset nor an expense of the business. It did not result in a
business transaction.
’s potential salary payment in July is neither an expense nor a liability as of March 31. The
company does not have an obligation on March 31 to pay her any compensation.
Question 1
Exhibit 1 presents the company’s initial three month income statement. It does not contain a
provision for taxes, since Carmen at this early date did not know if income taxes would be due on the
annual results.
The principal reasons why the cash balance declined during the three month profitable operating
period are:
1. The commercial sewing machine purchase reduced cash by $1,800 while the related
depreciation charge only reduced income by $90.
2. Ending inventory was higher than beginning inventory and the increase was paid for with
cash. That is, more inventory was bought for cash ($2,900) than the cost of goods sold
($2,100).
Exhibit 2 present a cash flow analysis for the three month operating period.
Question 2
Exhibit 3 presents the company’s June 30 balance sheet.
Question 3
Carmen’s business is off to a good start, but it will have to do better over the rest of the year if Carmen
plans to pay herself any meaningful compensations and repay the cousins’ loan at the end of the year.
When discussing Question 3 some students believe that Carmen should include a consideration of an
imputed compensation expense in deciding how well she has done. Students accept the non recognition of
her compensation in the income statement, but believe she should recognize that personally she has incurred an
opportunity cost for lost wages (at least four months x $1300).
In addition, students believe Carmen’s nonrecognition of any cost associated with using the
abandoned counters and display equipment overstates how well she is doing from an economic point of view.
These students would include some depreciation cost based on the asset’s fair value in their evaluation of how
“successful” the business has been to date.
Some students advocate including the free legal advice’s value ($600) in their assessment of the
company’s success to date.
The instructor may challenge the class to consider why these items (free legal advice, imputed salary
and depreciation) are not included in the company’s income statement.
Exhibit 1
Ribbons an’ Bows
Income Statement for the Period
April 1 to June 30, 2010
Sales $7,720
Cost of Sales (2,100)
Gross Margin $5,620
Employee wages (1,600)
Rent (1,800)
Office Supplies (80)
Depreciation – Computer (250)
Depreciation – Sewing Machine (60)
Interest (200)
Advertising (150)
Profit before Taxes $1,480
Exhibit 2
Ribbons an’ Bows
Analysis of Cash Flows for the Period
April 1 to June 30, 2010
Beginning Cash $4,000
Sales 7,400
Wages (1,510)
Rent (1,800)
Merchandise Inventory (2,900)
Sewing Machine (1,800)
Ending Cash $3,390
Exhibit 3
Ribbons an’ Bows
Balance Sheet as of June 30, 2010
Assets Liabilities
Cash $3,390 Wages owed $90
Accounts receivable 320 Interest owed 200
Merchandise Inventory 4,100 Cousins’ loan 10,000
Supplies 20 $10,290
Prepaid rent 1,200 Owner’s Equity
Computer (net) 1,750 Carmen’s equity $1,000
Sewing machine (net) 1,740 Earnings 1,480
Cash register deposit 250 $2,480
Total $12,770 Total $12,770
Case 1-2: Kim Fuller
Note 1: This case is updated from the Kim Fuller case in the Twelfth Edition.
Note 2: The instructor should be aware that the name, Kim Fuller, could refer either to a male or a
female. The case uses no pronouns that indicate gender to refer to Kim Fuller; the gender of
Kim Fuller has been left open to interpretation by the students and/or the instructor.
Approach
This case is not, as it may appear to be, an “armchair” case. It is a real situation-the case writer is one of
“Kim Fuller’s” (disguised name) sisters who invested in the business. The intent of the case is to get
students to begin thinking about the financial information needs of a business and what kinds of
underlying records must be maintained in order to support those needs. Some instructors may even wish
to discuss the nature of the required source documents, since we often tend to ignore that important matter
in accounting courses. Finally, the case can be used to begin introducing at an intuitive level some of
the 11 basic concepts that will be presented in Chapters 2 and 3.
Comments on Questions
An opening question might be, “What information does Kim Fuller need to maintain in order to operate
this business?” Then, as students begin to identify information needed, the instructor can press for, “Who
needs that information? What do they need it for?” The information needed, as well as the users and uses
can be recorded on the blackboard. The diagram in Illustration 1-1 of the text can be used to summarize
for students the variety of information and purposes they have identified. As suggested in the text, this
information includes such things as detailed payroll records for Fuller’s employees, records of deliveries
(which are sales) to Fuller’s customer and former employer, the chemical firm, and the amounts owed for
these sales, records concerning purchases of used plastic bottles and the amounts owed to the sources of
these bottles, checkbook records, records of the costs of the items of plant and equipment owned by the
business, records of the business’s mortgage payments and balance, and records of who the firm’s owners
are and the amount of each one’s ownership interests.
By this point in the discussion, you will likely have developed a long list of information items that are
required. I like to point out that we need some way of organizing this massive amount of information. The
financial framework-especially the balance sheet and the income statement-provides a convenient way to
organize much, but not all, of this information. As students list the company’s information needs, they
should classify it as either accounting or non-accounting information.
This leads naturally to a discussion of which information would appear in balance sheet accounts
(Question 2), which in turn provides an opportunity to introduce the entity, money measurement, cost,
going concern, and dual aspect concepts (all described formally in Chapter 2). The amount of time spent
on this discussion can be varied greatly at the discretion of the instructor: if assigned for a first session,
the usual first-day “housekeeping” announcements will necessarily cause this discussion to be brief; if
used on Day 2 of the course, the case can readily generate 60-80 minutes of discussion, if students are
pressed to be specific in their recommendations.
The balance sheet called for in Question 2 might look like this:
Assets Liabilities and Owners’ Equity
Cash .........................................................................................................................................................................................................$
50,000
Mortgage .................................................................................................................................................................................................$112,000
Equipment ...............................................................................................................................................................................................65,000 Total paid-in capital.................................................................................................................................................................................165,000
Building ...................................................................................................................................................................................................
162,000
__ _____
$277,000 $277,000
Question 3 provides the opportunity to introduce the time period, matching, and materiality concepts,
although some of the basic concepts in Chapter 3 may be too difficult to introduce at this point (.,
conservatism). It may also be possible to introduce the distinction between product costs and period costs.
Question 3 together with Question 4 also naturally leads to the distinction between financial accounting
and management accounting. With only a few family members as owners, and with the bank’s mortgage
on the building well secured (by definition), the company’s financial reporting requirements are rather
minimal. Indeed family-owned businesses of this small size and simplicity often prepare annual financial
statements for tax purposes, and then distribute these same statements to the family owners and bank.
However, Fuller would be well advised to have income statements—and probably also cash flow
statements—prepared at least quarterly, and perhaps monthly, to help ensure that the business is not
slipping into any financial holes. These would be management accounting reports, but they may, of
course, be shared with the investors. (The Small Business Administration periodically reports that poor
management accounting records, particularly inadequate records of product/production costs, are a major
cause of small business failures). Ultimately, Fuller will have to judge the extent of the need (and cost
justification) for preparation of formal management accounting reports to supplement Fuller’s personal
observation of the business. Of course, the problem encountered by many businesses is that reports are
not introduced as the business grows and becomes too complex to be managed primarily by the personal
observation of its owner-founder-general manager, and this person slowly—often, unwittingly—loses
control of the business.
In sum, students should glean from their discussion of this case the idea that there are some accounting
“universals”; but at the same time, the accounting records of a firm should fit its particular situation, not
vice versa. This is true whether the firm is starting with an entirely manual accounting system, or whether
it is purchasing some “off-the-shelf” accounting software for use on a personal or small business
computer.
Case 1-3: Baron Coburg
Note: This case is unchanged from the Twelfth Edition. It is adapted from an “academic note,” written by
. Andrews of Guilford College, which appeared in the April 1974 Accounting Review. Parts of
this commentary are adapted from Professor Andrews’s note.
Approach
This case enables a student to discover a number of important accounting concepts that are described in
detail in Chapters 2 and 3. The students also discover intuitively—and of necessity—the relationship
between two balance sheet “snapshots” and the income statement for the intervening period. In general,
the case illustrates the usefulness of the accounting function: It would be almost impossible to compare
the two performances without the logical structure of accounting.
Some instructors will prefer to have students read and briefly discuss this case near the end of one class,
identifying the basic problems of the case—what measurement unit is to be used, what the entities are and
who their owner(s) is (are), what a balance sheet shows, what an income statement shows, and how
relative performance might be measured. Then the next class can be devoted to discussing proposed
statements. Other instructors will prefer to assign the case without any suggestions as to how a student
should attack the problem. (I personally favor the latter approach, whereas Professor Andrews suggests
the former.) I find that the case works well not only with beginning students, but also in management
development programs where there are several experienced accountants in the group.
Comments on Questions
The first issue confronted by the students is the definition of the entity. As Question 1 implies, each plot
can be regarded as an entity, even though both plots are owned by the Baron. (Students should realize this
earlier because the Baron is referred to as a “landlord,” or because they recall something about feudalism
from a medieval history course.) The definition of separate entities is needed in order to compare their
economic results.
The second matter students must resolve is the basis of measurement. Although this is referred to as the
money measurement concept in Chapter 2, this case illustrates that a barter-equivalent measurement
unit—here, bushels of wheat—could also be used as a common denominator to value unlike things; a
monetary unit is simply easier to use in most instances.
Third, students must decide the basis of valuation. This issue arises most clearly in the case of the land,
which is said to be “worth” five bushels of wheat per acre. At this early stage, most students will value the
land at this amount per acre; but Chapter 2 will explain that assets are usually valued at acquisition cost,
not current value. Of course, the acquisition cost is indeterminable in this instance, so the Baron’s
appraisal is the only available valuation basis. Similar comments apply to the oxen.
At this point, development of the balance sheet can begin. I find it useful to develop an intuitive concept
of an asset, and then say that as each asset is valued, we will also record who provided the financing for
the asset, and who, therefore, has a claim (equity) against the entity’s assets. This leads to the beginning
balance sheets for the farms, as shown below.
Note that I have not called the Plot worked by Ivan “Ivan’s Plot,” because that might suggest to a student
that Ivan owns the Plot. Also, the balance sheet status report must show the date at which the status
“snapshot” was taken. Since the Baron has given (., contributed) the assets, all of the equities are his. I
have not included the plows, assuming that the “snapshots” were taken as the farmers left the castle. It is
useful, even if no student raises the question, to ask how the balance sheets would differ if the
“snapshots” were taken after a plow had been acquired for each farm.
BALANCE SHEET FOR PLOT WORKED BY IVAN
As of the Beginning of the Growing Season
Assets Equities
Seed ......................................................................................................................................................................................................... 20
bu.
Baron’s equity .........................................................................................................................................................................................162 bu.
Fertilizer .................................................................................................................................................................................................. 2
Ox ............................................................................................................................................................................................................ 40
Land.........................................................................................................................................................................................................100
Total...............................................................................................................................................................................................162 bu. Total.................................................................................................................................................................................................162 bu.
BALANCE SHEET FOR PLOT WORKED BY FREDERICK
As of the Beginning of the Growing Season
Assets Equities
Seed .........................................................................................................................................................................................................
10bu.
Baron’s equity .........................................................................................................................................................................................101 bu.
Fertilizer .................................................................................................................................................................................................. 1
Ox ............................................................................................................................................................................................................ 40
Land......................................................................................................................................................................................................... 50
Total ...........................................................................................................................................................................................101 bu. Total ...........................................................................................................................................................................................101 bu.
BALANCE SHEET FOR PLOT WORKED BY IVAN
As of the End of the Growing Season
Assets Equities
Ox ............................................................................................................................................................................................................ 36
bu.
Payable to Feyador .................................................................................................................................................................................. 3
bu.
Land.........................................................................................................................................................................................................100 Baron’s equity:
Wheat.......................................................................................................................................................................................................223 Contributed capital ..................................................................................................................................................................................162
Plow......................................................................................................................................................................................................... 0 Retained earnings ....................................................................................................................................................................................194
Total.........................................................................................................................................................................................................359 bu. Total ..................................................................................................................................................................................................359 bu.
BALANCE SHEET FOR PLOT WORKED BY FREDERICK
As of the End of the Growing Season
Assets Equities
Ox ............................................................................................................................................................................................................ 36
bu.
Land......................................................................................................................................................................................................... 50 Baron’s equity:
Wheat.......................................................................................................................................................................................................105 Contributed capital ..................................................................................................................................................................................101 bu.
Plow......................................................................................................................................................................................................... 2 Retained earnings .................................................................................................................................................................................... 92
Total ...........................................................................................................................................................................................193 bu. Total ....................................................................................................................................................................................................193 bu.
Next, the ending balance sheets can be prepared. This will raise the notion of depreciation. Most students
will intuit the write-down of each ox from 40 bushels to 36 bushels, since each has a useful life of 10
years. The broken down plow used by Ivan will be more troublesome, especially since it hasn’t been paid
for. I ask students to ignore for the moment how this plow was financed; does the plow have any further
value to the farm? They then see that it should be valued at zero, though it’s not a bad idea to show it on
the balance sheet, since it has not yet been disposed of. The plow used by Frederick is treated analogously
to the oxen.
On the equities side, the three bushels owed to Feyador introduce the concept of a liability and raise the
distinction between a liability and owners’ equity. Presumably, Ivan has incurred this liability as the
Baron’s agent; ., it is the entity’s obligation, not a personal debt of Ivan. We also can distinguish
between the Baron’s initial equity, now labeled “contributed capital,” and the earnings thus far retained
on the farm (“in the entity’’). At this stage, I introduce the dual aspect concept and treat retained earnings
as a “plug” (., balancing) amount. This gives the ending balance sheets that appear on page 13 of this
manual.
Next, I suggest we try to explain why the Baron’s equity (specifically, retained earnings) increased by 194
bushels and 92 bushels for the respective farms. Thus, students see at the start of the course that flow
statements “articulate” with the beginning and ending status reports. Our explanation of this change will
be called, of course, an income statement.
It is important to bring out how production assets (as opposed to monetary assets) become expenses as the
assets provide their utility. This is straightforward for the seed and fertilizer but less so for oxen and
plows. Also, students need to see that some of the wheat production has been distributed to the
plowmaker and to the owner, with the result that these production amounts are larger than those shown
for Wheat on the ending balance sheet. I also point out that although we have treated the wheat produced
as revenues, in practice, revenues are usually based on goods sold, not goods produced. (As a matter of
fact, the “production method” is permissible for certain readily marketable commodity items, such as
wheat, as described in Chapter 5.)
The case makes no mention of payments to the peasants for their services (“labor expense”). I point out
that this would reduce Wheat and Retained earnings on the balance sheet and would increase production
expenses on the income statement.
Note that the income statements are labeled with the applicable time period. The distinction between
expenses and owners’ drawings (or “dividends”) should be explained.
(Income statements appear on page 15 of this manual.)
At this point, we can discuss performance comparisons. How should we determine which was the “better”
plot? The plot worked by Ivan produced as much wheat as the plot worked by Frederick; but the
former had twice as much acreage. (Since both plots had the same value per acre, one can reasonably
presume that they were potentially equally productive.) This raises the concept of return on investment.
Treating beginning assets (which in this case also equals beginning owners’ equity) as the investment
base, the plot worked by Ivan returned 132 percent (214 divided by 162), whereas the plot worked by
Frederick had an ROI of 121 percent (122 divided by 101). This seems paradoxical, since the first plot
returned only bushels per acre, whereas the second returned bushels per acre. The explanation
lies in the fact that Ivan used “his” ox twice as productively as did Frederick. I then ask students to
pretend that “half an ox” could have been acquired for use on Frederick’s plot, and then adjust the ROI
fraction. Adding 2 to the numerator (2 bushels less depreciation expense) and subtracting 20 from the
denominator (half the cost of an ox) gives ROI of 153 percent (124 divided by 81). This vividly illustrates
the impact on ROI (121 vs. 153 percent) of operating with excess production capacity.
If a student should raise “profit margin” as a comparison criterion, this enables pointing out the fallacy of
this measure, even in this case where the entities are engaged in identical endeavors (the same industry).
Ivan’s margin was percent, Frederick’s was percent; again, the plot worked by Ivan had better
performance (ROI), despite having a slightly lower margin, because of better utilization of the ox.
Note, however, that this ox utilization was out of the peasants’ control. Thus, Ivan was not necessarily a
better farmer than Frederick. This points up the difference between evaluating the economic performance
of an entity and the performance of its manager, a distinction emphasized in Part 2 of the text.
INCOME STATEMENT FOR PLOT WORKED BY IVAN
FOR THE GROWING SEASON
Wheat produced.......................................................................................................................................................................................243 bu.
Production expenses:
Seed ....................................................................................................................................................................................................20 bu.
Fertilizer ............................................................................................................................................................................................. 2
Ox usage ............................................................................................................................................................................................. 4
Plow usage.......................................................................................................................................................................................... 3 29
Earnings...................................................................................................................................................................................................214
Withdrawn by owner ............................................................................................................................................................................... 20
Increase in retained earnings ...................................................................................................................................................................194 bu.
INCOME STATEMENT FOR PLOT WORKED BY FREDERICK
FOR THE GROWING SEASON
Wheat produced.......................................................................................................................................................................................138 bu.
Production expenses:
Seed ....................................................................................................................................................................................................10 bu.
Fertilizer ............................................................................................................................................................................................. 1
Ox usage ............................................................................................................................................................................................. 4
Plow usage.......................................................................................................................................................................................... 1 16
Earnings...................................................................................................................................................................................................122
Withdrawn by owner ............................................................................................................................................................................... 30
Increase in retained earnings ................................................................................................................................................................... 92 bu.
CHAPTER 2
BASIC ACCOUNTING CONCEPTS: THE BALANCE SHEET
Changes from Twelfth Edition
The Chapter has been updated.
Approach
It is helpful if students understand from the outset that financial accounting is being discussed in two
cycles. In the first cycle, Chapters 2 through 4, we go through the entire accounting process quickly, to
establish an overview. We then go through the process a second time, in Chapters 5 through 14, and go
into the same topics in much greater depth. Thus, students should not be concerned if they do not
understand all the fine points in Chapters 2-4, for these will be discussed again in subsequent chapters.
Neither should they be permitted to belabor questions that involve fine distinctions; the objective here is
to get the broad, overall picture.
Our experience invariably has been that beginning students find the introduction to accounting quite
confusing. Although they may be able to do the work assigned each day, they are unable to visualize the
whole structure of accounts. This leads to a feeling of frustration that may last several weeks. Then, all of
a sudden, the pieces fall into place. From that time forward they have no special trouble and can fit each
new concept into its proper place without difficulty. Usually, the “great awakening” comes by Chapter 6,
but it may not come until even later. We do not know of any way of eliminating this initial frustration.
We go through the text briefly, mostly to encourage questions that will help clear up obscure points. We
usually explain that we do not expect that all matters discussed in this chapter will immediately be clear.
For this reason, students may wish to refer back to this and to other chapters in Part 1, as the need arises.
Many instructors like to emphasize the notion of balance sheet changes, and this can be done by adding
more transactions to Music Mart. Transactions can be called out as fast as the instructor or students think
of them, and students should see that it is possible to record any transaction whatsoever in terms of its
effect on the balance sheet. This lays a foundation that is often helpful when complex or mechanical
matters are discussed later on.
In this and the next two or three chapters, a fairly uniform terminology has been used in both text and
cases. This is artificial since practice in companies varies widely, but it serves to reduce some of the
initial confusion on the part of the student. Beginning with Chapter 6, variations in terminology appear
with increasing frequency in the cases, but the text retains terminology that seems to be favored by the
FASB, so far as we can glean from its pronouncements and those of predecessor bodies. Also, in the text,
we have made an effort to use financial statement formats that reflect FASB preferences (although, unless
specifically noted, the financial statements can be constructed equally well with other formats and format
should not be overly emphasized.)
Some readers of this material have said that it tends to belittle accounting and accountants. We certainly
do not intend to give such impression. It is true that the text does attempt to set forth the limitations on
accounting information, and it does not imply that accounting is an exact science. This is not done to
belittle the subject or its practitioners, however. Students who are permitted to get the impression that
accounting is exact, or that it does give an accurate picture of a business, are in for a rude awakening
when they get out into actual business situations. We think, therefore, that it is most unfortunate if such an
impression is permitted to develop. Several CPAs and controllers who have participated in executive
development programs have said that one of the chief values of our approach is that it does show the
limitations as well as the usefulness of accounting. They say that one of their principal practical problems
is that some uninformed people expect too much of accounting and are disappointed or disgruntled when
the accountant cannot furnish them with precise or complete information. It is possible that
misconceptions of these people are generated from exposure to a course in which the value of accounting
was overemphasized and its limitations omitted.
The foregoing does not mean that one should ever apologize for the limitations of accounting. From time
to time it should be pointed out that these limitations are inherent in the job of attempting to reduce the
complexities of an actual business situation to a few monetary figures. Incidentally, we understand that
physics teachers got themselves into considerable trouble some years ago by overemphasizing the
accuracy and completeness of our knowledge about physical phenomena. Their current practice, we
understand, is to explain what is not known.
Cases
Cases 2-1 and 2-2 provide practice work for beginning students. These two are mechanical problems to be
worked as the text material is studied. Lone Pine Cafe (A) requires the student to think about the
application of basic concepts.
Additional Cases
Some instructors like to use one of the Chapter 1 cases with this chapter. Any of the concepts described
can be dealt with in the context of those cases.
Problem Solutions
Problem 2-1
Owners’ equity equals $55,000.
Liabilities equal $25,000.
Noncurrent assets equal $70,000.
Owners’ equity is $73,000.
Current assets $33,000 + Noncurrent assets $55,000 = Total assets $88,000.
Current liabilities are $15,000 ($33,000 / )
Total liabilities and Owners’ Equity = $88,000.
Owners’ equity $73,000 = Total liabilities and Owners’ equity $88,000 - Current liabilities $15,000.
Current ratio is ($35,000 / $25,000)
Current assets $35,000 = Total assets $95,000 - Noncurrent assets $60,000.
Current liabilities $25,000 = Total assets $95,000 - Owner’s equity $70,000.
This problem tests students’ understanding of balance sheet relationships using the basic accounting
equation and financial ratio.
Problem 2-2
. GREGORY COMPANY
BALANCE SHEET, JUNE 30, ----.
Assets Liabilities
Cash .........................................................................................................................................................................................................$ 89,0
00
Accounts payable ....................................................................................................................................................................................$ 241,000
Marketable securities...............................................................................................................................................................................379,000 Taxes payable ..........................................................................................................................................................................................125,000
Accounts receivable ................................................................................................................................................................................505,000 Accrued expenses .................................................................................................................................................................................... 107,000
Inventories
513,000
Current liabilities.....................................................................................................................................................................................473,000
Current assets .....................................................................................................................................................................................1,486,000 Notes payable ..........................................................................................................................................................................................200,000
Land.........................................................................................................................................................................................................230,000 Bonds payable ......................................................................................................................................................................................... 700,000
Buildings .................................................................................................................................................................................................1,120,000 Total liabilities.........................................................................................................................................................................................1,373,000
Accumulated depreciation.......................................................................................................................................................................(538,000)
Equipment ...............................................................................................................................................................................................761,000 Owners’ Equity
Accumulated depreciation.......................................................................................................................................................................(386,000) Capital stock ............................................................................................................................................................................................1,000,000
Investments..............................................................................................................................................................................................
320,000
Retained earnings .................................................................................................................................................................................... 620,000
Total assets .........................................................................................................................................................................................$2,993,000
Total liabilities
and owners’ equity..............................................................................................................................................................................$2,993,000
Some students may want to test the notes payable as a current liability. Notes payable are usually debt
instruments longer than one year, but in the absence of any details listing them as a current liability is
acceptable.
Problem 2-3
Cash + $100,000; Capital stock + $100,000.
Bonds payable - $25,000; Capital stock + $25,000.
Retained earnings (Depreciation expense) - $8,500.
(-)Accumulated depreciation on plant and equipment + $8,500.
Cash - $15,900; Inventory + $15,900.
Inventory + $9,400; Accounts payable + $9,400.
Inventory - $4,500; Accounts receivable + $7,200; Retained earnings + $2,700
Cash + $3,500; Accounts receivable - $3,500.
Dividends payable + $3,000; Retained earnings - $3,000.
Cash - $3,000; Dividends payable - $3,000.
No effect.
Some students may simply show the net effect on assets, liabilities, and owners’ equity without
reference to the specific accounts. While this is acceptable, students should be pushed to identify both
the net effect and the particular accounts involved. This will help students to become familiar with the
balance sheet account names.
Problem 2-4
CARSON LEGATT PARTNERSHIP
BALANCE SHEET AS OF JUNE 1, ----.
Assets Capital Accounts
Cash .........................................................................................................................................................................................................$ 50,000 Carson......................................................................................................................................................................................................$ 50,000
Inventory .................................................................................................................................................................................................
50,000
Legatt....................................................................................................................................................................................................... 50,000
Total assets .........................................................................................................................................................................................$100,000 Total capital ........................................................................................................................................................................................$100,000
CARSON LEGATT PARTNERSHIP
BALANCE SHEET AS OF JUNE 30, ----.
Assets Liabilities
Cash .........................................................................................................................................................................................................$ 22,100 Bank loan.................................................................................................................................................................................................$ 50,000
Inventory .................................................................................................................................................................................................58,500 Capital - Carson.......................................................................................................................................................................................51,550
Land.........................................................................................................................................................................................................25,000 Capital - Legatt ........................................................................................................................................................................................54,050
Building ...................................................................................................................................................................................................
50,000
________
$155,600 $155,600
CARSON LEGATT PARTNERSHIP
ACCOUNTS, JUNE 30, ----.
Carson
Capital - June 1 .................................................................................................................................................................................$50,000
Additions..........................................................................................................................................................................................7,750
Withdrawals ......................................................................................................................................................................................( 6,200)
Capital - June 30 ...............................................................................................................................................................................$51,550
Legatt
Capital - June 1 .................................................................................................................................................................................$50,000
Additions..........................................................................................................................................................................................7,750
Withdrawals ......................................................................................................................................................................................( 3,700)
Capital - June 30 ...............................................................................................................................................................................$54,050
Problem 2-5
Jan. 4: Retained earnings (Sales) + $12,000; Cash + $12,000 Inventory - $7,000 ;Retained earnings
(Cost of goods sold) - $7,000
Jan. 6: No effect.
Jan. 8: Inventory + $7,000; Accounts Payable + $7,000
Jan. 11: Inventory - $1,500; Cash + $2,500; Retained earnings (Sales) + $2,500; Retained earnings
(Cost of goods sold) - $1,500
Jan. 16: Inventory - $2,000; Retained earnings (Cost of goods sold) - $2,000; Accounts receivable +
$3,400; Retained earnings (Sales) + $3,400
Jan. 26: Cash - $4,200; Retained earnings (Wages) - $4,200
Jan. 29: Cash - $20,000; Land + $20,000
Jan. 31: Cash - $2,800; Prepaid insurance + $2,800
MARVIN COMPANY
BALANCE SHEET AS OF JANUARY 31, ----.
Assets Liabilities
Cash .........................................................................................................................................................................................................$12,500 Accounts payable ....................................................................................................................................................................................$
7,000
Accounts receivable ................................................................................................................................................................................3,400 Total current liabilities ............................................................................................................................................................................$7,000
Inventory ................................................................................................................................................................................................. 46,500
Current assets ..........................................................................................................................................................................................62,400 Notes payable ..........................................................................................................................................................................................
20,000
Land.........................................................................................................................................................................................................20,000 Total liabilities.........................................................................................................................................................................................27,000
Prepaid insurance ....................................................................................................................................................................................2,800 Owner’s Equity
Capital .....................................................................................................................................................................................................55,000
_______ Retained earnings ....................................................................................................................................................................................
3,200
Total assets........................................................................................................................................................................................$85,200 Total liabilities
and owners’ equity ..........................................................................................................................................................................$85,200
Problem 2-6
BRIAN COMPANY
CURRENT ASSETS AND LIABILITIES AS OF DECEMBER 31, ----.
Current Assets Current Liabilities
Cash .........................................................................................................................................................................................................$ 2,000 Accounts payable ....................................................................................................................................................................................$5,000
Marketable securities...............................................................................................................................................................................3,500 Wages payable.........................................................................................................................................................................................1,500
Accounts receivable ................................................................................................................................................................................
7,000
Bonds due – current portion .................................................................................................................................................................... 2,000
Current assets ..........................................................................................................................................................................................$12,500 Current liabilities.....................................................................................................................................................................................$8,500
Current ratio = .........................................................................................................................................................................................$12,500 $8,500 =
The current ratio is an indication of an entity’s ability to meet its current obligations.
Cases
Case 2-1: Maynard Company (A)
Note: This case is unchanged from Twelfth Edition.
Answers to Questions
Question 1
Two suggested balance sheets as required by Question 1 are shown below.
Question 2
This question provides an opportunity for students to step back and think about the information in a
financial statement, rather than focusing on the details of constructing a financial statement. Students can
begin to analyze and use the information that the financial statements contain. Students can be asked to
identify which accounts have changed significantly between the beginning and ending balance sheets.
These would include accounts receivable, note receivable, equipment, accounts payable, taxes payable,
and the bank note payable, in addition to the cash account. The only ratio explained in Chapter 2 of the
text is the current ratio, so students should be encouraged to ascertain what has happened to the current
ratio between June 1 and June 30. Cash has increased largely due to increased accounts and notes
payable, as well as cash generated by operations. Cash appears to have been increased by the collection of
the note receivable, but as explained in Question 3 below, this was offset by the declaration of an identical
dividend, so that the net effect on cash of these two transactions was zero. Equipment purchases were a
major use of cash. As a result of these events, the June 30 current ratio has fallen to from its June 1
level of . Even though the leverage ratios have not yet been introduced in the text, the instructor
might want to encourage students to observe that the proportion of liabilities on the right-hand side of the
balance sheet has increased, with a complementary decrease in the proportion of equities. The
capitalization ratio Total Liabilities/Total Liabilities + Equities has increased from 4% on June 1 to 9% on
June 30. While these ratios are still very low, students can be made aware of the importance of identifying
trends early.
Question 3
Retained Earnings has not increased by the amount of net income for the month, $19,635, since Diane
Maynard as the sole shareholder declared a dividend of $11,700, which she then used to cancel her loan
of $11,700 from the company. Hence, Retained Earnings increased by $7,935 during the month of June.
Question 4
This question is intended to emphasize early in the course that shareholder’s equity does not necessarily
reflect what the entity is worth. Time permitting, the instructor can have students estimate the cash
proceeds of piecemeal sale of the assets by a liquidation company, which, net of liabilities, will certainly
be less than $619,446. Then the value of the company as a going concern can be discussed; if June’s
$19,635 net income is typical, the firm would be worth more than $619,446 as a going concern.
Capitalizing June’s net income on an annual basis ($19,635 x 12) at 10 times earning gives the company a
value in excess of $2 million. The company’s return on equity is very high. On an annual basis it may be
as high as 32%. This figure is 12 months’ income ($19,635 x 12) divided by projected year-end equity
($619,446 + $19,635 x 6). This is not a typical business. It is better.
MAYNARD COMPANY
BALANCE SHEETS AS OF JUNE 1 AND JUNE 30
Assets
Current Assets: As of June I As of June 30:
Cash .........................................................................................................................................................................................................$ 34,983 $ 66,660
Accounts receivable ................................................................................................................................................................................21,798 26,505
Note receivable........................................................................................................................................................................................11,700 0
Merchandise inventory ............................................................................................................................................................................29,835 26,520
Supplies on hand .....................................................................................................................................................................................5,559 6,630
Prepaid insurance .................................................................................................................................................................................... 3,150 2,826
Total current assets .............................................................................................................................................................................$107,025 $129,141
Noncurrent assets:
Land.........................................................................................................................................................................................................89,700 89,700
Building ...................................................................................................................................................................................................585,000 585,000
Less: Accumulated depreciation.........................................................................................................................................................(156,000) 429,000 ( 157,950) 427,050
Equipment ...............................................................................................................................................................................................13,260 36,660
Less: Accumulated depreciation.........................................................................................................................................................( 5,304) 7,956 ( 5,928) 30,732
Other noncurrent assets ........................................................................................................................................................................... 4,857 5,265
Total noncurrent assets ....................................................................................................................................................................... 531,513 552,747
Total assets ........................................................................................................................................................................$638,538 $681,888
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable ....................................................................................................................................................................................$8,517 $ 21,315
Bank notes payable..................................................................................................................................................................................8,385 29,250
Taxes payable ..........................................................................................................................................................................................5,700 7,224
Accrued wages payable ........................................................................................................................................................................... 1,974
2,202
Total current liabilities .......................................................................................................................................................................$ 24,576 $ 59,991
Other noncurrent liabilities......................................................................................................................................................................
2,451
2,451
Total liabilities....................................................................................................................................................................................27,027 62,442
Shareholders’ Equity:
Capital stock ............................................................................................................................................................................................390,000 390,000
Retained earnings ....................................................................................................................................................................................221,511 229,446
Total shareholder’s equity .................................................................................................................................................................. 611,511 619,446
Total liabilities and shareholders’ equity ......................................................................................................................................$638,538 $681,888
Case 2-2: Music Mart, Inc.
Note: This case is unchanged from the Twelfth Edition.
Approach
This is a valuable type of problem. The student is in effect analyzing, journalizing, and posting
transactions without knowing the technicalities, and hence without being encumbered by them. Some
instructors prefer to make up similar transactions and give them in class, rather than, or in addition to,
using the set given in this problem. If students can handle these events comfortably, they really
understand the essentials of the balance sheet and of the balance sheet equation. They are urged to cross
out old balances, rather than erasing them, both because this aids in tracing errors, and because this is
analogous to what is done in the ledger.
Preservation of the underlying equation in each transaction and the balance sheet should be emphasized
throughout.
For the accounts already established (., Notes Payable), students should use the identical wording. This
helps avoid sloppy habits when they start to journalize later on. For new accounts (., Mortgage
Payable), they should be given latitude in selecting a title, but having selected one, they must stick to it.
MUSIC MART, INC.
BALANCE SHEET AS OF _____________________
Assets Liabilities and Owners’ Equity
Current assets: Current liabilities:
Cash .........................................................................................................................................................................................................$25,636 Notes payable ..........................................................................................................................................................................................$
6,500
Accounts receivable ................................................................................................................................................................................2,620 Accounts payable ....................................................................................................................................................................................
5,000
Inventory .................................................................................................................................................................................................4,700 Total current liabilities........................................................................................................................................................................11,500
Prepaid insurance ....................................................................................................................................................................................
1,224
Total current assets .............................................................................................................................................................................34,180 Other liabilities:
Mortgage payable ....................................................................................................................................................................................
9,000
Total liabilities ...................................................................................................................................................................20,500
Owners’ equity
Property: Paid-in capital ..........................................................................................................................................................................................25,000
Land......................................................................................................................................................................................................... 12,000 Retained earnings.....................................................................................................................................................................................
680
Total assets .........................................................................................................................................................................................$46,180 Total liabilities
and owners’ equity..............................................................................................................................................................................$46,180
Answers to Questions
1. Increase Inventory, $5,000; increase Accounts Payable, $5,000
2. Decrease Inventory, $1,500; increase Cash, $2,300; increase Retained Earnings, $800
3. Decrease Inventory, $1,700; increase Accounts Receivable, $2,620; increase Retained Earnings, $920
(Note that Retained Earnings increases whether or not the proceeds of the sale are received in cash.)
4. Increase Prepaid Insurance (or similar), $1,224; decrease Cash, $1,224
(Note that current practice is to treat this as a current asset even though the policy is in effect three
years; the basis is materiality.)
5. Increase Land, $24,000; decrease Cash, $6,000; increase Mortgage payable (noncurrent), $18,000
(In view of what happens subsequently, it can be argued that the land is a current asset, or that
$12,000 of it is. It depends on whether Smith plans to retain or to sell it. This point should be brought
out, to avoid the tendency to classify land as a fixed asset without thinking.)
6. Increase Cash, $3,000; decrease Mortgage Payable, $9,000; decrease Land, $12,000
Note the decrease in the liability even though it was not “paid off” in cash.)
7. No entry. Goodwill is recognized only when it is paid for.
8. Decrease Retained Earnings, $1,000; decrease Cash, $1,000.
9. Decrease Retained Earnings, $750; decrease Inventory, $750.
(Note the basic similarity between #8 and #9; the equity of Smith in the business decreases whenever
he, as an individual, takes out assets of the business. Students can of course handle this with a
drawing account if they wish to get fancy.)
10. No entry, in accordance with the basic principle of value. I think students who argue for appreciation
are on weak ground. They have no support from the text. This, together with #6 may be used to
contrast accounting with what some would say is the “common sense” or “logical” way to record the
events, although it is too much to expect that the arguments in favor of the cost basis of valuation
will be fully comprehended at this point.
11. Decrease Notes Payable, $6,000; decrease Cash, $6,000.
12. No entry. This is not a transaction of the corporation, but rather a transaction between two outside
parties.
Note also that the book value of the equity is not changed, even though there is clear evidence that
book value is less than market value or “real” value.
13. Decrease Inventory, $850; increase Cash, $1,310; increase Retained Earnings, $460.
The final balance sheet is shown on the previous page, classified in perhaps more detail than is
warranted for this simple set of items.
Case 2-3: Lone Pine Cafe (A)
Note: This case and its sequel in Chapter 3 are updated from the Twelfth Edition.
LONE PINE CAFÉ
BALANCE SHEET AS OF NOVEMBER 2, 2009
Assets
Current assets:
Cash .........................................................................................................................................................................................................$10,172
Inventory .................................................................................................................................................................................................2,800
Prepaid expense.......................................................................................................................................................................................
1,428
Tota1 current assets ............................................................................................................................................................................$14,440
Cafe equipment........................................................................................................................................................................................ 54,600
Total assets .........................................................................................................................................................................................$69,000
Liabilities and Owners’ Equity
Note payable............................................................................................................................................................................................$21,000
Owners’ equity: .......................................................................................................................................................................................
Mrs. Landers............................................................................................................................................................................................$16,000
Mr. Antoine .............................................................................................................................................................................................16,000
Mrs. Antoine............................................................................................................................................................................................ 16,000 48,000
Total liabilities and owners’ equity ....................................................................................................................................................$69,000
Approach
This case can be handled in either of two distinctly different ways: 1) It can be played straight; that is,
students can be required to give the answers to questions, and they can be discussed. 2) The balance sheet
for November 2 can be developed, and then the second balance sheet can be arrived at by changing the
original balance sheet for each transaction. When the latter approach is used, the beginning balance
sheet is put on the board (or on a Vugraph) leaving enough room between items so that the additional
accounts can be added as needed. Then e
