Statement of Cash Flows

The statement of cash flows provides information on the cash receipts and payments
for a specific period of time.The statement of cash flows reports (1) the cash
effects of a company’s operations during a period, (2) its investing transactions, (3)
its financing transactions, (4) the net increase or decrease in cash during the period,
and (5) the cash amount at the end of the period.
Reporting the sources, uses, and change in cash is useful because investors,
creditors, and others want to know what is happening to a company’s most liquid
resource.The statement of cash flows provides answers to the following simple but
important questions.
1. Where did cash come from during the period?
2. What was cash used for during the period?
3. What was the change in the cash balance during the period?

Balance Sheet

Balance Sheet
Softbyte’s balance sheet reports the assets, liabilities, and owner’s equity at a specific
date (in Softbyte’s case, September 30, 2010). The company prepares the
Not every company uses December 31 as the accounting year-end. Some companies
whose year-ends differ from December 31 are General Mills, May 27; Walt Disney
Productions, September 30; and Dunkin’ Donuts Inc., October 31. Why do companies choose
the particular year-ends that they do? Many choose to end the accounting year when inventory
or operations are at a low. Compiling accounting information requires much time and
effort by managers, so companies would rather do it when they aren’t as busy operating the
business. Also, inventory is easier and less costly to count when it is low.

Owner’s Equity Statement

The owner’s equity statement reports the changes in owner’s equity for a specific
period of time. The time period is the same as that covered by the income statement.
Data for the preparation of the owner’s equity statement come from the
owner’s equity columns of the tabular summary (Illustration 1-8) and from the income
statement. The first line of the statement shows the beginning owner’s
equity amount (which was zero at the start of the business). Then come the
owner’s investments, net income (or loss), and the owner’s drawings. This statement
indicates why owner’s equity has increased or decreased during the period.
What if Softbyte had reported a net loss in its first month? Let’s assume that
during the month of September 2010, Softbyte lost $10,000. Illustration 1-10 shows
the presentation of a net loss in the owner’s equity statement.

Income Statement

The income statement reports the revenues and expenses for a specific period of
time. (In Softbyte’s case, this is “For the Month Ended September 30, 2010.”)
Softbyte’s income statement is prepared from the data appearing in the owner’s
equity columns of Illustration 1-8.
The income statement lists revenues first, followed by expenses. Finally the
statement shows net income (or net loss). Net income results when revenues exceed
expenses. A net loss occurs when expenses exceed revenues.
Although practice varies, we have chosen in our illustrations and homework
solutions to list expenses in order of magnitude. (We will consider alternative formats
for the income statement in later chapters.)
Note that the income statement does not include investment and withdrawal
transactions between the owner and the business in measuring net income. For
example, as explained earlier, Ray Neal’s withdrawal of cash from Softbyte was not
regarded as a business expense.

the fundamental accounting equation

Assets = Liabilities + Owners’ Equity
Assets are the economic resources of the entity, and include such items as cash, accounts receivable
(amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible
assets like patents and other legal rights and claims. Assets are presumed to entail probable future
economic benefits to the owner.
Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations
arising in the course of business.
Owners’ equity is the owner’s “interest” in the business. It is sometimes called net assets, because it is
equivalent to assets minus liabilities for a particular business. Who are the “owners?” The answer to this
question depends on the legal form of the entity; examples of entity types include sole proprietorships,
partnerships, and corporations. A sole proprietorship is a business owned by one person, and
its equity would typically consist of a single owner’s capital account. Conversely, a partnership is a
business owned by more than one person, with its equity consisting of a separate capital account for
each partner. Finally, a corporation is a very common entity form, with its ownership interest being
represented by divisible units of ownership called shares of stock. These shares are easily transferable,
with the current holder(s) of the stock being the owners. The total owners’ equity (i.e., “stockholders’
equity) of a corporation usually consists of several amounts, generally corresponding to the owner
investments in the capital stock (by shareholders) and additional amounts generated through
earnings that have not been paid out to shareholders as dividends (dividends are distributions to
shareholders as a return on their investment). Earnings give rise to increases in “retained earnings,”
while dividends (and losses) cause decreases.

accounting Ma nagerial

In sharp contrast to financial accounting, managerial accounting information is intended to serve the
specific needs of management. Business managers are charged with business planning, controlling,
and decision making. As such, they may desire specialized reports, budgets, product costing data, and
other details that are generally not reported on an external basis. Further, management may dictate
the parameters under which such information is to be accumulated and presented. For instance,
GAAP may require that certain research costs be deducted immediately in computing a business’s
externally reported income; on the other hand, management may see these costs as a long-term
investment and stipulate that internal decision making be based upon income numbers that exclude
such costs. This is their prerogative. Hopefully, such internal reporting is being done logically and
rationally, but it need not follow any particular set of guidelines.
Both financial accounting and
managerial accounting depend upon
a strong information system to
reliably capture and summarize
business transaction data.
Information technology has radically
reshaped this mundane part of the
practice of accounting during the
past 30 years. The era of the “green
eye-shaded” accountant has been
relegated to the annals of history.
Now, accounting is more of a
dynamic, decision-making discipline,
rather than a bookkeeping task.

Transaction Analysis

Transaction Analysis

The following examples are business transactions for a computer programming business

during its first month of operations.

Transaction (1). Investment By Owner. Ray Neal decides to open a computer

programming service which he names Softbyte. On September 1, 2010, he invests

$15,000 cash in the business.This transaction results in an equal increase in assets

and owner’s equity.The asset Cash increases $15,000, as does the owner’s equity,

identified as R. Neal, Capital.The effect of this transaction on the basic equation is:

Assets Liabilities Owner’s Equity

R. Neal,

Cash Capital

(1) $15,000 $15,000

Transactions

(business transactions) are a business’s economic events
recorded by accountants. Transactions may be external or internal.
External transactions involve economic events between the company and
some outside enterprise. For example, Campus Pizza’s purchase of cooking
equipment from a supplier, payment of monthly rent to the landlord,
and sale of pizzas to customers are external transactions. Internal transactions are
economic events that occur entirely within one company. The use of cooking and
cleaning supplies are internal transactions for Campus Pizza.
Companies carry on many activities that do not represent business transactions.
Examples are hiring employees, answering the telephone, talking with customers,
and placing merchandise orders. Some of these activities may lead to business transactions:
Employees will earn wages, and suppliers will deliver ordered merchandise.
The company must analyze each event to find out if it affects the components of the
accounting equation. If it does, the company will record the transaction. Illustration
1-7 (page 15) demonstrates the transaction-identification process.
Each transaction must have a dual effect on the accounting equation. For example,
if an asset is increased, there must be a corresponding: (1) decrease in another
asset, or (2) increase in a specific liability, or (3) increase in owner’s equity.
Two or more items could be affected. For example, as one asset is increased
$10,000, another asset could decrease $6,000 and a liability could increase $4,000.
Any change in a liability or ownership claim is subject to similar analysis

DECREASES IN OWNER’S EQUITY

Investments by Owner. Investments by owner are the assets the owner puts
into the business.These investments increase owner’s equity.They are recorded in
a category called owner’s capital.
Revenues. Revenues are the gross increase in owner’s equity resulting from
business activities entered into for the purpose of earning income. Generally, revenues
result from selling merchandise, performing services, renting property, and
lending money. Common sources of revenue are sales, fees, services, commissions,
interest, dividends, royalties, and rent.
Revenues usually result in an increase in an asset.They may arise from different
sources and are called various names depending on the nature of the business.
Campus Pizza, for instance, has two categories of sales revenues—pizza sales and
beverage sales.
DECREASES IN OWNER’S EQUITY
In a proprietorship, owner’s drawings and expenses decrease owner’s equity.
Drawings. An owner may withdraw cash or other assets for personal use.We use
a separate classification called drawings to determine the total withdrawals for
each accounting period. Drawings decrease owner’s equity.
Expenses. Expenses are the cost of assets consumed or services used in the
process of earning revenue. They are decreases in owner’s equity that result from
operating the business. For example, Campus Pizza recognizes the following
expenses: cost of ingredients (meat, flour, cheese, tomato paste, mushrooms, etc.);
cost of beverages; wages expense; utility expense (electric, gas, and water expense);
telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies expense
(napkins, detergents, aprons, etc.); rent expense; interest expense; and property
tax expense.
In summary, owner’s equity is increased by an owner’s investments and by revenues
from business operations. Owner’s equity is decreased by an owner’s withdrawals
of assets and by expenses. Illustration 1-6 expands the basic accounting
equation by showing the accounts that comprise owner’s equity. This format is
referred to as the expanded accounting equation.
The Basic Accounting Equation 13
H E L P F U L H I N T
In some places we use
the term ”owner’s
equity” and in others
we use ”owners’ equity.”
Owner’s (singular,
possessive) refers to
one owner (the case
with a sole proprietorship).
Owners’ (plural,
possessive) refers to
multiple owners (the
case with partnerships
or corporations).
Illustration 1-6
Expanded accounting
equation
Basic Equation: Assets Liabilities Owner’s Equity
Expanded Assets Liabilities Owner’s Capital Owner’s Drawings
Equation: Revenues Expenses

INCREASES IN OWNER’S EQUITY

In a proprietorship, owner’s investments and revenues increase owner’s equity.
Investments by Owner. Investments by owner are the assets the owner puts
into the business.These investments increase owner’s equity.They are recorded in
a category called owner’s capital.
Revenues. Revenues are the gross increase in owner’s equity resulting from
business activities entered into for the purpose of earning income. Generally, revenues
result from selling merchandise, performing services, renting property, and
lending money. Common sources of revenue are sales, fees, services, commissions,
interest, dividends, royalties, and rent.
Revenues usually result in an increase in an asset.They may arise from different
sources and are called various names depending on the nature of the business.
Campus Pizza, for instance,

Accounting in Action

 Assets = Liabilities + Owner’s Equity

This relationship is the basic accounting equation. Assets must equal the sum of

liabilities and owner’s equity. Liabilities appear before owner’s equity in the basic
accounting equation because they are paid first if a business is liquidated.
The accounting equation applies to all economic entities regardless of size,
nature of business, or form of business organization. It applies to a small proprietorship
such as a corner grocery store as well as to a giant corporation such as
PepsiCo. The equation provides the underlying framework for recording and summarizing
economic events.
Let’s look in more detail at the categories in the basic accounting equation.
Assets
As noted above, assets are resources a business owns.The business uses its assets in
carrying out such activities as production and sales. The common characteristic
possessed by all assets is the capacity to provide future services or benefits. In a
business, that service potential or future economic benefit eventually results in
cash inflows (receipts). For example, Campus Pizza owns a delivery truck that provides
economic benefits from delivering pizzas. Other assets of Campus Pizza are
tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.
Liabilities
Liabilities are claims against assets—that is, existing debts and obligations.
Businesses of all sizes usually borrow money and purchase merchandise on credit.
These economic activities result in payables of various sorts:
• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on
credit from suppliers.These obligations are called accounts payable.
• Campus Pizza also has a note payable to First National Bank for the money
borrowed to purchase the delivery truck.
• Campus Pizza may also have wages payable to employees and sales and real estate
taxes payable to the local government.
All of these persons or entities to whom Campus Pizza owes money are its creditors.
Creditors may legally force the liquidation of a business that does not pay its
debts. In that case, the law requires that creditor claims be paid before ownership
claims.
Owner’s Equity
The ownership claim on total assets is owner’s equity. It is equal to total assets minus
total liabilities. Here is why:The assets of a business are claimed by either creditors
or owners. To find out what belongs to owners, we subtract the creditors’
claims (the liabilities) from assets. The remainder is the owner’s claim on the
assets—the owner’s equity. Since the claims of creditors must be paid before ownership
claims, owner’s equity is often referred to as residual equity.

Generally Accepted Accounting Principles

generally accepted accounting principles (GAAP)

how to report economic events.

The primary accounting standard-setting body in the United States is the

. These standards indicateFinancial Accounting Standards Board (FASB)

Commission (SEC)

financial markets and accounting standard-setting bodies.The SEC relies on

the FASB to develop accounting standards, which public companies must

follow. Many countries outside of the United States have adopted the accounting

standards issued by the

Board (IASB)

try to minimize the differences in their standards and principles.

One important accounting principle is the cost principle. The

principle

at their cost.This is true not only at the time the asset is purchased, but

also over the time the asset is held. For example, if

land for $30,000, the company initially reports it in its accounting records

at $30,000. But what does Best Buy do if, by the end of the next year, the land has

increased in value to $40,000? Under the cost principle it continues to report the

land at $30,000.

Critics contend the cost principle is misleading. They argue that market value

(the value determined by the market at any particular time) is more useful to financial

decision makers than is cost. Those who favor the cost principle counter

that cost is the best measure.The reason: Cost can be easily verified, whereas market

value is often subjective (it depends on who you ask). Recently, the FASB has

changed some accounting rules and now requires that certain investment securities

be recorded at their market value. In choosing between cost and market value, the

FASB used two qualities that make accounting information useful for decision

making—reliability and relevance: In this case, it weighed the

figures versus the

is the agency of the U.S. government that oversees U.S.International Accounting Standards. In recent years the FASB and IASB have worked closely tocost(or historical cost principle) dictates that companies record assetsBest Buy purchasesreliability of costrelevance of market value.

Assumptions

Assumptions provide a foundation for the accounting process. Two main

assumptions are the

assumption

monetary unit assumption and the economic entity.

MONETARY UNIT ASSUMPTION

The

records only transaction data that can be expressed in money terms. This

assumption enables accounting to quantify (measure) economic events.The monetary

unit assumption is vital to applying the cost principle.

This assumption prevents the inclusion of some relevant information in the

accounting records. For example, the health of a company’s owner, the quality of

service, and the morale of employees are not included. The reason: Companies

cannot quantify this information in money terms. Though this information is

important, companies record only events that can be measured in money.

monetary unit assumption requires that companies include in the accounting

ECONOMIC ENTITY ASSUMPTION

An economic entity can be any organization or unit in society.

company (such as

municipality (Seattle), a school district (St. Louis District 48), or a church

(Southern Baptist).The

of the entity be kept separate and distinct from the activities of its

owner and all other economic entities. To illustrate, Sally Rider, owner of

Sally’s Boutique, must keep her personal living costs separate from the expenses

of the Boutique. Similarly,

Schweppes

purposes.A business owned by one person is generally a proprietorship.Usually only a relatively small amount of money (capital) is necessary

There is no legal distinction between the business as an economic unit and the

owner, but the accounting records of the business activities are kept separate

from the personal records and activities of the owner.

Partnership.

is a

that more than one owner is involved. Typically a partnership agreement (written

or oral) sets forth such terms as initial investment, duties of each partner, division

of net income (or net loss), and settlement to be made upon death or

withdrawal of a partner. Each partner generally has unlimited personal liability

for the debts of the partnership.

the partnership transactions must be kept separate from the personal activities

of the partners.

businesses, including professional practices (lawyers, doctors, architects, and certified

public accountants).

A business owned by two or more persons associated as partnerspartnership. In most respects a partnership is like a proprietorship exceptLike a proprietorship, for accounting purposesPartnerships are often used to organize retail and service-type

Corporation.

law and having ownership divided into transferable shares of stock is a

A business organized as a separate legal entity under state corporation

corporation

they are not personally liable for the debts of the corporate entity. Stockholders

.The holders of the shares (stockholders) enjoy limited liability; that is,

may transfer all or part of their ownership shares to other investors at any time

(i.e., sell their shares). The ease with which ownership can change adds to the attractiveness

of investing in a corporation. Because ownership can be transferred

without dissolving the corporation, the corporation

Although the combined number of proprietorships and partnerships in the

United States is more than five times the number of corporations, the revenue produced

by corporations is eight times greater. Most of the largest enterprises in the

United States—for example,

and

Indicate whether each of the five statements presented below is true or false.

enjoys an unlimited life.ExxonMobil, General Motors, Wal-Mart, Citigroup,Microsoft—are corporations.

1.

communication.

The three steps in the accounting process are identification, recording, and

2.

officers.

The two most common types of external users are investors and company

3.

behavior and decrease the likelihood of future corporate scandals.

Congress passed the Sarbanes-Oxley Act of 2002 to reduce unethical

4.

Financial Accounting Standards Board (FASB).

The primary accounting standard-setting body in the United States is the

5.

periods, however, the market value of the asset must be used if market value

is higher than its cost.

The cost principle dictates that companies record assets at their cost. In later

Proprietorship.

The owner is often the manager/operator of the business. Small service-type businesses

(plumbing companies, beauty salons, and auto repair shops), farms, and

small retail stores (antique shops, clothing stores, and used-book stores) are often

proprietorships.

to start in business as a proprietorship. The owner (proprietor) receives

any profits, suffers any losses, and is personally liable for all debts of the business.

It may be aCrocs, Inc.), a governmental unit (the state of Ohio), aeconomic entity assumption requires that the activitiesMcDonald’s, Coca-Cola, and Cadbury-are segregated into separate economic entities for accounting. The Securities and Exchange