Business Activities—The Source of Accounting Information 45
CHAPTER 2
Business Activities—The Source of Accounting Information
Thinking Beyond the Question
How do we know how well our business is doing?
Revenues are earned when goods are transferred or services are provided to customers. In most cases, these events are associated with completion of certain critical events, such as delivery of goods. Expenses are incurred when resources are consumed in the process of providing goods and services. Therefore, a system that identifies when goods are transferred, services are provided, and resources are consumed is important for identifying revenues and expenses.
Some resources are consumed when goods or services are transferred to customers: the cost of goods, supplies, and labor associated with particular jobs. In other cases, the amount of resources consumed is measured each fiscal period: salaries and wages, utilities, rent, and insurance. Depending on the type of resource consumed, identification of the cost of the resource associated with specific sales or identification of the cost of the resource associated with a fiscal period is an important event for identifying expenses during a fiscal period.
QUESTIONS
Q2-1 Chapter 2 illustrates two sources of money for companies—loans and owner contributions. Chapter 1 discussed the three forms of business organizations—proprietorships, partnerships, and corporations. To maintain control, Joan probably would want to organize her business as a proprietorship. If she has enough money or other resources, she can borrow the rest of the capital she needs from a bank. If she does not have enough money or other resources and cannot borrow as much as she needs, she may have to find one or more partners to help finance the business. Because this is a small business, she is unlikely to want or need to incorporate at this time or to issue bonds.
Q2-2 Major sources of financing for corporations are stocks and debt. Bank loans also are possible. Managers should consider how much stock or how much debt they can incur, what amount of money they will receive from the issuance, and whether they can repay debt as it becomes due from the profits they expect to earn.
Q2-3 From the corporation’s perspective, this event was a financing activity. The corporation raised capital (i.e., raised financing) by selling shares of stock to Jerrilyn.
Q2-4 Assets = Liabilities + Equity. The question indicates that assets are accurately reported. Therefore, if liabilities are understated, equity must be overstated. For example, assume assets, liabilities, and equity are correctly reported as $10,000, $3,000, and $7,000 respectively ($10,000 = $3,000 + $7,000). If liabilities are understated by $1,000, equity must be overstated by $1,000 to make the accounting equation balance ($10,000 = $2,000 + $8,000).
Q2-5 Both liabilities and owners’ equity represent claims to a company’s resources.
Q2-6 The accounting equation presents the relationship between resources and claims to resources. Financial resources to acquire assets are obtained from financing activities and from revenues earned by the company. When assets are consumed, expenses are created that reduce a company’s profits. The profits earned during a period increase owners’ equity, as reported in retained earnings. The total amount of assets is equal to the total amount of liabilities and owners’ equity.
Q2-7 Purchasing merchandise inventory is an operating activity. The operating activities section of the cash flow statement reports cash from selling goods and services and cash paid for expense-related activities.
Q2-8 Contributed capital represents claims to resources provided by the owners. Sales revenue represents owners’ claims to resources that were earned and retained by the company.
Q2-9 No. Retained Earnings represents earnings kept in the business. These earnings are reinvested and may be included in various kinds of assets. Retained Earnings does not equal cash.
Q2-10 The possibilities will depend on the specific company selected and industry in which it operates. Exhibit 12 in the text should give students a good start on this question.
Q2-11 The left side of a balance sheet reveals how an organization’s managers have used investors’ capital. That is, what does the organization own? Or, what amount of capital has been committed to which assets? The right side of a balance sheet reveals where the capital came from to
acquire the assets listed on the left side. It reveals how much of the organization’s capital was provided by investors loaning money or extending credit (i.e., liabilities). It also reveals how much capital was provided by the owners’ contributions (invested capital) as well as how much capital has been provided by profitable operations of the company (retained earnings).
Q2-12 A balance sheet reports the assets, liabilities, and equity of an organization. The income statement reports revenues and expenses. The statement of cash flows reports the net cash flows from operating activities, investing activities, and financing activities.
Q2-13 The accounting equation, Assets = Liabilities + Equity, illustrates that assets are provided by creditors (liabilities) or by owners (equity). Thus, creditors and owners have claims on a company’s assets.
Q2-14 The income statement provides information about how well a company has performed during a period based on the operating activities for that period. These activities may affect cash flows of prior or future periods. The income statement helps decision makers assess the long-run success of a company.
The statement of cash flows describes the cash flows that resulted from current-period operating activities. It provides information about a company’s ability to pay current obligations. A company must generate sufficient cash to pay creditors, suppliers, employees, and other providers of goods and services. Net income, as reported on the income statement, does not ensure short-run survival of a company.
Q2-15 Most companies of size have hundreds or thousands of individual accounts. A mere list of accounts and balances would overwhelm the reader with detail and be unlikely to convey any useful information. Accounts and balances are arranged into financial statements for the purpose of conveying information quickly and conveniently. Similar accounts are grouped, such as all revenues, all expenses, all assets, etc. Then, to provide further information, certain groups of accounts are arranged into financial statements. For example, revenues and expenses are matched on the income statement. Assets, liabilities, and equity are grouped on the balance sheet. Account balances are summarized on financial statements because they yield more information in this form.
EXERCISES
E2-1 Definitions of all terms are listed in the glossary.
E2-2 1. Operating activity
2. Financing activity
3. Investing activity
4. Financing activity
5. Investing activity
6. Operating activity
7. Investing activity
8. Financing activity
9. Investing activity
10. Operating activity
E2-3 a. I
b. O
c. F
d. O
e. O
f. I
g. F
h. O
i. O
j. F
E2-4
ASSETS / = / LIABILITIES / + / OWNERS' EQUITYDate / Accounts / Cash / Other
Assets / Contributed
Capital / Retained
Earnings
Beginning Amounts / 40,000 / + 60,000 / = / 30,000 / + / 50,000 / + 20,000
June 1 / Merchandise Inventory / 15,000
Cash / –15,000
June 15 / Cash / 60,000
Sales Revenue / 60,000
Cost of Goods Sold / –28,000
Merchandise Inventory / –28,000
June 23 / Cash / 250,000
Bank Loan Payable / 250,000
June 25 / Supplies Expense / –2,000
Cash / –2,000
June 28 / Wages Expense / –5,000
Cash / –5,000
June 30 / Equipment / 100,000
Cash / –100,000
June 30 / Utilities Expense / –6,000
Cash / –6,000
Ending Amounts / 222,000 / +147,000 / = / 280,000 / + / 50,000 / + 39,000
E2-5 June 1 Operating
June 15 Operating
June 23 Financing
June 25 Operating
June 28 Operating
June 30 Investing
June 30 Operating
E2-6
ASSETS / = / LIABILITIES / + / OWNERS' EQUITYDate / Accounts / Cash / Other
Assets / Contributed
Capital / Retained
Earnings
Beginning Amounts / 70,000 / + 90,000 / = / 60,000 / + / 60,000 / + 40,000
May 1 / Cash / 10,000
Contributed Capital / 10,000
May 5 / Cash / 35,000
Sales / 35,000
Cost of Goods Sold / –14,000
Merchandise Inventory / –14,000
May 10 / Merchandise Inventory / 45,000
Cash / –45,000
May 15 / Notes Payable / –2,000
Cash / –2,000
May 22 / Equipment / 4,000
Cash / –4,000
May 31 / Utilities Expense / –800
Cash / –800
May 31 / Wages Expense / –7,500
Cash / –7,500
Ending Amounts / 55,700 / + 125,000 / = / 58,000 / + / 70,000 / + 52,700
E2-7 May 1 Financing
May 5 Operating
May 10 Operating
May 15 Financing
May 22 Investing
May 31 Operating
May 31 Operating
E2-8 a. Cash increased $18,000; Owners’ Investment increased $18,000.
The owners invested $18,000 in the company.
b. Equipment increased $12,000; Cash decreased $12,000.
The company purchased equipment using cash.
c. Cash decreased $8,500; Notes Payable decreased $8,500.
The company paid down the balance of a note.
d. Supplies inventory increased $13,500; Cash decreased $13,500.
The company purchased supplies costing $13,500 using cash.
e. Merchandise Inventory decreased $10,000; Cost of Goods Sold increased $10,000.
The company sold merchandise costing $10,000.
f. Cash increased $23,500; Sales Revenue increased $23,500.
The company sold goods for $23,500 cash.
g. Supplies Expense increased $3,000; Supplies inventory decreased $3,000.
The company removed supplies costing $3,000 from inventory and used them.
E2-9
ASSETS / = / LIABILITIES / + / OWNERS' EQUITYDate / Accounts / Cash / Other
Assets / Contributed
Capital / Retained
Earnings
Beginning Amounts / 5,000 / = / 1,500 / + / 3,000 / + 500
Feb. 2 / Cash / 1,800
Revenues / 1,800
Feb. 3 / Rent Expense / –1,200
Cash / –1,200
Feb. 4 / Cash / –300
Loan Payable / –300
Feb. 4 / Miscellaneous Expense / –35
Cash / –35
Feb. 5 / Cash / 4,250
Revenues / 4,250
Feb. 5 / Equipment / 3,200
Cash / –3,200
Feb. 6 / Wages Expense / –525
Cash / –525
Feb. 6 / Office Supplies Expense / –128
Cash / –128
Ending Amounts / 5,662 / + 3,200 / = / 1,200 / + / 3,000 / + 4,662
Amelio’s Law Firm
Income Statement
For the First Week of February
Revenues $ 6,050
Rent (1,200)
Miscellaneous (35)
Wages (525)
Office supplies (128)
Net income $ 4,162
E2-10 Feb. 2 Operating
Feb. 3 Operating
Feb. 4 Financing
Feb. 4 Operating
Feb. 5 Operating
Feb. 5 Investing
Feb. 6 Operating
Feb. 6 Operating
E2-11 Assets = Liabilities + Owners’ Equity
Cash $ 1,500
Flowers and Plants 26,000
Supplies Inventory 4,350
Buildings 79,500
Equipment 12,750
Notes Payable $57,500
Proprietor’s Capital $66,600
Total $124,100 = $57,500 + $66,600
E2-12
ASSETS / = / LIABILITIES / + / OWNERS' EQUITYDate / Accounts / Cash / Other
Assets / Contributed
Capital / Retained
Earnings
Cash / 220,000
Contributed Capital / 80,000
Bank Loan / 140,000
a. / Equipment / 45,150
Cash / –45,150
b. / Merchandise Inventory / 129,600
Cash / –129,600
c. / Cash / 85,000
Sales / 85,000
Cost of Goods Sold / –43,200*
Merchandise Inventory / –43,200
d. / Wages Expense / –12,300
Rent Expense / –15,500
Utilities Expense / –4,800
Postage Expense / –650
Insurance Expense / –1,290
Cash / –34,540
* $129,600 ÷ 3 = $43,200
E2-13 Chang’s Pottery Works
Schedule of Retained Earnings
For the Month Ended November 30
Retained earnings, November 1 $ 95,000
Net income for November 15,000
Less: Payment to owners in November (4,000)
Retained earnings, November 30 $106,000
E2-14 Christmas Cookie Company
Income Statement
For the Month Ended December 31
Sales revenue $234,000
Cost of goods sold (60,000)
Wages expense (97,500)
Utilities expense (24,000)
Net income $ 52,500
E2-15 a. Cash flows from financing activities:
Proceeds from owners $ 30,957
Proceeds from issuance of note payable 13,057
Payments of debt (80,323)
Net cash used for financing activities $(36,309)
b. Cash flows from investing activities:
Proceeds from sales of plant and equipment $ 1,986
Additions to plant and equipment (5,379)
Net cash provided by investing activities $ (3,393)
E2-16 Cash collected from customers $270,000
Cash paid for merchandise inventory (83,500)
Cash paid for utilities (25,000)
Cash paid for insurance (23,000)
Cash paid to employees (58,000)
Cash paid for postage (7,500)
Net cash from operating activities $ 73,000
E2-17 Wages expense Income statement
Cost of goods sold Income statement
Sales revenue Income statement
Merchandise inventory Balance sheet
Net income Income statement
Retained earnings Balance sheet
Contributed capital Balance sheet
Rent expense Income statement
Cash Balance sheet, Statement of cash flows
Notes payable Balance sheet
E2-18 Brothers’ Lawn Service
Income Statement
For the Six Months Ended June 30, 2007
Service revenue $ 12,300
Supplies expense (4,000)
Wages expense (6,000)
Utilities expense (500)
Rent expense (1,000)
Net income $ 800
E2-19 Brothers’ Lawn Service
Balance Sheet
At June 30, 2007
Assets
Cash $3,000
Supplies inventory 500
Equipment 5,000
Total assets $8,500
Liabilities and Owners’ Equity
Notes payable $1,000
Contributed capital 6,700
Retained earnings 800
Total liabilities and owners’ equity $8,500
E2-20
June 1 / Merchandise Inventory / 15,000Cash / 15,000
June 15 / Cash / 60,000
Sales / 60,000
Cost of Goods Sold / 28,000
Merchandise Inventory / 28,000
June 23 / Cash / 250,000
Bank Loan Payable / 250,000
June 25 / Supplies Expense / 2,000
Cash / 2,000
June 28 / Wages Expense / 5,000
Cash / 5,000
June 30 / Equipment / 100,000
Cash / 100,000
June 30 / Utilities Expense / 6,000
Cash / 6,000
E2-21
May 1 / Cash / 10,000Contributed Capital / 10,000
May 5 / Cash / 35,000
Sales / 35,000
Cost of Goods Sold / 14,000
Merchandise Inventory / 14,000
May 10 / Merchandise Inventory / 45,000
Cash / 45,000
May 15 / Notes Payable / 2,000
Cash / 2,000
May 22 / Equipment / 4,000
Cash / 4,000
May 31 / Utilities Expense / 800
Cash / 800
May 31 / Wages Expense / 7,500
Cash / 7,500
E2-22
Feb 2 / Cash / 1,800Revenues / 1,800
Feb 3 / Rent Expense / 1,200
Cash / 1,200
Feb 4 / Loan Payable / 300
Cash / 300
Feb 4 / Miscellaneous Expense / 35
Cash / 35
Feb 5 / Cash / 4,250
Revenues / 4,250
Feb 5 / Equipment / 3,200
Cash / 3,200
Feb 6 / Wages Expense / 525
Cash / 525
Feb 6 / Office Supplies Expense / 128
Cash / 128
E2-23