Accounting and Its Use in Business Decisions

Learning objectives

• Identify and describe the three basic forms of business organizations. 
  
• Distinguish among the three types of activities performed by business organizations. 
  
• Describe the content and purposes of the income statement, statement of retained earnings, balance sheet, and statement of cash flows. 
  
• State the basic accounting equation and describe its relationship to the balance sheet. 
  
• Using the underlying assumptions or concepts, analyze business transactions and determine their effects on items in the financial statements. 
  
• Prepare an income statement, a statement of retained earnings, and a balance sheet. 
  
• Analyze and use the financial results - the equity ratio
  

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A career as an entrepreneur

When today's college students are polled about their long-term career choice, a surprisingly large number respond that they wish to someday own and manage their own business. In fact, the aspiration to start a business, to be an entrepreneur, is nearly universal. It is widely acknowledged that a degree in accounting offers many advantages to a would-be entrepreneur. In fact, if you ask owners of small businesses which skill they wish they had more expertise in, they will very frequently reply "accounting". No matter what the business may be, the owner and/or manager must be able to understand the accounting and financial consequences of business decisions.

Most successful entrepreneurs have learned that it takes a lot more than a great marketing idea or product innovation to make a successful business. There are many steps involved before an idea becomes a successful and rewarding business. Entrepreneurs must be able to raise capital, either from banks or investors. Once a business has been launched, the entrepreneur must be a manager - a manager of people, inventory, facilities, customer relationships, and relationships with the very banks and investors that provided the capital. Business owners quickly learn that in order to survive they need to be well-rounded, savvy individuals who can successfully manage these diverse relationships. An accounting education is ideal for providing this versatile background.

In addition to providing a good foundation for entrepreneurship in any business, an accounting degree offers other ways of building your own business. For example, a large percentage of public accountants work as sole proprietors - building and managing their own professional practice. This can be a very rewarding career, working closely with individuals and small businesses. One advantage of this career is that you can establish your practice in virtually any location ranging from large cities to rural settings. Finally, many accountants who have gained specialized expertise and experience in a particular field start their own practice as consultants. Expertise such as this, which may be in a field outside of traditional accounting practice, can generate billing rates well in the excess of USD 100 an hour.

The introduction to this text provided a background for your study of accounting. Now you are ready to learn about the forms of business organizations and the types of business activities they perform. This chapter presents the financial statements used by businesses. These financial statements show the results of decisions made by management. Investors, creditors, and managers use these statements in evaluating management's past decisions and as a basis for making future decisions.

In this chapter, you also study the accounting process (or accounting cycle) that accountants use to prepare those financial statements. This accounting process uses financial data such as the records of sales made to customers and purchases made from suppliers. In a systematic manner, accountants analyze, record, classify, summarize, and finally report these data in the financial statements of businesses. As you study this chapter, you will begin to understand the unique, systematic nature of accounting - the language of business.

Forms of business organizations

Accountants frequently refer to a business organization as an accounting entity or a business entity. A business entity is any business organization, such as a hardware store or grocery store, that exists as an economic unit. For accounting purposes, each business organization or entity has an existence separate from its owner(s), creditors, employees, customers, and other businesses. This separate existence of the business organization is known as the business entity concept. Thus, in the accounting records of the business entity, the activities of each business should be kept separate from the activities of other businesses and from the personal financial activities of the owner(s).

Assume, for example, that you own two businesses, a physical fitness center and a horse stable. According to the business entity concept, you would consider each business as an independent business unit. Thus, you would normally keep separate accounting records for each business. Now assume your physical fitness center is unprofitable because you are not charging enough for the use of your exercise equipment. You can determine this fact because you are treating your physical fitness center and horse stable as two separate business entities. You must also keep your personal financial activities separate from your two businesses. Therefore, you cannot include the car you drive only for personal use as a business activity of your physical fitness center or your horse stable. However, the use of your truck to pick up feed for your horse stable is a business activity of your horse stable.

As you will see shortly, the business entity concept applies to the three forms of businesses - single proprietorships, partnerships, and corporations. Thus, for accounting purposes, all three business forms are separate from other business entities and from their owner(s). Since most large businesses are corporations, we use the corporate approach in this text and include only a brief discussion of single proprietorships and partnerships.

A single proprietorship is an unincorporated business owned by an individual and often managed by that same person. Single proprietors include physicians, lawyers, electricians, and other people in business for themselves. Many small service businesses and retail establishments are also single proprietorships. No legal formalities are necessary to organize such businesses, and usually business operations can begin with only a limited investment.

In a single proprietorship, the owner is solely responsible for all debts of the business. For accounting purposes, however, the business is a separate entity from the owner. Thus, single proprietors must keep the financial activities of the business, such as the receipt of fees from selling services to the public, separate from their personal financial activities. For example, owners of single proprietorships should not enter the cost of personal houses or car payments in the financial records of their businesses.

A partnership is an unincorporated business owned by two or more persons associated as partners. Often the same persons who own the business also manage the business. Many small retail establishments and professional practices, such as dentists, physicians, attorneys, and many CPA firms, are partnerships.

A partnership begins with a verbal or written agreement. A written agreement is preferable because it provides a permanent record of the terms of the partnership. These terms include the initial investment of each partner, the duties of each partner, the means of dividing profits or losses between the partners each year, and the settlement after the death or withdrawal of a partner. Each partner may be held liable for all the debts of the partnership and for the actions of each partner within the scope of the business. However, as with the single proprietorship, for accounting purposes, the partnership is a separate business entity.

A corporation is a business incorporated under the laws of a state and owned by a few stockholders or thousands of stockholders. Almost all large businesses and many small businesses are incorporated.

The corporation is unique in that it is a separate legal business entity. The owners of the corporation are stockholders, or shareholders. They buy shares of stock, which are units of ownership, in the corporation. Should the corporation fail, the owners would only lose the amount they paid for their stock. The corporate form of business protects the personal assets of the owners from the creditors of the corporation.

Stockholders do not directly manage the corporation. They elect a board of directors to represent their interests. The board of directors selects the officers of the corporation, such as the president and vice presidents, who manage the corporation for the stockholders.

Accounting is necessary for all three forms of business organizations, and each company must follow generally accepted accounting principles (GAAP). Since corporations have such an important impact on our economy, we use them in this text to illustrate basic accounting principles and concepts.

An accounting perspective: Business insight

Although corporations constitute about 17 per cent of all business organizations, they account for almost 90 per cent of all sales volume. Single proprietorships constitute about 75 per cent of all business organizations but account for less than 10 per cent of sales volume.

Types of activities performed by business organizations

The forms of business entities discussed in the previous section are classified according to the type of ownership of the business entity. Business entities can also be grouped by the type of business activities they perform - service companies, merchandising companies, and manufacturing companies. Any of these activities can be performed by companies using any of the three forms of business organizations.

• Service companies perform services for a fee. This group includes accounting firms, law firms, and dry cleaning establishments. The early chapters of this text describe accounting for service companies. 
  
• Merchandising companies purchase goods that are ready for sale and then sell them to customers. Merchandising companies include auto dealerships, clothing stores, and supermarkets. 
• Manufacturing companies buy materials, convert them into products, and then sell the products to other companies or to the final consumers. Manufacturing companies include steel mills, auto manufacturers, and clothing manufacturers.
  

Financial statements of business organizations

Business entities may have many objectives and goals. For example, one of your objectives in owning a physical fitness center may be to improve your physical fitness. However, the two primary objectives of every business are profitability and solvency. Profitability is the ability to generate income. Solvency is the ability to pay debts as they become due. Unless a business can produce satisfactory income and pay its debts as they become due, the business cannot survive to realize its other objectives.

There are four basic financial statements. Together they present the profitability and strength of a company. The financial statement that reflects a company's profitability is the income statement. The statement of retained earnings shows the change in retained earnings between the beginning and end of a period (e.g. a month or a year). The balance sheet reflects a company's solvency and financial position. The statement of cash flows shows the cash inflows and outflows for a company over a period of time. The headings and elements of each statement are similar from company to company. You can see this similarity in the financial statements of actual companies in the appendix of this textbook.

The income statement, sometimes called an earnings statement, reports the profitability of a business organization for a stated period of time. In accounting, we measure profitability for a period, such as a month or year, by comparing the revenues earned with the expenses incurred to produce these revenues. Revenues are the inflows of assets (such as cash) resulting from the sale of products or the rendering of services to customers. We measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services. Expenses are the costs incurred to produce revenues. Expenses are measured by the assets surrendered or consumed in serving customers. If the revenues of a period exceed the expenses of the same period, net income results. Thus,

Net income = Revenues – Expenses

Net income is often called the earnings of the company. When expenses exceed revenues, the business has a net loss, and it has operated unprofitably.

In Exhibit 2, Part A shows the income statement of Metro Courier, Inc., for July 2010. This corporation performs courier delivery services of documents and packages in San Diego in the state of California, USA.

Metro's income statement for the month ended 2010 July 31, shows that the revenues (or delivery fees) generated by serving customers for July totaled USD 5,700. Expenses for the month amounted to USD 3,600. As a result of these business activities, Metro's net income for July was USD 2,100. To determine its net income, the company subtracts its expenses of USD 3,600 from its revenues of USD 5,700. Even though corporations are taxable entities, we ignore corporate income taxes at this point.

One purpose of the statement of retained earnings is to connect the income statement and the balance sheet. The statement of retained earnings explains the changes in retained earnings between two balance sheet dates. These changes usually consist of the addition of net income (or deduction of net loss) and the deduction of dividends.

Dividends are the means by which a corporation rewards its stockholders (owners) for providing it with investment funds. A dividend is a payment (usually of cash) to the owners of the business; it is a distribution of income to owners rather than an expense of doing business. Corporations are not required to pay dividends and, because dividends are not an expense, they do not appear on the income statement.

The effect of a dividend is to reduce cash and retained earnings by the amount paid out. Then, the company no longer retains a portion of the income earned but passes it on to the stockholders. Receiving dividends is, of course, one of the primary reasons people invest in corporations.

The statement of retained earnings for Metro Courier, Inc., for July 2010 is relatively simple (see Part B of Exhibit 2). Organized on June 1, Metro did not earn any revenues or incur any expenses during June. So Metro's beginning retained earnings balance on July 1 is zero. Metro then adds its USD 2,100 net income for July. Since Metro paid no dividends in July, the USD 2,100 would be the ending balance of retained earnings. See below.

Exhibit 2:

Next, Metro carries this USD 2,100 ending balance in retained earnings to the balance sheet (Part C). If there had been a net loss, it would have deducted the loss from the beginning balance on the statement of retained earnings. For instance, if during the next month (August) there is a net loss of USD 500, the loss would be deducted from the beginning balance in retained earnings of USD 2,100. The retained earnings balance at the end of August would be USD 1,600.

Dividends could also have affected the Retained Earnings balance. To give a more realistic illustration, assume that (1) Metro Courier, Inc.'s net income for August was actually USD 1,500 (revenues of USD 5,600 less expenses of USD 4,100) and (2) the company declared and paid dividends of USD 1,000. Then, Metro's statement of retained earnings for August would be:

The balance sheet, sometimes called the statement of financial position, lists the company's assets, liabilities, and stockholders' equity (including dollar amounts) as of a specific moment in time. That specific moment is the close of business on the date of the balance sheet. Notice how the heading of the balance sheet differs from the headings on the income statement and statement of retained earnings. A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time. The other two statements are for a period of time. As you study about the assets, liabilities, and stockholders' equity contained in a balance sheet, you will understand why this financial statement provides information about the solvency of the business. Assets are things of value owned by the business. They are also called the resources of the business. Examples include cash, machines, and buildings.

Assets have value because a business can use or exchange them to produce the services or products of the business. In Part C of Exhibit 2 the assets of Metro Courier, Inc., amount to USD 38,700. Metro's assets consist of cash, accounts receivable (amounts due from customers for services previously rendered), trucks, and office equipment.

Liabilities are the debts owed by a business. Typically, a business must pay its debts by certain dates. A business incurs many of its liabilities by purchasing items on credit. Metro's liabilities consist of accounts payable (amounts owed to suppliers for previous purchases) and notes payable (written promises to pay a specific sum of money) totaling USD 6,600.

Metro Courier, Inc., is a corporation. The owners' interest in a corporation is referred to as stockholders' equity. Metro's stockholders' equity consists of (1) USD 30,000 paid for shares of capital stock and (2) retained earnings of USD 2,100. Capital stock shows the amount of the owners' investment in the corporation. Retained earnings generally consists of the accumulated net income of the corporation minus dividends distributed to stockholders. We discuss these items later in the text. At this point, simply note that the balance sheet heading includes the name of the organization and the title and date of the statement. Notice also that the dollar amount of the total assets is equal to the claims on (or interest in) those assets. The balance sheet shows these claims under the heading "Liabilities and Stockholders' Equity".

Management is interested in the cash inflows to the company and the cash outflows from the company because these determine the company's cash it has available to pay its bills when due. The statement of cash flows shows the cash inflows and cash outflows from operating, investing, and financing activities. Operating activities generally include the cash effects of transactions and other events that enter into the determination of net income. Investing activities generally include business transactions involving the acquisition or disposal of long-term assets such as land, buildings, and equipment. Financing activities generally include the cash effects of transactions and other events involving creditors and owners (stockholders).

Chapter 16 describes the statement of cash flows in detail. Our purpose here is to merely introduce this important financial statement. Normally, a firm prepares a statement of cash flows for the same time period as the income statement. The following statement, however, shows the cash inflows and outflows for Metro Courier, Inc., since it was formed on 2010 June 1. Thus, this cash flow statement is for two months.

At this point in the course, you need to understand what a statement of cash flows is rather than how to prepare it. We do not ask you to prepare such a statement until you have studied Chapter 16.

The income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows of Metro Courier, Inc., show the results of management's past decisions. They are the end products of the accounting process, which we explain in the next section. These financial statements give a picture of the solvency and profitability of the company. The accounting process details how this picture was made. Management and other interested parties use these statements to make future decisions. Management is the first to know the financial results; then, it publishes the financial statements to inform other users. The most recent financial statements for most companies can be found on their websites under "Investor Relations" or some similar heading.

The financial accounting process

In this section, we explain the accounting equation - the framework for the entire accounting process. Then, we show you how to recognize a business transaction and describe underlying assumptions that accountants use to record business transactions. Next you learn how to analyze and record business transactions.

In the balance sheet presented in Exhibit 2 (Part C), the total assets of Metro Courier, Inc., were equal to its total liabilities and stockholders' equity. This equality shows that the assets of a business are equal to its equities; that is,

Assets = Equities

Assets were defined earlier as the things of value owned by the business, or the economic resources of the business. Equities are all claims to, or interests in, assets. For example, assume that you purchased a new company automobile for USD 15,000 by investing USD 10,000 in your own corporation and borrowing USD 5,000 in the name of the corporation from a bank. Your equity in the automobile is USD 10,000, and the bank's equity is USD 5,000. You can further describe the USD 5,000 as a liability because you owe the bank USD 5,000. If you are a corporation, you can describe your USD 10,000 equity as stockholders' equity or interest in the asset. Since the owners in a corporation are stockholders, the basic accounting equation becomes:

Assets A = Liabilities L + Stockholders' Equity SE

From Metro's balance sheet in Exhibit 2 (Part C), we can enter in the amount of its assets, liabilities, and stockholders' equity:

A = L + SE

USD 38,700 = USD 6,600 + USD 32,100

Remember that someone must provide assets or resources - either a creditor or a stockholder. Therefore, this equation must always be in balance.

You can also look at the right side of this equation in another manner. The liabilities and stockholders' equity show the sources of an existing group of assets. Thus, liabilities are not only claims against assets but also sources of assets.

Together, creditors and owners provide all the assets in a corporation. The higher the proportion of assets provided by owners, the more solvent the company. However, companies can sometimes improve their profitability by borrowing from creditors and using the funds effectively. As a business engages in economic activity, the dollar amounts and composition of its assets, liabilities, and stockholders' equity change. However, the equality of the basic accounting equation always holds.

An accounting transaction is a business activity or event that causes a measurable change in the accounting equation, Assets = Liabilities + Stockholders' equity. An exchange of cash for merchandise is a transaction. The exchange takes place at an agreed price that provides an objective measure of economic activity. For example, the objective measure of the exchange may be USD 5,000. These two factors - evidence and measurement - make possible the recording of a transaction. Merely placing an order for goods is not a recordable transaction because no exchange has taken place.

A source document usually supports the evidence of the transaction. A source document is any written or printed evidence of a business transaction that describes the essential facts of that transaction. Examples of source documents are receipts for cash paid or received, checks written or received, bills sent to customers for services performed or bills received from suppliers for items purchased, cash register tapes, sales tickets, and notes given or received. We handle source documents constantly in our everyday life. Each source document initiates the process of recording a transaction.

Underlying assumptions or concepts

In recording business transactions, accountants rely on certain underlying assumptions or concepts. Both preparers and users of financial statements must understand these assumptions: 

• Business entity concept (or accounting entity concept). Data gathered in an accounting system relates to a specific business unit or entity. The business entity concept assumes that each business has an existence separate from its owners, creditors, employees, customers, other interested parties, and other businesses.
• Money measurement concept. Economic activity is initially recorded and reported in a common monetary unit of measure - the dollar in the United States. This form of measurement is known as money measurement. 
  
• Exchange-price (or cost) concept (principle). Most of the amounts in an accounting system are the objective money prices determined in the exchange process. As a result, we record most assets at their acquisition cost. Cost is the sacrifice made or the resources given up, measured in money terms, to acquire some desired thing, such as a new truck (asset). 
  
• Going-concern (continuity) concept. Unless strong evidence exists to the contrary, accountants assume that the business entity will continue operations into the indefinite future. Accountants call this assumption the going-concern or continuity concept. Assuming that the entity will continue indefinitely allows accountants to value long-term assets, such as land, at cost on the balance sheet since they are to be used rather than sold. Market values of these assets would be relevant only if they were for sale. For instance, accountants would still record land purchased in 1988 at its cost of USD 100,000 on the 2010 December 31, balance sheet even though its market value has risen to USD 300,000. 
  
• Periodicity (time periods) concept. According to the periodicity (time periods) concept or assumption, an entity's life can be meaningfully subdivided into time periods (such as months or years) to report the results of its economic activities.
  

Now that you understand business transactions and the five basic accounting assumptions, you are ready to follow some business transactions step by step. To begin, we divide Metro's transactions into two groups: (1) transactions affecting only the balance sheet in June, and (2) transactions affecting the income statement and/or the balance sheet in July. Note that we could also classify these transactions as operating, investing, or financing activities, as shown in the statement of cash flows.

Transactions affecting only the balance sheet

Since each transaction affecting a business entity must be recorded in the accounting records, analyzing a transaction before actually recording it is an important part of financial accounting. An error in transaction analysis results in incorrect financial statements.

To illustrate the analysis of transactions and their effects on the basic accounting equation, the activities of Metro Courier, Inc., that led to the statements in Exhibit 2 follow. The first set of transactions (for June), 1a, 2a, and so on, are repeated in the summary of transactions, Exhibit 3 (Part A). The second set of transactions (for July) (1b–6b) are repeated in Exhibit 4 (Part A).

1a. Owners invested cash

When Metro Courier, Inc., was organized as a corporation on 2010 June 1, the company issued shares of capital stock for USD 30,000 cash to Ron Chaney, his wife, and their son. This transaction increased assets (cash) of Metro by USD 30,000 and increased equities (the capital stock element of stockholders' equity) by USD 30,000. Consequently, the transaction yields the following basic accounting equation:

2a. Borrowed money

The company borrowed USD 6,000 from Chaney's father. Chaney signed the note for the company. The note bore no interest and the company promised to repay (recorded as a note payable) the amount borrowed within one year. After including the effects of this transaction, the basic accounting equation is:

3a. Purchased trucks and office equipment for cash

Metro paid USD 20,000 cash for two used delivery trucks and USD 1,500 for office equipment. Trucks and office equipment are assets because the company uses them to earn revenues in the future. Note that this transaction does not change the total amount of assets in the basic equation but only changes the composition of the assets. This transaction decreased cash and increased trucks and office equipment (assets) by the total amount of the cash decrease. Metro received two assets and gave up one asset of equal value. Total assets are still USD 36,000. The accounting equation now is:

4a. Purchased office equipment on account (for credit)

Metro purchased an additional USD 1,000 of office equipment on account, agreeing to pay within 10 days after receiving the bill. (To purchase an item on account means to buy it on credit.) This transaction increased assets (office equipment) and liabilities (accounts payable) by USD 1,000. As stated earlier, accounts payable are amounts owed to suppliers for items purchased on credit. Now you can see the USD 1,000 increase in the assets and liabilities as follows:

5a. Paid an account payable 

Eight days after receiving the bill, Metro paid USD 1,000 for the office equipment purchased on account (transaction 4a). This transaction reduced cash by USD 1,000 and reduced accounts payable by USD 1,000. Thus, the assets and liabilities both are reduced by USD 1,000, and the equation again balances as follows:

Exhibit 3: Balance Sheet

Exhibit 3, Part A, is a summary of transactions prepared in accounting equation form for June. A summary of transactions is a teaching tool used to show the effects of transactions on the accounting equation. Note that the stockholders' equity has remained at USD 30,000. This amount changes as the business begins to earn revenues or incur expenses. You can see how the totals at the bottom of Part A of Exhibit 3 tie into the balance sheet shown in Part B. The date on the balance sheet is 2010 June 30. These totals become the beginning balances for July 2010.

Thus far, all transactions have consisted of exchanges or acquisitions of assets either by borrowing or by owner investment. We used this procedure to help you focus on the accounting equation as it relates to the balance sheet. However, people do not form a business only to hold existing assets. They form businesses so their assets can generate greater amounts of assets. Thus, a business increases its assets by providing goods or services to customers. The results of these activities appear in the income statement. The section that follows shows more of Metro's transactions as it began earning revenues and incurring expenses.

Transactions affecting the income statement and/or balance sheet

To survive, a business must be profitable. This means that the revenues earned by providing goods and services to customers must exceed the expenses incurred.

In July 2010, Metro Courier, Inc., began selling services and incurring expenses. The explanations of transactions that follow allow you to participate in this process and learn the necessary accounting procedures.

1b. Earned service revenue and received cash

As its first transaction in July, Metro performed delivery services for customers and received USD 4,800 cash. This transaction increased an asset (cash) by USD 4,800. Stockholders' equity (retained earnings) also increased by USD 4,800, and the accounting equation was in balance.

The USD 4,800 is a revenue earned by the business and, as such, increases stockholders' equity (in the form of retained earnings) because stockholders prosper when the business earns profits. Likewise, if the corporation sustains a loss, the loss would reduce retained earnings.

Revenues increase the amount of retained earnings while expenses and dividends decrease them. (In this first chapter, we show all of these items as immediately affecting retained earnings. In later chapters, the revenues, expenses, and dividends are accounted for separately from retained earnings during the accounting period and are transferred to retained earnings only at the end of the accounting period as part of the closing process) The effects of this USD 4,800 transaction on the financial position of Metro are:

Metro would record the increase in stockholders' equity brought about by the revenue transaction as a separate account, retained earnings. This does not increase capital stock because the Capital Stock account increases only when the company issues shares of stock. The expectation is that revenue transactions will exceed expenses and yield net income. If net income is not distributed to stockholders, it is in fact retained. Later chapters show that because of complexities in handling large numbers of transactions, revenues and expenses affect retained earnings only at the end of an accounting period. The preceding procedure is a shortcut used to explain why the accounting equation remains in balance.

2b. Service revenue earned on account (for credit)

Metro performed courier delivery services for a customer who agreed to pay USD 900 at a later date. The company granted credit rather than requiring the customer to pay cash immediately. This is called earning revenue on account. The transaction consists of exchanging services for the customer's promise to pay later. This transaction is similar to the preceding transaction in that stockholders' equity (retained earnings) increases because the company has earned revenues. However, the transaction differs because the company has not received cash. Instead, the company has received another asset, an account receivable. As noted earlier, an account receivable is the amount due from a customer for goods or services already provided. The company has a legal right to collect from the customer in the future. Accounting recognizes such claims as assets. The accounting equation, including this USD 900 item, is as follows:

3b. Collected cash on accounts receivable

Metro collected USD 200 on account from the customer in transaction 2b. The customer will pay the remaining USD 700 later. This transaction affects only the balance sheet and consists of giving up a claim on a customer in exchange for cash. The transaction increases cash by USD 200 and decreases accounts receivable by USD 200. Note that this transaction consists solely of a change in the composition of the assets. When the company performed the services, it recorded the revenue. Therefore, the company does not record the revenue again when collecting the cash.

4b. Paid salaries

Metro paid employees USD 2,600 in salaries. This transaction is an exchange of cash for employee services. Typically, companies pay employees for their services after they perform their work. Salaries (or wages) are costs companies incur to produce revenues, and companies consider them an expense. Thus, the accountant treats the transaction as a decrease in an asset (cash) and a decrease in stockholders' equity (retained earnings) because the company has incurred an expense. Expense transactions reduce net income. Since net income becomes a part of the retained earnings balance, expense transactions also reduce the retained earnings.

5b. Paid rent

In July, Metro paid USD 400 cash for office space rental. This transaction causes a decrease in cash of USD 400 and a decrease in retained earnings of USD 400 because of the incurrence of rent expense. Transaction 5b has the following effects on the amounts in the accounting equation:

6b. Received bill for gas and oil used

At the end of the month, Metro received a USD 600 bill for gas and oil consumed during the month. This transaction involves an increase in accounts payable (a liability) because Metro has not yet paid the bill and a decrease in retained earnings because Metro has incurred an expense. Metro's accounting equation now reads:

Summary of balance sheet and income statement transactions

Part A of Exhibit 4 summarizes the effects of all the preceding transactions on the assets, liabilities, and stockholders' equity of Metro Courier, Inc., in July. The beginning balances are the ending balances in Part A of Exhibit 3. The summary shows subtotals after each transaction; these subtotals are optional and may be omitted. Note how the accounting equation remains in balance after each transaction and at the end of the month.

The ending balances in each of the columns in Part A of Exhibit 4 are the dollar amounts in Part B and those reported earlier in the balance sheet in Part C of Exhibit 2. The itemized data in the Retained Earnings column are the revenue and expense items in Part C of Exhibit 4 and those reported earlier in the income statement in Part A of Exhibit 2. The beginning balance in the Retained Earnings column (USD 0) plus net income for the month (USD 2,100) is equal to the ending balance in retained earnings (USD 2,100) shown earlier in Part B of Exhibit 2. Remember that the financial statements are not an end in themselves, but are prepared to assist users of those statements to make informed decisions. Throughout the text we show how people use accounting information in decision making.

Dividends paid to owners (stockholders)

Stockholders' equity is (1) increased by capital contributed by stockholders and by revenues earned through operations and (2) decreased by expenses incurred in producing revenues. The payment of cash or other assets to stockholders in the form of dividends also reduces stockholders' equity. Thus, if the owners receive a cash dividend, the effect would be to reduce the retained earnings part of stockholders' equity; the amount of dividends is not an expense but a distribution of income.

An ethical perspective: State university

James Stevens was taking an accounting course at State University. Also, he was helping companies find accounting systems that would fit their information needs. He advised one of his clients to acquire a software computer package that could record the business transactions and prepare the financial statements. The licensing agreement with the software company specified that the basic charge for one site was USD 4,000 and that USD 1,000 must be paid for each additional site where the software was used. James was pleased that his recommendation to acquire the software was followed. However, he was upset that management wanted him to install the software at eight other sites in the company and did not intend to pay the extra USD 8,000 due the software company. A member of management stated, "The software company will never know the difference and, besides, everyone else seems to be pirating software. If they do find out, we will pay the extra fee at that time. Our expenses are high enough without paying these unnecessary costs". James believed he might lose this client if he did not do as management instructed.

An accounting perspective: Uses of technology

Accountants and others can access the home pages of companies to find their annual reports and other information, home pages of CPA firms to find employment opportunities and services offered, and home pages of government agencies, universities, and any other agency that has established a home page. By making on- screen choices you can discover all kinds of interesting information about almost anything. You can access libraries, even in foreign countries, newspapers, such as The Wall Street Journal, and find addresses and phone numbers of anyone in the nation. We have included some Internet Projects at the end of the chapters to give you some experience at “surfing the net” for accounting applications.

Analyzing and using the financial results - the equity ratio

The two basic sources of equity in a company are stockholders and creditors; their combined interests are called total equities. To find the equity ratio, divide stockholders' equity by total equities or total assets, since total equities equals total assets. In formula format:

Equity ratio = Stockholders 'equity Total equities

The higher the proportion of equities (or assets) supplied by the owners, the more solvent the company. However, a high portion of debt may indicate higher profitability because quite often the interest rate on debt is lower than the rate of earnings realized from using the proceeds of the debt. An example illustrates this concept: Suppose that a company with USD 100,000 in assets could have raised the funds to acquire those assets in these two ways:

When a company suffers operating losses, its assets decrease. In Case 1, the assets would have to shrink by 80 per cent before the liabilities would equal the assets. In Case 2, the assets would have to shrink only 20 per cent before the liabilities would equal the assets. When the liabilities exceed the assets, the company is said to be insolvent. Therefore, creditors are safer in Case 1 and will more readily lend money to the company.

However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2 is preferable in terms of profitability. Therefore, owners are better off in Case 2 if the borrowed funds can earn more than they cost.

Next, we examine the recent equity ratios of some actual companies:

As you can see from the preceding data, the equity ratios of actual companies vary widely. Companies such as Johnson & Johnson and 3M Corporation employ a higher proportion of stockholders' equity (a lower proportion of debt) than GE in an effort to have stronger balance sheets (more solvency). GE employs a greater proportion of debt, possibly in an attempt to increase profitability. Every company must strike a balance between solvency and profitability to ensure long- run survival. The correct balance between proportions of stockholder and creditor equities depends on the industry, general business conditions, and management philosophy.

Chapter 1 has introduced two important components of the accounting process - the accounting equation and the business transaction. In Chapter 2, you learn about debits and credits and how accountants use them in recording transactions. Understanding how data are accumulated, classified, and reported in financial statements helps you understand how to use financial statement data in making decisions.

An accounting perspective: Uses of technology

When you apply for your first job after graduation, prospective employers will expect you to know how to use a PC to perform many tasks. Therefore, before you graduate you should be able to use word processing, spreadsheet, and database software. You should be able to use the Internet to find useful information. In many universities, you can learn these skills in courses taken for credit. If your school does not offer credit courses, take noncredit courses or attend a training center.