14 Chapter 1 Introduction to Accounting and Business
OBJECTIVE 4
Describe and illustrate how business transactions can be recorded in terms of the resulting
change in the elements of the accounting equation.
SYNOPSIS
Using a sample company called NetSolutions, this objective demonstrates how business transactions
affect a company’s financial condition. Transactions, such as depositing cash, purchasing assets, selling
services, and paying bills, etc., affect the accounting equation. This shows students that through each
transaction the two sides of the accounting equation are always equal.
Key Terms and Definitions
• Account Payable – The liability created by a purchase on account.
• Account Receivable – A claim against the customer created by selling merchandise or services
on credit.
• Business Transaction – An economic event or condition that directly changes an entity’s
financial condition or directly affects its results of operations
• Common Stock – The stock outstanding when a corporation has issued only one class of stock.
• Dividends – Distribution of a corporation’s earnings to stockholders.
• Expenses – Assets used up or services consumed in the process of generating revenues.
• Fees Earned – Revenue from providing services.
• Interest Revenue – Money received for interest.
Relevant Example Exercises and Exhibits
• Example Exercise 1-3 – Transactions
• Exhibit 5 – Summary of Transactions for NetSolutions
• Exhibit 6 – Effects of Transactions on Stockholders’ Equity
SUGGESTED APPROACH
This objective illustrates recording business transactions within the framework of the accounting
equation. The text defines a business transaction as “an economic event or condition that directly changes
the entity’s financial condition or its results of operations.” Problem 1-1A or Problem 1-1B, as well as
TM 1-12, describe some of the economic events that are recorded as business transactions. This list can
assist your students in determining which events/conditions to record. For practice, ask students to list
transactions that they recently entered into with a business entity, such as purchasing gas for the car,
getting their hair cut, or purchasing their textbook from the bookstore.
Chapter 1 Introduction to Accounting and Business 15
The basics of recording transactions can be effectively illustrated by working a sample problem for the
students. Problem 1-1A or 1-1B provides several example transactions for a property rental management
business or an insurance agency, respectively. You can use either of these problems to demonstrate how
transactions are recorded yet any of the problems will work. Try to choose the problem opposite a
homework assignment. If you usually work A problems as homework problems, then work all
corresponding B problems in class. List the accounts that will be needed to record these transactions:
Accounts Accounts Stockholder’s
Cash Receivable Supplies Payable Equity + Others (see problem)
You will probably need to emphasize the following points as you demonstrate transactions:
1. The accounting equation must always stay in balance. Transactions may require additions to both
2. Revenue represents the receipt of assets (cash or accounts receivable) for goods sold or services
4. Expenses are costs incurred in generating revenues. Purchases of assets, payments of liabilities, and
dividend payments are not recorded as expenses.
A discussion of the “six different categories of accounts” (Assets, Liabilities, Stockholders’ Equity,
Dividends, Revenue, and Expenses) may be beneficial at this time. Letting the students know that
Stockholder Investments and Revenue increase Stockholders’ Equity, while Dividend Payments and
Expenses decrease Stockholders’ Equity can help students understand the impact that transactions have
on the accounting equation.
It may be beneficial to write the accounting equation on the board and then re-write the equation as
follows: Assets = Liabilities + Common Stock – Dividend Payments + Revenue – Expenses. Note that
Stockholders’ Equity is affected by the last four variables in the equation. Two of them increase
Stockholders’ Equity (Common Stock and Revenue), and two decrease Stockholders’ Equity (Dividend
Payments and Expenses).
GROUP LEARNING ACTIVITY—Recording Business Transactions
Rather than working through all of the transactions in TM 1-13 for your students, consider working only
the first few. Divide the class into small groups (two to three students) and ask them to complete the
exercise in five to ten minutes. TM 1-14 provides the solution. Give your students the opportunity to
check their work and ask questions after they have completed their assignment.
16 Chapter 1 Introduction to Accounting and Business
OBJECTIVE 5
Describe the financial statements of a corporation and explain how they interrelate.
SYNOPSIS
This objective shows the income statement, retained earnings statement, balance sheet, and statement of
cash flows. Using the same NetSolutions example as the previous objective, the order, preparation, and
relationship between the four financial statements is demonstrated. Each statement is prepared for a
specific period of time, except the balance sheet; it is prepared for a point in time. Revenue minus
Key Terms and Definitions
• Account Form – The form of balance sheet that resembles the basic format of the accounting
equation, with assets on the left side and Liabilities and Owner’s Equity sections on the right
side.
• Balance Sheet – A list of the assets, liabilities, and owner’s equity as of a specific date,
usually at the close of the last day of a month or a year.
• Statement of Cash Flows – A summary of the cash receipts and cash payments for a specific
period of time, such as a month or a year.
Relevant Example Exercises and Exhibits
• Example Exercise 1-4 – Income Statement
• Example Exercise 1-5 – Retained Earnings Statement
Chapter 1 Introduction to Accounting and Business 17
SUGGESTED APPROACH
This objective introduces the four financial statements of a corporation (in order of preparation: Income
Statement, Retained Earnings Statement, Balance Sheet, and Statement of Cash Flows) and explains how
they interrelate.
This objective also introduces the concept of “matching.” It is helpful to emphasize that matching is one
of the most important concepts in accounting. If revenues and expenses are not properly matched, then the
amount reported for net income is incorrect, making every statement thereafter incorrect.
1-15 also shows formats without figures. Review these formats with your class, emphasizing the
following:
1. The date portion of the heading varies among the financial statements. The Income Statement,
3. The ending retained earnings balance from the Retained Earnings Statement is the amount shown as
“Retained Earnings” on the balance sheet. As a result, the balance sheet “balances.”
Next, ask your students to build on the transactions recorded for Jim’s Lawn Care in the following Group
Learning Activity.
After covering the income statement, retained earnings statement, and balance sheet, you may want to
describe the statement of cash flows. Coverage of the cash flow statement also may be completely
GROUP LEARNING ACTIVITY—Preparing Financial Statements
Use Jim’s Lawn Care transactions solution (TM 1-14) to display the solution on screen; divide the class
into small groups. Ask students to use the balances from your problem to prepare financial statements for
the month. TM 1-15 can be used to provide a template for the students to follow. TM 1-16 shows the
completed income statement, retained earnings statement, and balance sheet for Jim’s Lawn Care, Inc.
Handout 1-1 can be distributed here for the first time or re-assigned after a discussion about financial
statements to see how students will perform with a little accounting knowledge on their side.
Handout 1-1 is a group exercise that has proven to be an excellent attention getter to assist students in
creating financial statements and understanding the importance of consistent application of GAAP. The
18 Chapter 1 Introduction to Accounting and Business
exercise gives students information about the operations of an upholstery shop for a period of one year.
The students are asked to calculate the shop’s profit.
The upholstery shop exercise contains many accounting twists that the beginning student will not know
how to handle, such as credit customers who have not yet paid, supplies that have been purchased but not
used, and assets that will last more than one year. These twists will generally spur considerable student
discussion. They also allow the instructor to illustrate the need for standardized accounting procedures.
The groups typically will provide a wide range of answers. This will allow you to emphasize that there
must be standards for recording business transactions and rules on how to determine profit if that
information is going to be useful to decision makers.
Once students have spent time attempting to calculate the profits on their own, provide an income
statement in proper form to demonstrate the correct solution.
For your information, the shop’s net income for its first year of operation is $18,580.
OBJECTIVE 6
Describe and illustrate the use of the ratio of liabilities to stockholders’ equity in evaluating
a company’s financial condition.
SYNOPSIS
Using the financial statements prepared in the previous objective, the use of the ratio of liabilities to
stockholders’ equity is examined. The total liabilities amount is divided by the total stockholders’ equity
amount to calculate this ratio. Since creditors have rights to a business’s assets before the owner, this ratio
is important to both owners and creditors. This ratio can affect how a business pays its creditors and
foretells how well a business will do in poor economic conditions. As this ratio increases, the creditors
and the business become more at risk.
Key Terms and Definitions
• Ratio of Liabilities to Stockholders’ Equity – A comprehensive leverage ratio that measures the
relationship of the claims of creditors to stockholders’ equity.
Chapter 1 Introduction to Accounting and Business 19
Relevant Example Exercises and Exhibits
• Example Exercise 1-8 – Ratio of Liabilities to Stockholders’ Equity
SUGGESTED APPROACH
This objective introduces the ratio of liabilities to stockholders’ equity. Explain that the ability of a
business to meet its financial obligations is a measure of the strength or weakness of its financial
condition.
Remind students that the rights of creditors to a business’s assets come before the rights of stockholders.
TM 1-19 shows the equation in words followed by the figures for Jim’s Lawn Care from its Balance
Sheet used in Objective 5.
To help students understand this concept, ask them to compute their personal ratio and examine how it
would change under a variety of different circumstances (such as taking out a student loan on the one
hand or winning the lottery on the other).
Handout 1-1
CLASSIC UPHOLSTERY SHOP, INC.
Tyler Smith had worked in an upholstery shop for 10 years. Last year, Tyler’s wages were $20,000.
Lately, Tyler had been unhappy with the shop’s owner. Convinced that he could run an upholstery shop
that did better work at a lower cost, Tyler decided to go into business for himself and opened CLASSIC
UPHOLSTERY SHOP, INC. He organized his business as a corporation and deposited $25,000 into a
business bank account in exchange for shares of common stock.
To get the business going, Tyler decided to invest heavily in advertising. He spent $6,000 on advertising
aimed at consumers and another $2,000 on advertising aimed at getting work from interior decorators and
interior design stores. Tyler also purchased industrial sewing machines costing $4,000 and other tools and
equipment costing $3,000. He estimated that the sewing machines can be used for about five years before
maintenance costs will be too high and the machines will need to be replaced. The other tools and
equipment are not as durable and will have to be replaced in three years.
At the end of the first year of business, Tyler had received $80,000 in cash from customers for upholstery
work. Tyler was owed another $2,500 from customers who are not required to pay cash but are billed
every 30 days.
A review of Tyler’s checkbook shows he paid the following expenses (in addition to those mentioned
previously) during the first year of business:
Upholstery fabric $40,000
Other supplies 10,000
Wages—part-time assistant 9,500
Rent 4,800
Insurance (two-year policy) 3,200
Utilities 2,500
Miscellaneous expenses 1,700
Tyler’s utility bill for the last month of the year has not arrived. He estimates that the bill will be
approximately $320.
Tyler keeps some stock of upholstery fabric in popular colors on hand for customers who do not want to
wait for special-order fabric to arrive. At the end of the year, about $14,000 of the fabric purchased during
the year was in his store stock. In addition, $2,300 in supplies had not been used.
EX 19 Income statement 5 Easy 5 min. Analytic FN – Measurement Financial Statements Apply x x
EX 20 Missing amounts from balance sheet and income statement data 5 Moderate 10 min. Analytic FN – Measurement Financial Statements Apply x
EX 22 Financial statements 5 Easy 5 min. Analytic FN – Measurement Financial Statements, Recording Transactions Apply x
EX 24 Statement of cash flows 5 Easy 10 min. Analytic FN – Measurement Statement of Cash Flows Apply x
EX 25 Financial statements 5 Moderate 10 min. Analytic FN – Measurement Financial Statements Remember
EX 27 Ratio of liabilities to stockholders’ equity 6 Moderate 10 min. Analytic FN – Measurement Financial Statements, Financial Statement Analysis Apply x x x
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP – APC Bloom’s EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 Easy 5 min. Analytic BB – Industry Purpose Remember
DQ 2 Easy 5 min. Analytic BB – Industry Purpose Remember
DQ 3 Easy 5 min. Analytic BB – Industry Purpose Remember
DQ 4 Easy 5 min. Analytic FN – Measurement Recording Transactions Remember
DQ 5 Easy 5 min. Analytic FN – Measurement Recording Transactions Remember
DQ 6 Easy 5 min. Analytic FN – Measurement Recording Transactions Remember
DQ 7 Easy 5 min. Analytic FN – Measurement GAAP Remember
DQ 8 Easy 5 min. Analytic FN – Measurement Financial Statements Remember
DQ 9 Easy 5 min. Analytic FN – Measurement Financial Statements Remember
DQ 10 Easy 5 min. Analytic FN – Measurement Financial Statements Remember
PE 1A Cost concept 2 Easy 5 min. Analytic FN – Measurement GAAP Apply x
PE 1B Cost concept 2 Easy 5 min. Analytic FN – Measurement GAAP Apply x
PE 2A Accounting equation 3 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply x
PE 2B Accounting equation 3 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply x
PE 3A Transactions 4 Easy 10 min. Analytic FN – Measurement Recording Transactions Apply x
PE 3B Transactions 4 Easy 10 min. Analytic FN – Measurement Recording Transactions Apply x
PE 4A Income statement 5 Easy 10 min. Analytic FN – Measurement Financial Statements Apply x
PE 4B Income statement 5 Easy 10 min. Analytic FN – Measurement Financial Statements Apply x
PE 5A Retained earnings statement 5 Easy 5 min. Analytic FN – Measurement Financial Statements Apply x
PE 5B Retained earnings statement 5 Easy 5 min. Analytic FN – Measurement Financial Statements Apply x
PE 6A Balance sheet 5 Easy 10 min. Analytic FN – Measurement Financial Statements Apply x
PE 6B Balance sheet 5 Easy 10 min. Analytic FN – Measurement Financial Statements Apply x
PE 7A Statement of cash flows 5 Easy 10 min. Analytic FN – Measurement Statement of Cash Flows Apply x
PE 7B Statement of cash flows 5 Easy 10 min. Analytic FN – Measurement Statement of Cash Flows Apply x
PE 8A Ratio of liabilities to stockholders’ equity 6 Easy 10 min. Analytic FN – Measurement Financial Statement Analysis Apply x x
PE 8B Ratio of liabilities to stockholders’ equity 6 Easy 10 min. Analytic FN – Measurement Financial Statement Analysis Apply x x
EX 1 Types of businesses 1 Easy 5 min. Analytic BB – Industry Business Forms, Recording Transactions Apply x x
EX 2 Professional ethics 1 Easy 5 min. Ethics BB – Industry Purpose Apply x x
EX 3 Business entity concept 2 Easy 10 min. Analytic BB – Industry GAAP Apply
EX 4 Accounting equation 3 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply x x
EX 5 Accounting equation 3 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply x x
EX 6 Accounting equation 3 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply x
EX 7 Accounting equation 3, 4 Moderate 10 min. Analytic FN – Measurement Recording Transactions Apply x
EX 8 Asset, liability, and stockholders’ equity items 3 Easy 5 min. Analytic FN – Measurement GAAP Remember
EX 9 Effect of transactions on accounting equation 4 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply
EX 10 Effect of transactions on accounting equation 4 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply x x
EX 11 Effect of transactions on stockholders’ equity 4 Easy 5 min. Analytic FN – Measurement Recording Transactions Apply
HOMEWORK CHART WITH LEARNING OUTCOMES TAGGING
TAGGING
RESOURCES
FOCUS