Chapter 1
Accounting and the Business Environment
Review Questions
1. What is accounting?
Accounting is the information system that measures business activities, processes the information
2. Briefly describe the two major fields of accounting.
Financial accounting provides information for external decision makers, such as outside investors,
3. Describe the various types of individuals who use accounting information and how they use that
information to make important decisions.
Individuals use accounting information to help them manage their money, evaluate a new job, and
4. What are two certifications available for accountants? Briefly explain each certification.
Certified Public Accountants (CPAs) are licensed professional accountants who serve the general
5. What is the role of the Financial Accounting Standards Board (FASB)?
The FASB oversees the creation and governance of accounting standards. They work with
governmental regulatory agencies, congressionally created groups, and private groups.
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6. Explain the purpose of Generally Accepted Accounting Principles (GAAP), including the
organization currently responsible for the creation and governance of these standards.
The guidelines for accounting information are called GAAP. It is the main U.S. accounting rule
7. Describe the similarities and differences among the four different types of business entities discussed
in the chapter.
A sole proprietorship has a single owner, terminates upon the owner’s death or choice, the owner has
8. A business purchases an acre of land for $5,000. The current market value is $5,550, and the land
was assessed for property tax purposes at $5,250. What value should the land be recorded at, and
which accounting principle supports your answer?
The land should be recorded at $5,000. The cost principle states that assets should be recorded at
their historical cost.
9. What does the going concern assumption mean for a business?
10. Which concept states that accounting information should be complete, neutral, and free from
material error?
The faithful representation concept states that accounting information should be complete, neutral,
and free from material error.
11. Financial statements in the United States are reported in U.S. dollars. What assumption supports this
statement?
12. Explain the role of the International Accounting Standards Board (IASB) in relation to International
Financial Reporting Standards (IFRS).
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13. What is the accounting equation? Briefly explain each of the three parts.
Assets = Liabilities + Equity. Assets are economic resources that are expected to benefit the
business in the future. They are things of value that a business owns or has control of. Liabilities
14. How does retained earnings increase? What are the two ways that retained earnings decreases?
Retained earnings increases with revenues. Retained earnings decreases with expenses and
dividends.
15. How is net income calculated? Define revenues and expenses.
16. What are the steps used when analyzing a business transaction?
17. List the four financial statements. Briefly describe each statement.
Income Statement – Shows the difference between an entity’s revenues and expenses and reports the
net income or net loss for a specific period.
18. What is the calculation for return on assets (ROA)? Explain what ROA measures.
Return on Assets = Net income / Average total assets. ROA measures how profitably a company
uses its assets.
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Short Exercises
S1-1 Identifying users of accounting information
Learning Objective 1
For each user of accounting information, identify if the user would use financial accounting (FA) or
managerial accounting (MA).
SOLUTION
a. FA
e. MA
b. FA
c. FA
g. MA
d. MA
h. FA
S1-2 Determining organizations that govern accounting
Learning Objective 2
Suppose you are starting a business, Wholly Shirts, to imprint logos on T-shirts. In organizing the
business and setting up its accounting records, you take your information to a CPA to prepare financial
statements for the bank. Name the organization that governs the majority of the guidelines that the CPA
will use to prepare financial statements for Wholly Shirts. What are those guidelines called?
SOLUTION
S1-3 Identifying types of business organizations
Learning Objective 2
Chloe Michaels plans on opening Chloe Michaels Floral Designs. She is considering the various types of
business organizations and wishes to organize her business with unlimited life and wants owners of the
business to not be held personally liable for the business’s debts. Additionally, Chloe wants the business
to be a separate taxable entity. Which type of business organization will meet Chloe’s needs best?
SOLUTION
Chloe’s needs will best be met by organizing a corporation since a corporation has an unlimited life and
S1-4 Identifying types of business organizations
Learning Objective 2
You would like to start a cellular telephone equipment service business. You are considering organizing
the business as a sole proprietorship. Identify the advantages and disadvantages of owning a sole
proprietorship.
SOLUTION
Advantages:
1. Easy to organize.
S1-5 Applying accounting assumptions and principles
Learning Objective 2
Michael McNamee is the proprietor of a property management company, Apartment Exchange, near the
campus of Pensacola State College. The business has cash of $8,000 and furniture that cost $9,000 and
has a market value of $13,000. The business debts include accounts payable of $6,000. Michael’s
personal home is valued at $400,000, and his personal bank account has a balance of $1,200. Consider
the accounting principles and assumptions discussed in the chapter, and identify the principle or
assumption that best matches the situation:
a. Michael’s personal assets are not recorded on the Apartment Exchange’s balance sheet.
b. The Apartment Exchange records furniture at its cost of $9,000, not its market value of $13,000.
c. The Apartment Exchange reports its financial statements in U.S. dollars.
d. Michael expects the Apartment Exchange to remain in operation for the foreseeable future.
SOLUTION
a. The economic entity assumption
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S1-6 Using the accounting equation
Learning Objective 3
Kenmore Handyman Services has total assets for the year of $16,400 and total liabilities of $8,680.
Requirements
1. Use the accounting equation to solve for equity.
2. If next year assets increased by $3,500 and equity decreased by $2,580, what would be the amount
of total liabilities for Kenmore Handyman Services?
SOLUTION
Requirement 1
Kenmore Handyman Services has equity of $7,720.
S1-7 Using the accounting equation
Learning Objective 3
Josh’s Overhead Doors reports the following financial information:
Requirements
1. Use the accounting equation to solve for the missing information.
2. Did Josh’s Overhead Doors report net income or net loss?
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SOLUTION
Requirement 1
Assets
=
Liabilities
+
Equity
Contributed
Capital
+
Retained Earnings
$42,600
+
$26,240
+
$12,080
S1-8 Identifying accounts
Learning Objective 3
Consider the following accounts:
Identify each account as Asset (A), Liability (L), or Equity (E).
SOLUTION
a. L
f. E
b. A
g. A
c. E
h. E
d. A
i. A
e. E
j. E
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S1-9 Using the accounting equation to analyze transactions
Learning Objective 4
Tiny Town Kennel earns service revenue by caring for the pets of customers. Tiny Town Kennel is
organized as a corporation. During the past month, Tiny Town Kennel has the following transactions:
a. Received $520 cash for service revenue earned.
b. Paid $325 cash for salaries expense.
c. Investors contributed $1,000 to the corporation in exchange for common stock.
d. Earned $640 for service revenue, but the customer has not paid Tiny Town Kennel yet.
e. Received utility bill of $85, which will be paid next month.
f. Cash dividends of $100 were paid to stockholders.
Indicate the effects of the business transactions on the accounting equation for Tiny Town Kennel.
Transaction (a) is answered as a guide.
a. Increase asset (Cash); Increase equity (Service Revenue)
SOLUTION
a. Increase asset (Cash); Increase equity (Service Revenue)
S1-10 Using the accounting equation to analyze transactions
Learning Objective 4
Elaine’s Inflatables earns service revenue by providing party planning services and inflatable
playscapes. Elaine’s Inflatables is organized as a corporation. During the past month, Elaine’s
Inflatables had the following transactions:
a. Investors contributed $10,000 to the corporation in exchange for common stock.
b. Purchased equipment for $5,000 on account.
c. Paid $400 for office supplies.
d. Earned and received $2,500 cash for service revenue.
e. Paid $400 for wages to employees.
f. Cash dividends of $1,000 were paid to stockholders.
g. Earned $1,000 for services provided. Customer has not yet paid.
h. Paid $1,000 for rent.
i. Received a bill for $250 for the monthly utilities. The bill has not yet been paid.
Indicate the effects of the business transactions on the accounting equation for Elaine’s Inflatables.
Transaction (a) is answered as a guide.
a. Increase asset (Cash); Increase equity (Common Stock)
SOLUTION
a. Increase asset (Cash); Increase equity (Common Stock)
S1-11 Identifying accounts on the financial statements
Learning Objective 5
Consider the following accounts:
Identify the financial statement (or statements) that each account would appear on. Use I for Income
Statement, RE for Statement of Retained Earnings, and B for Balance Sheet.
SOLUTION
a. B
f. I
b. B
g. B
h. RE
d. B
i. B
e. I
j. I
Use the following information to answer Short Exercises S1-12 through S1-14.
Decorating Arrangements has just completed operations for the year ended December 31, 2016. This is
the third year of operations for the company. The following data have been assembled for the business:
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S1-12 Preparing the income statement
Learning Objective 5
Prepare the income statement of Decorating Arrangements for the year ended December 31, 2016.
SOLUTION
DECORATING ARRANGEMENTS
Income Statement
Year Ended December 31, 2016
Revenue:
Service Revenue
Expenses:
Salaries Expense
Rent Expense
Insurance Expense
Utilities Expense
Total Expenses
Net Income
S1-13 Preparing the statement of retained earnings
Learning Objective 5
Prepare the statement of retained earnings of Decorating Arrangements for the year ended December 31,
2016.
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SOLUTION
DECORATING ARRANGEMENTS
Statement of Retained Earnings
Year Ended December 31, 2016
S1-14 Preparing the balance sheet
Learning Objective 5
Prepare the balance sheet of Decorating Arrangements as of December 31, 2016.
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SOLUTION
DECORATING ARRANGEMENTS
Balance Sheet
December 31, 2016
S1-15 Preparing the statement of cash flows
Learning Objective 5
Pushing Daisies Homes had the following cash transactions for the month ended July 31, 2016.
Prepare the statement of cash flows for Pushing Daisies Homes for the month ended July 31, 2016.
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SOLUTION
PUSHING DAISIES HOMES
Statement of Cash Flows
Month Ended July 31, 2016
Cash flows from operating activities:
Receipts:
Collections from customers
$ 24,000
Payments:
For rent
For salaries
For utilities
Net cash provided by operating activities
Cash flows from investing activities:
Purchase of equipment
Net cash used by investing activities
Cash flows from financing activities:
Issued common stock
Payment of cash dividend
Net cash provided by financing activities
Net increase in cash
Cash balance, July 1, 2016
Cash balance, July 31, 2016
S1-16 Calculating Return on Assets (ROA)
Learning Objective 6
Refined Water Services had net income for the month of October of $74,000. Assets as of the beginning
and end of the month totaled $350,000, and $390,000, respectively. Calculate Refined Water Services’
return on assets (ROA) for the month of October.
SOLUTION
Return on assets
=
Net income / Average total assets
=
$74,000 / (($350,000 + $390,000) / 2)
=
$74,000 / $370,000
=
20%
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Exercises
E1-17 Identifying users of accounting information
Learning Objective 1
For each of the users of accounting information, identify whether the user is an external decision maker
(E) or an internal decision maker (I):
SOLUTION
a. E
e. E
E1-18 Using accounting vocabulary
Learning Objective 2
Consider the following accounting terms and definitions, and match each term to the definition:
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SOLUTION
1. d
6. f
2. e
7. b
3. g
8. c
4. a
9. j
5. i
10. h
E1-19 Using accounting vocabulary
Learning Objectives 3, 5
Consider the following accounting terms and definitions, and match each term to the definition:
SOLUTION
1. e
7. d
2. a
8. c
3. i
9. g
4. f
10. h
5. j
11. k
6. b
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E1-20 Using the accounting equation
Learning Objective 3
Compute the missing amount in the accounting equation for each entity from the financial information
presented:
SOLUTION
Assets
Liabilities
Equity
65,000
E1-21 Using the accounting equation
Learning Objective 3
Green City Builders’ balance sheet data at May 31, 2016, and June 30, 2016, follow:
For each of the following situations with regard to common stock and dividends of a corporation,
compute the amount of net income or net loss during June 2016.
a. The company issued $7,500 of common stock and paid no dividends.
b. The company issued no common stock. It paid cash dividends of $13,000.
c. The company issued $20,000 of common stock and paid cash dividends of
$18,000.
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SOLUTION
a.
b.
c.
Stockholders’ equity, May 31, 2016
($188,000 – $122,000)
$ 66,000
$ 66,000
$ 66,000
Issuance of common stock
Net income for the month
Dividends
($244,000 – $88,000)
E1-22 Using the accounting equation
Learning Objective 3
Star Nursery started 2016 with total assets of $24,000 and total liabilities of $5,000. At the end of 2016,
Star Nursery’s total assets stood at $18,000 and total liabilities were $1,000.
Requirements
1. Did the stockholders’ equity of Star Nursery increase or decrease during 2016? By how much?
2. Identify the four possible reasons that stockholders’ equity can change.
SOLUTION
Requirement 1
Assets
=
Liabilities
+
Equity
Beginning of 2016
$24,000
=
$5,000
+
?
$24,000
=
$5,000
+
End of 2016
$18,000
=
$1,000
+
?
$18,000
=
+
Requirement 2
a. Increase through issuance of common stock.
b. Increase through net income.
c. Decrease through dividend payment.
d. Decrease through net loss.
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E1-23 Using the accounting equation
Learning Objective 3
During 2016, Peaceful River Spa reported revenue of $40,000. Total expenses for the year were
$35,000. Peaceful River Spa ended the year with total assets of $23,000, and it owed debts totaling
$9,000. At year-end 2015, the business reported total assets of $18,000 and total liabilities of $9,000.
Requirements
1. Compute Peaceful River Spa’s net income for 2016.
2. Did Peaceful River Spa’s stockholders’ equity increase or decrease during 2016? By how much?
SOLUTION
Requirement 1
Revenues
–
Expenses
=
Net Income
–
=
Equity
$9,000
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E1-24 Using the accounting equation
Learning Objective 3
The records of Meehan Company show the following at December 31, 2016:
Requirements
1. Compute the missing amount for Meehan Company. You will need to determine Retained Earnings,
December 31, 2016, and total stockholders’ equity.
2. Did Meehan earn a net income or suffer a net loss for the year? Compute the amount.
SOLUTION
Requirement 1
Assets
−
Liabilities
=
Equity
Beginning of 2016
$64,000
−
$44,000
=
$20,000
Retained Earnings, Jan. 1, 2016
Plus: Revenues
Less: Expenses
Less: Dividends
(4,000)
Retained Earnings, Dec. 31, 2016
Common Stock
Retained Earnings
−
Net Income (Loss)
−
E1-25 Using the accounting equation to analyze transactions
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Learning Objective 4
As the manager of a Papa Sean’s restaurant, you must deal with a variety of business transactions. Give
an example of a transaction that has each of the following effects on the accounting equation:
a. Increase one asset and decrease another asset.
b. Decrease an asset and decrease equity.
c. Decrease an asset and decrease a liability.
d. Increase an asset and increase equity.
e. Increase an asset and increase a liability.
SOLUTION
Student responses will vary. Examples include:
a. Cash purchase of office supplies.
E1-26 Using the accounting equation to analyze business transactions
Learning Objective 4
Indicate the effects of the following business transactions on the accounting equation of Vivian’s Online
Video store. Transaction (a) is answered as a guide.
a. Received cash of $10,000 from issuance of common stock.
Answer: Increase asset (Cash); Increase equity (Common Stock)
b. Earned video rental revenue on account, $2,800.
c. Purchased office furniture on account, $300.
d. Received cash on account, $400.
e. Paid cash on account, $100.
f. Rented videos and received cash of $200.
g. Paid monthly office rent of $1,000.
h. Paid $100 cash to purchase office supplies.
SOLUTION
a. Increase asset (Cash); Increase equity (Common Stock)
b. Increase asset (Accounts Receivable); Increase equity (Rental Revenue)