Starting a Proprietorship: Changes That Affect the Accounting Equation

Transcription

1 C H A P T E R 1 Starting a Proprietorship: Changes That Affect the Accounting Equation STOCKBYTE/GETTY IMAGES O B J E C T I V E S After studying Chapter 1, you will be able to: 1. Define accounting terms related to starting a service business organized as a proprietorship and to changes that affect the accounting equation. 2. Identify accounting concepts and practices related to starting a service business organized as a proprietorship and to changes that affect the accounting equation. 3. Classify accounts as assets, liabilities, or owner s equity and demonstrate their relationships in the accounting equation. 4. Analyze how transactions affect accounts in an accounting equation. K E Y T E R M S accounting accounting system accounting records financial statements service business proprietorship asset equities liability owner s equity accounting equation ethics business ethics transaction account account title account balance capital revenue sale on account expense withdrawals ( ) Point Your Browser 4

2 ACCOUNTING IN THE REAL WORLD Gold s Gym Gold s Gym and the Importance of Location Are you ready for a good workout? With so many labor-saving devices available today, many people look to fitness facilities for their daily physical exercise. For a fee, a member can make use of a variety of cardiovascular machines, weightlifting/resistance equipment, free weights, and indoor tracks. Many facilities offer classes and personal trainers. You can even shop for specialty food and workout clothing. GOLD S GYM INTERNATIONAL Gold s Gym is a franchise operation, meaning that individuals or groups buy the right to open and operate a Gold s Gym. The first Gold s Gym opened in 1965 in Venice, California. Since then, more than 65 Gold s Gyms have opened in the United States and in 23 countries around the world. When considering the possibility of opening a new Gold s Gym, there are many decisions that have to be made. These decisions include where to locate the gym, how big the facility should be, what equipment to include, and how to let people know about the new facility. INTERNET ACTIVITY Small Business Administration Go to the homepage for the Small Business Administration, a government organization designed to help small businesses in the United States. Search the site for advice about starting a business. Use the link or do a search for the Small Business Administration if the link is no longer accurate. Instructions 1. List at least five aids that the Small Business Administration site pro- DIGITAL VISION/GETTY IMAGES vides to help a person Critical Thinking 1. Why is the location of a business important to the success of that business? start a business. 2. Briefly explain which aid you feel is most helpful. 2. What things would you consider when deciding where to locate a business such as Gold s Gym? Source: 5

3 L E S S O N 1-1 The Accounting Equation WHAT IS ACCOUNTING? Planning, recording, analyzing, and interpreting financial information is called accounting. A planned process for providing financial information that will be useful to management is called an accounting system. Organized summaries of a business s financial activities are called accounting records. Accounting is the language of business. Many individuals in a business complete accounting forms and prepare accounting reports. Owners, managers, and accounting personnel use their knowledge of accounting to understand the information provided in the accounting reports. Regardless of their responsibilities within an organization, individuals can perform their jobs more efficiently if they know the language of business accounting. Suppliers that are considering extending credit to a business and institutions that are considering extend- ing loans to a business are also interested in a business s financial activities. Financial reports that summarize the financial condition and operations of a business are called financial statements. Business owners and managers also use financial statements to make business decisions. Inaccurate accounting records often contribute to business failure and bankruptcy. Failure to understand accounting information can result in poor business decisions for both businesses and nonprofit organizations. Understanding accounting helps managers and owners make better business decisions. In addition, nearly everyone in the United States earns money and must submit income tax reports to the federal and state governments. Everyone must plan ways to keep spending within available income in both their personal and business lives. THE BUSINESS TECHKNOW CONSULTING A business that performs an activity for a fee is called a service business. Kim Park decided to start her own business, helping set up and troubleshoot computer networks. A business owned by one person is called a proprietorship. A proprietorship is also referred to as a sole proprietorship. Kim named her new proprietorship TechKnow Consulting. TechKnow Consulting will rent office space and the equipment needed to troubleshoot network problems. Since TechKnow Consulting is a new business, Kim must design the accounting system that will be used to keep TechKnow Consulting s accounting records. Kim must be careful to keep these accounting records separate from her own personal financial records. For example, Kim owns a house and a personal car. TechKnow Consulting s financial records must not include information about Kim s house, car, or other personal belongings. Kim must use one checking account for her personal expenses and another checking account for TechKnow Consulting. The accounting concept Business Entity is applied when a business s financial information is recorded and reported separately from the owner s personal financial information. [CONCEPT: Business Entity] 6 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

4 Accounting concepts are described throughout this textbook when an application of a concept first occurs. When additional applications occur, a concept reference, such as [CON- CEPT: Business Entity], indicates an application of a specific accounting concept. A brief description of each accounting concept used in this text is also provided on the Century 21 Accounting web site at After completing a computer networking program at a local community college, Kim decided to start her own business so she would have more control over her daily schedule. After only two months, she has made all the arrangements and is ready to begin. Kim enjoys both helping schools, businesses, and individuals set up a computer network and troubleshooting a network that is not working properly. She also enjoys being her own boss. She gets satisfaction from keeping her own accounting records and seeing that she is making money every month. PHOTODISC/GETTY IMAGES BUSINESS STRUCTURES Forming and Dissolving a Proprietorship PHOTO: PHOTODISC/GETTY IMAGES A proprietorship is a business owned and controlled by one person. The advantages of a proprietorship include: Ease of formation. Total control by the owner. Profits that are not shared. However, there are some disadvantages of organizing a proprietorship: Limited resources. The owner is the only person who can invest cash and other assets in the business. Unlimited liability. The owner is totally responsible for the liabilities of the business. Personal assets, such as a car, can be claimed by creditors to pay the business s liabilities. Limited expertise. Limited time, energy, and experience can be put into the business by the owner. Limited life. A proprietorship must be dissolved when the owner dies or decides to stop doing business. Obligation to follow the laws of both the federal government and the state and city in which the business is formed. Most cities and states have few, if any, legal procedures to follow. Once any legal requirements are met, the proprietorship can begin business. Should the owner decide to dissolve the proprietorship, he or she merely needs to stop doing business. Noncash assets can be sold, with the cash used to pay any outstanding liabilities. Critical Thinking 1. Why do you think more businesses are organized as proprietorships than any other form of business organization? 2. What kinds of people do you think would be most successful as owners of a proprietorship? The Accounting Equation Lesson 1-1 7

5 THE ACCOUNTING EQUATION Assets Left side amount $ Liabilities Owner s Equity Right side amounts $ $ TechKnow Consulting will own items such as cash and supplies that will be used to conduct daily operations. Anything of value that is owned is called an asset. Assets have value because they can be used either to acquire other assets or to operate a business. For example, TechKnow Consulting will use cash to buy supplies for the business. TechKnow Consulting will then use the asset supplies in the operation of the computer consulting business. Financial rights to the assets of a business are called equities. A business has two types of equities: (1) Equity of those to whom money is owed. For example, TechKnow Consulting may buy some supplies and agree to pay for the supplies at a later date. The business from whom supplies are bought will have a right to some of TechKnow s assets until TechKnow pays for the supplies. An amount owed by a business is called a liability. (2) Equity of the owner. Kim will own TechKnow Consulting and invest in the assets of the business. Therefore, she will have a right to decide how the assets will be used. The amount remaining after the value of all liabilities is subtracted from the value of all assets is called owner s equity. The relationship among assets, liabilities, and owner s equity can be written as an equation. An equation showing the relationship among assets, liabilities, and owner s equity is called the accounting equation. The accounting equation is most often stated as: Assets Liabilities Owner s Equity The accounting equation must be in balance. The total of the amounts on the left side must always equal the total of the amounts on the right side. Before a business starts, its accounting equation would show all zeros. CHARACTER COUNTS Accounting Scandals Rock the Financial World Entering the 21st century, Enron, World- Com, and Andersen were three of the most celebrated names in corporate America. But the actions of a few individuals forced financial mammoths Enron and WorldCom into bankruptcy. Andersen, once one of the prestigious Big 5 accounting firms, was forced out of business. These accounting scandals caused hundreds of thousands of employees to lose their jobs and millions of individuals to lose billions of dollars in investment and retirement accounts. The scandals rocked the public s confidence in the accounting profession and the stock markets. The principles of right and wrong that guide an individual in making decisions are called ethics. The use of ethics in making business decisions is called business ethics. Making ethical business decisions is a skill you can learn. Each chapter of this textbook contains a feature on business ethics. In Part 1, you will explore a model that guides your evaluation of business decisions. In later chapters, you will apply that model to make ethical business decisions. You will also be exposed to sources that will enable you to continue learning about business ethics long after you have completed this accounting course. Instructions Obtain an article that describes an accounting scandal such as Enron, WorldCom, Adelphia, Healthcorp South, or Parmalat. Write a one-paragraph summary that describes what happened and the individuals involved. PHOTO: BLEND IMAGES/GETTY IMAGES 8 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

6 TERMS REVIEW accounting accounting system accounting records financial statements service business proprietorship asset equities liability owner s equity accounting equation ethics business ethics End of Lesson REVIEW AUDIT YOUR UNDERSTANDING 1. What is accounting? 2. Give two examples of service businesses. 3. What is a proprietorship? 4. State the accounting equation. WORK TOGETHER 1-1 Completing the accounting equation Write the answers to the following problem in the Working Papers. Your instructor will guide you through the following example. 1. For each line, fill in the missing amount to complete the accounting equation. Assets Liabilities Owner s Equity? 3, 8, 1,? 6, 63, 35,? ON YOUR OWN 1-1 Completing the accounting equation Write the answers to the following problem in the Working Papers. Work this problem independently. 1. For each line, fill in the missing amount to complete the accounting equation. Assets Liabilities Owner s Equity 3,? 13,? 6, 2, 51, 25,? The Accounting Equation Lesson 1-1 9

7 L E S S O N 1-2 How Business Activities Change the Accounting Equation RECEIVING CASH Beginning Balances Received cash from owner as an investment New Balances Assets Liabilities Owner s Equity Cash $ 5, $5, $ $ Kim Park, Capital $ 5, $5, Business activities change the amounts in the accounting equation. A business activity that changes assets, liabilities, or owner s equity is called a transaction. For example, a business that pays cash for supplies is engaging in a transaction. After each transaction, the accounting equation must remain in balance. The accounting concept Unit of Measurement is applied when business transactions are stated in numbers that have common values that is, using a common unit of measurement. [CONCEPT: Unit of Measurement] For example, in the United States, business transactions are recorded in dollars. The unit of measurement concept is followed so that the financial reports of businesses can be clearly stated and understood in numbers that have comparable values. Received Cash Investment from Owner Ms. Park uses $5,. of her own money to invest in TechKnow Consulting. TechKnow Consulting should be concerned only with the effect of this transaction on TechKnow Consulting s records. The business should not be concerned about Ms. Park s personal records. [CON- CEPT: Business Entity] Transaction 1 August 1. Received cash from owner as an investment, $5,.. A record summarizing all the information pertaining to a single item in the accounting equation is called an account. The name given to an account is called an account title. Each part of the accounting equation consists of one or more accounts. In the accounting equation shown above, the asset account, Cash, is increased by $5,., the amount of cash received by the business. This increase is on the left side of the accounting equation. The amount in an account is called the account balance. Before the owner s investment, the account balance of Cash was zero. After the owner s investment, the account balance of Cash is $5,.. The account used to summarize the owner s equity in a business is called capital. The capital account is an owner s equity account. In the accounting equation shown above, the owner s equity account, Kim Park, Capital, is increased by $5,.. This increase is on the right side of the accounting equation. Before the owner s investment, the account balance of Kim Park, Capital was zero. After the owner s investment, the account balance of Kim Park, Capital is $5,.. The accounting equation has changed as a result of the receipt of cash. However, both sides of the equation are changed by the same amount. The $5,. increase on the left side of the equation equals the $5,. increase on the right side of the equation. Therefore, the accounting equation is still in balance. 1 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

8 PAYING CASH Balances Paid cash for supplies Balances Paid cash for insurance New Balances Cash $5, 275 $4,725 1,2 $3,525 Assets Liabilities Owner s Equity Supplies $ 275 $275 $275 Prepaid Insurance $ $ 1,2 $1,2 $ $ $ Kim Park, Capital $5, $5, $5, TechKnow Consulting pays cash for supplies and insurance. Paid Cash for Supplies TechKnow Consulting needs supplies to operate the business. Kim Park uses some of TechKnow Consulting s cash to buy supplies. Transaction 2 August 3. Paid cash for supplies, $275.. In this transaction, two asset accounts are changed. One asset, cash, has been exchanged for another asset, supplies. The asset account, Cash, is decreased by $275., the amount of cash paid out. This decrease is on the left side of the accounting equation. The asset account, Supplies, is increased by $275., the amount of supplies bought. This increase is also on the left side of the accounting equation. For this transaction, two assets are changed. Therefore, the two changes are both on the left side of the accounting equation. When changes are made on only one side of the accounting equation, the equation must still be in balance. Therefore, if one account is increased, another account on the same side of the equation must be decreased. After this transaction, the new account balance of Cash is $4,725.. The new account balance of Supplies is $275.. The sum of the amounts on the left side is $5,. (Cash, $4, Supplies, $275.). The amount on the right side is also $5,.. Therefore, the accounting equation is still in balance. Paid Cash for Insurance Insurance premiums must be paid in advance. For example, TechKnow Consulting pays a $1,2. insurance premium for future insurance coverage. Transaction 3 August 4. Paid cash for insurance, $1,2.. In return for this payment, TechKnow Consulting is entitled to insurance coverage for the length of the policy. The insurance coverage is something of value owned by TechKnow Consulting. Therefore, the insurance coverage is an asset. Because insurance premiums are paid in advance, or prepaid, the premiums are recorded in an asset account titled Prepaid Insurance. In this transaction, two assets are changed. One asset, cash, has been exchanged for another asset, prepaid insurance. The asset account, Cash, is decreased by $1,2., the amount of cash paid out. The asset account, Prepaid Insurance, is increased by $1,2., the amount of insurance bought. After this transaction, the new account balance of Cash is $3,525.. The new account balance of Prepaid Insurance is $1,2.. The sum of the amounts on the left side is $5,. (Cash, $3,525. Supplies, $275. Prepaid Insurance, $1,2.). The amount on the right side is also $5,.. Therefore, the accounting equation is still in balance. How Business Activities Change the Accounting Equation Lesson

9 TRANSACTIONS ON ACCOUNT Balances Bought supplies on account New Balances Paid cash on account New Balances Cash $3,525 $3,525 3 Assets Liabilities Owner s Equity Supplies $275 5 $775 Prepaid Insurance $1,2 $1,2 Accts. Pay. Supply Depot $ 5 $5 3 Kim Park, Capital $5, $5, $3,225 $775 $1,2 $2 $5, Bought Supplies on Account TechKnow Consulting needs to buy additional supplies. The supplies are obtained from Supply Depot, and Tech- Know arranges to pay for them at the end of the month. It is a common business practice to buy items and pay for them at a future date. Another way to state this activity is to say that these items are bought on account. Transaction 4 August 7. Bought supplies on account from Supply Depot, $5.. Paid Cash on Account Since TechKnow Consulting is a new business, Supply Depot has not done business with TechKnow Consulting before. Supply Depot allows TechKnow Consulting to buy supplies on account but requires TechKnow Consulting to send a check for $3. immediately. TechKnow Consulting will pay the remaining portion of this liability at a later date. Transaction 5 August 11. Paid cash on account to Supply Depot, $3.. In this transaction, one asset and one liability are changed. The asset account, Supplies, is increased by $5., the amount of supplies bought. Supply Depot will have a claim against some of TechKnow Consulting s assets until TechKnow Consulting pays for the supplies bought. Therefore, Accounts Payable Supply Depot is a liability account. The liability account, Accounts Payable Supply Depot, is increased by $5., the amount owed for the supplies. After this transaction, the new account balance of Supplies is $775.. The new account balance of Accounts Payable Supply Depot is $5.. The sum of the amounts on the left side is $5,5. (Cash, $3,525. Supplies, $775. Prepaid Insurance, $1,2.). The sum of the amounts on the right side is also $5,5. (Accounts Payable Supply Depot, $5. Kim Park, Capital, $5,.). Therefore, the accounting equation is still in balance. R E M E M B E R The left side of the accounting equation (assets) must always equal the right side (liabilities plus owner s equity). In this transaction, one asset and one liability are changed. The asset account, Cash, is decreased by $3., the amount of cash paid out. After this payment, Tech- Know Consulting owes less money to Supply Depot. Therefore, the liability account, Accounts Payable Supply Depot, is decreased by $3., the amount paid on account. After this transaction, the new account balance of Cash is $3,225.. The new account balance of Accounts Payable Supply Depot is $2.. The sum of the amounts on the left side is $5,2. (Cash, $3,225. Supplies, $775. Prepaid Insurance, $1,2.). The sum of the amounts on the right side is also $5,2. (Accounts Payable Supply Depot, $2. Kim Park, Capital, $5,.). Therefore, the accounting equation is still in balance. 12 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

10 TERMS REVIEW transaction account account title account balance capital End of Lesson REVIEW AUDIT YOUR UNDERSTANDING 1. What must be done if a transaction increases the left side of the accounting equation? 2. How can a transaction affect only one side of the accounting equation? 3. To what does the phrase on account refer? WORK TOGETHER 1-2 Determining how transactions change an accounting equation Write the answers to the following problem in the Working Papers. Your instructor will guide you through the following example. Trans. No. Assets Liabilities Owner s Equity For each transaction, place a plus () in the appropriate column if the classification is increased. Place a minus () in the appropriate column if the classification is decreased. Transactions: 1. Bought supplies on account. 3. Paid cash for insurance. 2. Received cash from owner as an investment. 4. Paid cash on account. ON YOUR OWN 1-2 Determining how transactions change an accounting equation Write the answers to the following problem in the Working Papers. Work this problem independently. Trans. No. Assets Liabilities Owner s Equity For each transaction, place a plus () in the appropriate column if the classification is increased. Place a minus () in the appropriate column if the classification is decreased. Transactions: 1. Received cash from owner as an investment. 4. Paid cash for insurance. 2. Bought supplies on account. 5. Paid cash on account. 3. Paid cash for supplies. How Business Activities Change the Accounting Equation Lesson

11 L E S S O N 1-3 How Transactions Change Owner s Equity in an Accounting Equation REVENUE TRANSACTIONS Balances Received cash from sales New Balances Sold services on account New Balances Cash $3, $3,52 $3,52 Accts. Rec. Oakdale School $ $ 35 $35 Assets Liabilities Owner s Equity Supplies $775 $775 $775 Prepaid Insurance $1,2 $1,2 $1,2 Accts. Pay. Supply Depot $2 $2 $2 Kim Park, Capital $5, 295 $5, $5,645 (revenue) (revenue) Total of left side: $3,52 $35 $775 $1,2 $5,845 Total of right side: $2 $5,645 $5,845 Received Cash from Sales A transaction for the sale of goods or services results in an increase in owner s equity. An increase in owner s equity resulting from the operation of a business is called revenue. When cash is received from a sale, the total amount of both assets and owner s equity is increased. Transaction 6 August 12. Received cash from sales, $295.. When TechKnow Consulting receives cash for services performed, the asset account, Cash, is increased by the amount of cash received, $295.. This increase is on the left side of the equation. The owner s equity account, Kim Park, Capital, is also increased by $295.. This increase is on the right side of the equation. After this transaction is recorded, the equation is still in balance. In this chapter, three different kinds of transactions that affect owner s equity are described. Therefore, a description of the transaction is shown in parentheses to the right of the amount in the accounting equation. Sold Services on Account A sale for which cash will be received at a later date is called a sale on account, or a charge sale. TechKnow Consulting contracts with a school and an Internet cafe to provide consulting services for payment at a later date. All other customers must pay cash at the time of the service. Regardless of when payment is made, the revenue should be recorded at the time of a sale. The accounting concept Realization of Revenue is applied when revenue is recorded at the time goods or services are sold. [CONCEPT: Realization of Revenue] Transaction 7 August 12. Sold services on account to Oakdale School, $35.. When TechKnow Consulting sells services on account, the asset account, Accounts Receivable Oakdale School, is increased by $35., the amount of cash that will be received. This increase is on the left side of the equation. The owner s equity account, Kim Park, Capital, is also increased by $35. on the right side of the equation. The equation is still in balance. 14 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

12 EXPENSE TRANSACTIONS Balances Paid cash for rent New Balances Paid cash for telephone bill New Balances Cash $3,52 3 $3,22 4 $3,18 Accts. Rec. Oakdale School $35 $35 $35 Assets Liabilities Owner s Equity Supplies $775 $775 $775 Prepaid Insurance $1,2 $1,2 $1,2 Accts. Pay. Supply Depot $2 $2 $2 Kim Park, Capital $5,645 3 $5,345 4 $5,35 (expense) (expense) Total of left side: $3,18 $35 $775 $1,2 $5,55 Total of right side: $2 $5,35 $5,55 A transaction to pay for goods or services needed to operate a business results in a decrease in owner s equity. A decrease in owner s equity resulting from the operation of a business is called an expense. When cash is paid for expenses, the business has less cash. Therefore, the asset account, Cash, is decreased. The owner s equity account, Kim Park, Capital, is also decreased by the same amount. Paid Cash for Rent Transaction 8 August 12. Paid cash for rent, $3.. The asset account, Cash, is decreased by $3., the amount of cash paid out. This decrease is on the left side of the equation. The owner s equity account, Kim Park, Capital, is also decreased by $3.. This decrease is on the right side of the equation. After this transaction is recorded, the equation is still in balance. Paid Cash for Telephone Bill Transaction 9 August 12. Paid cash for telephone bill, $4.. The asset account, Cash, is decreased by $4., the amount of cash paid out. This decrease is on the left side of the equation. The owner s equity account, Kim Park, Capital, is also decreased by $4.. This decrease is on the right side of the equation. After this transaction is recorded, the equation is still in balance. Other expense transactions might be for advertising, equipment rental or repairs, charitable contributions, and other miscellaneous items. All expense transactions affect the accounting equation in the same way as in Transactions 8 and 9. PHOTODISC/GETTY IMAGES How Transactions Change Owner s Equity in an Accounting Equation Lesson

13 OTHER CASH TRANSACTIONS Balances Received cash on account New Balances Paid cash to owner for personal use New Balances Cash $3,18 2 $3, $3,255 Accts. Rec. Oakdale School $35 2 $15 $15 Assets Liabilities Owner s Equity Supplies $775 $775 $775 Prepaid Insurance $1,2 $1,2 $1,2 Accts. Pay. Supply Depot $2 $2 $2 Kim Park, Capital $5,35 $5, (withdrawal) $5,18 Total of left side: $3,255 $15 $775 $1,2 $5,38 Total of right side: $2 $5,18 $5,38 Received Cash on Account When a business receives cash from a customer for a prior sale, the transaction increases the cash account balance and decreases the accounts receivable balance. Transaction 1 August 18. Received cash on account from Oakdale School, $2.. The asset account, Cash, is increased by $2.. This increase is on the left side of the equation. The asset account, Accounts Receivable Oakdale School, is decreased by $2.. This decrease is also on the left side of the equation. After this transaction is recorded, the equation is still in balance. Paid Cash to Owner for Personal Use Assets taken out of a business for the owner s personal use are called withdrawals. A withdrawal decreases owner s equity. Although an owner may withdraw any kind of asset, usually an owner withdraws cash. The withdrawal decreases the account balance of the withdrawn asset, such as Cash. Transaction 11 August 18. Paid cash to owner for personal use, $125.. The asset account, Cash, is decreased by $125.. This decrease is on the left side of the accounting equation. The owner s equity account, Kim Park, Capital, is also decreased by $125.. This decrease is on the right side of the equation. After this transaction is recorded, the equation is still in balance. A decrease in owner s equity because of a withdrawal is not a result of the normal operations of a business. Therefore, a withdrawal is not considered an expense. Summary of Changes in Owner s Equity Immediately after recording the beginning investment used to start TechKnow Consulting, the total owner s equity was $5,., which represented the investment by the owner, Kim Park. Since that initial investment, five additional transactions that changed owner s equity were recorded in the accounting equation. These transactions increased owner s equity by $18., from $5,. to $5,18.. Transaction 1, cash received on account, is not listed because it affects two accounts that are both on the left side of the accounting equation. Transaction Kind of Change in Number Transaction Owner s Equity 6 Revenue (cash) Revenue (on account) Expense (rent) 3. 9 Expense (telephone) Withdrawal 125. Net change in owner s equity Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

14 TERMS REVIEW revenue sale on account expense withdrawals End of Lesson REVIEW AUDIT YOUR UNDERSTANDING 1. How is owner s equity affected when cash is received from sales? 2. How is owner s equity affected when services are sold on account? 3. How is owner s equity affected when cash is paid for expenses? WORK TOGETHER 1-3 Determining how transactions change an accounting equation Write the answers to the following problem in the Working Papers. Your instructor will guide you through the following example. 1. Place a plus () in the appropriate column if the account is increased. Place a minus () in the appropriate column if the account is decreased. Assets Liabilities Owner s Equity Trans. No. Cash Accts. Rec. Bowman Co. Supplies Prepaid Insurance Accts. Pay. Maxwell Co. Susan Sanders, Capital 1. Transactions: 1. Received cash from sales. 4. Received cash on account from Bowman Company. 2. Sold services on account to Bowman Company. 5. Paid cash to owner for personal use. 3. Paid cash for telephone bill. ON YOUR OWN 1-3 Determining how transactions change an accounting equation Write the answers to the following problem in the Working Papers. Work this problem independently. 1. Place a plus () in the appropriate column if the account is increased. Place a minus () in the appropriate column if the account is decreased. Assets Liabilities Owner s Equity Trans. No. Cash Accts. Rec. Navarro Co. Supplies Prepaid Insurance Accts. Pay. Barrett Co. Vincent Orr, Capital 1. Transactions: 1. Sold services on account to Navarro Company. 4. Paid cash to owner for personal use. 2. Received cash from sales. 5. Paid cash for rent. 3. Received cash on account from Navarro Company. How Transactions Change Owner s Equity in an Accounting Equation Lesson

15 SUMMARY After completing this chapter, you can: 1. Define accounting terms related to starting a service business organized as a proprietorship and to changes that affect the accounting equation. 2. Identify accounting concepts and practices related to starting a service business organized as a proprietorship and to changes that affect the accounting equation. 3. Classify accounts as assets, liabilities, or owner s equity and demonstrate their relationships in the accounting equation. 4. Analyze how transactions affect accounts in an accounting equation. EXPLORE ACCOUNTING What Is GAAP? The standards and rules that accountants follow while recording and reporting financial activities are commonly referred to as generally accepted accounting principles, or GAAP. These rules have not been developed by any one group of rule makers but have instead evolved over time and from many sources. By law, the Securities and Exchange Commission (SEC) has the authority to establish GAAP. The SEC, however, has allowed a series of private organizations to determine GAAP. Currently, the organization that has the authority to set accounting standards is the Financial Accounting Standards Board (FASB), which was established in The standard-setting process includes getting input and feedback from many sources. FASB listens to this feedback and considers all sides of each issue. Why Is GAAP Necessary? Users of financial statements rely on the information those statements contain. If the preparers of financial statements were allowed to follow any measurement, recording, and reporting rules, the users of the statements would have no way to determine if the financial statements present fairly the financial position of the business. By requiring the financial statement preparers to consistently follow certain standards and rules such as GAAP the users are able to compare the financial statements of several companies and to track the results of one company over several time periods. Discussion: Why would a group of people disagree with a proposed accounting standard? Research: Using your local library or the Internet, find additional information about the FASB. Write a one-page report on your findings. PHOTO: PHOTOGRAPHER S CHOICE/GETTY IMAGES 18 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

16 1-1 APPLICATION PROBLEM Completing the accounting equation Instructions: For each line, fill in the missing amount to complete the accounting equation. Use the form in your Working Papers to complete this problem. Assets Liabilities Owner s Equity 95, 51,?? 44, 2, 4,? 2,5 138, 7,? 19,? 11,? 4, 12, 35, 13,?? 12, 49, 8,? 3,2 86, 48,? 12,? 7,? 8, 22, 47, 24,?? 29, 13, 57,? 36, 125, 69,? 11,? 6,? 2, 3,3 1-2 APPLICATION PROBLEM Determining how transactions change an accounting equation Calvin Parish is starting Parish Repair Shop, a small service business. Parish Repair Shop uses the accounts shown in the following accounting equation. Use the form in your Working Papers to complete this problem. Assets Trans. No. Cash Supplies Beg. Bal. 1. New Bal. 2. 3, 3, Prepaid Insurance Liabilities Accts. Pay. Five Star Supply Accts. Pay. Riverland Company Owner s Equity Calvin Parish, Capital 3, 3, ( ) Go Beyond the Book For more information go to Starting a Proprietorship: Changes That Affect the Accounting Equation Chapter 1 19

17 Transactions: 1. Received cash from owner as an investment, $3,.. 2. Paid cash for insurance, $1, Bought supplies on account from Five Star Supply, $ Bought supplies on account from Riverland Company, $ Paid cash on account to Five Star Supply, $ Paid cash on account to Riverland Company, $ Paid cash for supplies, $ Received cash from owner as an investment, $1,5.. Instructions: For each transaction, complete the following. Transaction 1 is given as an example. a. Analyze the transaction to determine which accounts in the accounting equation are affected. b. Write the amount in the appropriate columns using a plus () if the account increases or a minus () if the account decreases. c. Calculate the new balance for each account in the accounting equation. d. Before going on to the next transaction, determine that the accounting equation is still in balance. 1-3 APPLICATION PROBLEM Determining how revenue, expense, and withdrawal transactions change an accounting equation Peter Smith operates a service business called Peter s Service Company. Peter s Service Company uses the accounts shown in the following accounting equation. Use the form in your Working Papers to complete this problem. Assets Trans. No. Cash Accts. Rec. Lisa Lee Supplies Prepaid Insurance Liabilities Owner s Equity Accts. Pay. Peter Smith, Kline Co. Capital Beg. Bal ,1 3 (expense) New Bal Transactions: 1. Paid cash for rent, $ Paid cash to owner for personal use, $ Received cash from sales, $ Paid cash for equipment repairs, $ Sold services on account to Lisa Lee, $ Received cash from sales, $ Paid cash for charitable contributions, $ Received cash on account from Lisa Lee, $3.. 2 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

18 Instructions: For each transaction, complete the following. Transaction 1 is given as an example. a. Analyze the transaction to determine which accounts in the accounting equation are affected. b. Write the amount in the appropriate columns, using a plus () if the account increases or a minus () if the account decreases. c. For transactions that change owner s equity, write in parentheses a description of the transaction to the right of the amount. d. Calculate the new balance for each account in the accounting equation. e. Before going on to the next transaction, determine that the accounting equation is still in balance. 1-4 MASTERY PROBLEM Determining how transactions change an accounting equation Marion Cassidy operates a service business called Cassidy Company. Cassidy Company uses the accounts shown in the following accounting equation. Use the form in your Working Papers to complete this problem. Assets Liabilities Owner s Equity Trans. No. Cash Accts. Rec. Ana Santiago Supplies Prepaid Insurance Accts. Pay. Delta Co. Marion Cassidy, Capital Beg. Bal. 1. 2,3 4 New Bal. 2. 1, ,8 8 4 (expense) 2 1 1,8 4 Transactions: 1. Paid cash for rent, $ Received cash from owner as an investment, $ Paid cash for telephone bill, $ Received cash from sales, $1, Bought supplies on account from Delta Company, $ Sold services on account to Ana Santiago, $ Paid cash for advertising, $ Paid cash for supplies, $ Received cash on account from Ana Santiago, $ Paid cash on account to Delta Company, $1, Paid cash for one month of insurance, $ Received cash from sales, $1, Paid cash to owner for personal use, $1,2.. Instructions: For each transaction, complete the following. Transaction 1 is given as an example. a. Analyze the transaction to determine which accounts in the accounting equation are affected. b. Write the amount in the appropriate columns, using a plus () if the account increases or a minus () if the account decreases. c. For transactions that change owner s equity, write in parentheses a description of the transaction to the right of the amount. d. Calculate the new balance for each account in the accounting equation. e. Before going on to the next transaction, determine that the accounting equation is still in balance. Starting a Proprietorship: Changes That Affect the Accounting Equation Chapter 1 21

19 1-5 CHALLENGE PROBLEM Determining how transactions change an accounting equation Zachary Martin owns Zachary s Repair Shop. On February 1, Zachary s Repair Shop s accounting equation indicated the following account balances. Use the form in your Working Papers to complete this problem. Assets Liabilities Owner s Equity Trans. No. Cash Accts. Rec. Mary Lou Pier Supplies Prepaid Insurance Accts. Pay. Kollasch Co. Zachary Martin, Capital Beg. Bal. 1. 8,552 1,748 1, ,145 9,255 Transactions: 1. Took $4. of supplies for personal use. 2. Had equipment repaired at Kollasch Company and agreed to pay Kollasch Company at a later date, $ Mr. Martin had some personal property, which he sold for $5. cash. 4. Paid Kollasch Company $12. on account. Instructions: 1. For each transaction, complete the following. a. Analyze the transaction to determine which accounts in the accounting equation are affected. b. Write the amount in the appropriate columns, using a plus () if the account increases or a minus () if the account decreases. c. For transactions that change owner s equity, write in parentheses a description of the transaction to the right of the amount. d. Calculate the new balance for each account in the accounting equation. e. Before going on to the next transaction, determine that the accounting equation is still in balance. 2. Answer the following questions. a. Why can the owner of a business withdraw assets from that business for personal use? b. Why would the owner withdraw assets other than cash? APPLIED COMMUNICATION A resume provides a statement of your education, experience, and qualifications for a prospective employer. Your resume should be accurate, honest, and perfect in every respect. It should include all work experience along with the companies and dates of employment. Education, activities, and interests are all important items that should be covered. Instructions: Research how to prepare an appropriate resume using the library or the Internet. Then prepare a resume that you could send to a prospective employer. 22 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

20 CASES FOR CRITICAL THINKING Case 1 Akira Shinoda starts a new business. Mr. Shinoda uses his personal car in the business with the expectation that later the business can buy a car. All expenses for operating the car, including license plates, gasoline, oil, tune-ups, and new tires, are paid for out of business funds. Is this an acceptable procedure? Explain. Case 2 At the end of the first day of business, Quick Clean Laundry has the assets and liabilities shown below. The owner, Anh Vu, wants to know the amount of her equity in Quick Clean Laundry. Determine this amount and explain what this amount represents. Assets Liabilities Cash $3,5. A/P Smith Office Supplies $ 75. Supplies 95. A/P Super Supplies Company 1,5. Prepaid Insurance 1,2. GRAPHING WORKSHOP The assets, liabilities, and owner s equity for three different companies are given in the graph at right. Analyze the graph to answer the following questions. 1. Which category is largest? 2. Why will assets always be 5% of the total? Assets Equity Liabilities Arrow Co. Dexter Co. Grand Co. ANALYZING BEST BUY S FINANCIAL STATEMENTS Selected published financial information for Best Buy Co., Inc., is reproduced in Appendix B. Look at pages B-5 through B-8, where you will find Best Buy s financial statements. Under the heading on each page, you will see the phrase $ in millions. This means that all dollar amounts are rounded to the nearest million. Therefore, an amount such as $174 actually means $174,,. Another way to think of this is that you can calculate the actual amount by multiplying the rounded amount by 1,, ($174 1,, $174,,). Not all companies round the amounts in their financial statements to the nearest million. Many companies round to the nearest thousand. Instructions 1. List the actual amount of Accounts Payable and Revenue for Best Buy for The financial statements for Barnes & Noble include the phrase thousands of dollars. In 25, the financial statements included Accounts Payable, $828,852, and Sales, $5,13,4. List the actual amount of Accounts Payable and Sales. Starting a Proprietorship: Changes That Affect the Accounting Equation Chapter 1 23

21 Accounting SOFTWARE ACCOUNTING SOFTWARE As you begin your journey into the exciting world of accounting, it is important that you also experience how today s businesses use personal computers to record their transactions and prepare financial statements. How are transactions entered onto computer screens? How does the computer keep track of the total of the Cash account? How is the information that is collected reported on financial statements? At the end of every chapter, this feature will introduce you to Peachtree, one of the most widely recognized brands of computer accounting systems. Your teacher may also have you complete selected end-of-chapter problems using Peachtree. You will discover that the knowledge of accounting you learn in this textbook will enable you to understand how Peachtree operates and provides management with the information it needs to make good business decisions. The Peachtree brand was first introduced in 1976, a time when personal computers were just beginning to become available to individuals and businesses. Since then, Peachtree Software has merged with many other software companies to form Sage Software. With millions of customers in the United States and Canada, Sage Software provides a wide variety of accounting and management software to small and medium-sized businesses. PEACHTREE ACTIVITY* 1. Access the Sage Software web site at 2. Identify the most current versions of Peachtree that are available. 3. Identify what version of Peachtree is available at your school. ACCOUNTING SOFTWARE During your study of accounting, your instructor may introduce you to an accounting software program called QuickBooks. Accounting software programs are more efficient and can be much more accurate than completing tasks manually. Many companies require new employees to have some knowledge of accounting software programs. Therefore, learning how to use QuickBooks can make you more employable. QuickBooks accounting software was developed by the Intuit Company, which was founded in The software is available in many versions. The version used by a company depends on the tasks that the company wishes to complete electronically. However, all versions of QuickBooks have general items in common. During your study of accounting, you will learn how to manually complete an accounting task. You may then be asked to complete the same task using QuickBooks. It is important to understand the manual tasks before using accounting software so that you can understand what the software is doing. An understanding of accounting also allows you to review the information that is produced electronically and check it for accuracy. QUICKBOOKS ACTIVITY* 1. Access the Intuit web site at 2. Identify the most current versions of QuickBooks that are available. 3. Identify what version of QuickBooks is available at your school. 24 Chapter 1 Starting a Proprietorship: Changes That Affect the Accounting Equation

22 ACCOUNTING SOFTWARE Electronic spreadsheets are one of the most popular software programs used by accountants. The reason is simple the row and column structure of an electronic spreadsheet resembles the journal paper used by accountants for decades, some say even centuries. It is not surprising, then, that publications read by accountants frequently contain articles about electronic spreadsheets. The Journal of Accountancy, published by the American Institute of Certified Public Accountants, is sent to over 3, accountants. The Journal regularly publishes articles that provide detailed instructions for using electronic spreadsheet features. More importantly, the articles provide examples of accounting applications of the features. As you study accounting in this course, you will have the opportunity to complete several problems on an electronic spreadsheet. Along the way, you will learn a variety of helpful features. In some cases, you will be able to try out these features in your exercises. EXCEL ACTIVITY* 1. Identify what electronic spreadsheet version is available at your school. 2. Access the Journal of Accountancy online at Perform a search for the name of your electronic spreadsheet. 3. Select one of the articles in the search results. Write a short summary of the feature described in the article. ACCOUNTING SOFTWARE Automated Accounting was developed by Warren Allen and Dale Klooster in the late 197s for use in their accounting classrooms. They were pioneers in the use of computer technology in the classroom. The software includes a complete accounting system, with modules for specialized activities such as bank statement reconciliation, plant assets, inventory, and payroll. The software was so comprehensive and easy to use that some small businesses also used the software for their business needs. South-Western acquired the software in the early 198s as a companion to its Century 21 Accounting textbooks. Automated Accounting has been revised and updated continuously since then. AUTOMATED ACCOUNTING ACTIVITY* 1. Consider the problems you have worked in Chapter 1. If you used a computerized accounting system to work the problems, what kinds of errors would the computerized accounting system prevent? 2. For the problems in Chapter 1, what kinds of errors would not be prevented by using a computerized accounting system? *COMPUTER SAFETY AND HEALTH BASICS There are some basic safety and health precautions for using computer equipment. Read the safety and health tips on the Century 21 Accounting web site. Starting a Proprietorship: Changes That Affect the Accounting Equation Chapter 1 25