c.

  Statement of cash flows

Concept Questions d.  Income statement
  5.  The revenue recognition principle states that:
  1.  What is the definition of accounting? a. assets are recorded and maintained at their his-
  2. What is the going concern assumption of ­accounting torical costs.
and why is it necessary for accounting? b.  revenues are recorded when they are earned.
  3. What is the economic entity assumption of c.  the dollar, unadjusted for inflation, is the best
­accounting and why is it important? means of accounting in the U.S.
  4. What two terms are used to determine and describe d.  revenues are recorded when cash is received.
the ­profitability of an entity?   6.  During the year, Callie’s Bagel Shop had revenues
  5. When are revenues recognized? of `1,25,000. Rent expense was `12,000. Salaries
  6. What does the matching principle state about the expense was `25,000. Short-term investments were
recording of revenues and expenses? `35,000. Other expenses totaled `40,000. What was
  7. How are revenues different from assets? Callie’s net income?
a.  `85,000
  8. What five terms are used to describe the financial
b.  `13,000
position of an entity?
c.  `48,000
  9. How are liabilities different from expenses?
d.  `60,000
10. Explain the difference between contributed capital
and equity.   7.  Which of the following accurately describes the
matching principle?
11. What are the three principles used in ­recording rev-
a.  Matches assets and liabilities
enues, expenses, and assets?
b.  Matches income and dividends
12. How are assets recorded?
c.  Matches retained earnings and income
13. How are the balance sheet and income statement linked?
d.  Matches revenues and expenses
14. Explain why the different financial statements are
  8.  The basic accounting equation states:
used in accounting, and what purpose each state-
a.  assets and liabilities equal equity.
ment serves.
b.  assets equal liabilities plus equity.
15. What are the qualitative characteristics of ­accounting
c.  liabilities equal equity plus assets.
and why are they necessary to accounting information?
d.  revenues minus expenses equals net income.
16. How are relevance and materiality related?
  9.  Which financial statement reports assets, ­liabilities,
17. What is the conceptual framework of ­accounting
and equity?
and what purpose does it serve?
a.  Statement of cash flows
b.  Balance sheet
c.  Income statement
d.  Statement of retained earnings
MULTIPLE CHOICE 10.  Retained earnings is defined as:
a.  the difference between assets and liabilities.
  1.  Which of the following is not included in the defini- b. equity generated from profitable operations and
tion of accounting? retained in the business.
a.  Identifying economic information c.  a decrease in assets resulting from selling a good
b.  Measuring economic information or providing a service.
c.  Developing economic information d.  equity resulting from contributions from owners.
d.  Communicating economic information 11.  As of December 31, Lurie Company has assets of
  2.  Which assumption states that an economic entity `18,400 and equity of `6,500. What are the ­liabilities
will continue its operations indefinitely? for Lurie Company as of December 31?
a.  Monetary unit a.  `24,900
b.  Time period b.  `11,900
c.  Going concern c.  `14,200
d.  Economic entity d.  `8,600
  3.  Net income is created in a time period when: 12.  Maker’s Company had the following account totals:
a.  assets exceed liabilities. cash `25,000; inventory `15,000; accounts payable
b.  revenues exceed expenses. `15,000; retained earnings `25,000; equipment
c.  revenues are less than expenses. `80,000; investments `10,000; and other assets
d.  liabilities are greater than assets. `40,000. What is Maker’s total assets?
  4.  Which financial statement reports revenues and a.  `1,70,000
expenses? b.  `1,90,000
a.  Statement of retained earnings c.  `85,000
b.  Balance sheet d.  `2,10,000

16 Chapter 1: Financial Accounting

13.  The statement of retained earnings links which two 4. Identify Accounting Principles
financial statements? Each of the following statements is an application
a.  The income statement and the balance sheet of the revenue recognition principle, the matching
b. The balance sheet and the statement of cash flows principle, or the cost principle.
c.  The income statement and the statement of cash 1. A company records Equipment for the purchase
flows price of `10,000 although the “suggested retail
d. The statement of retained earnings does not link price” was `13,000.
any statements 2. A company receives `2,000 for a service to be
14.  A company begins a period with a `5,000 retained performed but records only `1,000 as Service
earnings balance. The company generates `12,000 ­Revenue because it earned only half in the
of revenues and `10,000 of expenses during the ­current period.
period and pays `1,000 of dividends. What is the 3. A company pays `6,000 for insurance but uses
retained earnings balance at the end of the period? only `4,000 during the period. Therefore, it
a.  `7,000 records only `4,000 as Insurance Expense.
b.  `5,000
c.  `6,000 5. Calculate Retained Earnings
d.  `1,000 At the beginning of the year, a company
15.  Which of the following is not one of the ­sections on has retained earnings of `1,75,000. During
the statement of cash flows? the year, the company generates `1,10,000
a.  Investing activities of net income and distributes `10,000 in
b.  Financing activities dividends.
c.  Operating activities
Required
d.  Income activities
Calculate the company’s retained earnings at
16.  Which of the following is not a qualitative character- year end.
istic of accounting?
a.  Understandability 6. Calculate Cash Flows
b.  Relevance
A company starts the year with `1,75,000 in
c.  Pertinence
cash. During the year, the company generates
d.  Consistency
`6,80,000 from operations, uses `5,16,000 in
investing activities, and uses `98,000 in financing
activities.
Required
brief Exercises Calculate the company’s cash at year end.

1. Calculate Net Income 7. Identify Accounting Assumptions and

Ted’s Typing Service generated `4,000 in revenue ­Qualitative Characteristics
in the month of January. Salaries were `1,500 for Consider the following independent scenarios:
the month, and supplies used were `200. Addition- 1. Luigi’s Pizza has been in business for 25 years. All
ally, Ted’s incurred `50 for advertising during the of its operations are profitable, and the accoun-
month. tants believe that the company will operate into
the foreseeable future.
Required
2. A bank used the information presented in
Calculate Ted’s net income for the month of January.
Tiger Auto’s financial statements to determine
if it should extend a `300,000 loan to Tiger. The
2. Calculate Net Income information in the financial statements
A manager of a small company has a goal of gen- made a difference in the bank’s lending
erating `13,000 in net income. He is confident that decision.
his expenses will be approximately `82,500. 3. Jim Furio, manager of Martha’s Antiques, does
Required not like to change accounting procedures
Calculate the amount of revenue the manager must ­because it hinders his ability to make year-to-year
generate to reach his goal. comparisons.
4. Lynn Hagood, owner of Jonesboro Animal Hospi-
3. Calculate Equity tal, informs his accountant that he does not want
A company reports assets of `10,000 and liabilities to review any accounting issue that is smaller
of `6,000. than 1% of net income.
Required Required
Calculate the company’s equity. Identify the accounting assumption or qualitative
Identify which ­principle relates to each statement. characteristic that relates to each scenario.

Chapter 1: Financial Accounting 17

 Exercises
Required
Indicate whether each of the above items is an
asset (A), a liability (L), or part of equity (E).
8. Principles and Assumptions
The following basic accounting principles and 11. Accounting Terms
assumptions were discussed in the chapter: Consider the following information:
•  Economic entity  •  Going concern  Item Appears On Classified As
•  Monetary unit   •  Cost principle 
1.  Salaries expense ____________ ____________
•  Time period
_________ 1. Lester Company has a division in Ger- 2.  Equipment ____________ ____________
many. Before preparing the financial 3.  Cash ____________ ____________
statements for the company and the 4.  Accounts payable ____________ ____________
foreign division, Lester translates the 5.  Buildings ____________ ____________
financial statements of its Germany
6.  Contributed capital ____________ ____________
division from the euro to Indian rupee.
_________ 2. Matt enters into a partnership to start 7.  Retained earnings ____________ ____________
a bike shop with a friend. Each partner 8.  Interest revenue ____________ ____________
makes an initial cash investment of 9.  Advertising expense ____________ ____________
`8 lakh. Matt opens a checking account
in the name of the company and trans- Required
fers `8 lakh from his personal account Classify each of the items above according to
into the new account. (1) whether it appears on the income statement
_________ 3. Dreamland Inc. has always prepared or balance sheet and (2) whether it is classified as
financial statements with a year-end a revenue, expense, asset, liability, or equity.
of March 31. However, the company is
going to sell stock to the public for the 12. Accounting Terms
first time and is required by the SEC to The following items were taken from the financial
give quarterly financial reports. statements of Tiger Inc.:
_________ 4. Platt Corp. purchases a fifty acre plot of a.  Income tax expense f.  Inventory
land to build the world’s largest factory. b.  Interest expense g.  Accounts payable
The company recorded the property at c.  Service revenue h.  Contributed capital
the amount of cash given to acquire it. d.  Accounts receivable i.   Dividends
_________ 5. Lockbox Corp. is in its ninetieth year of e.  Retained earnings
business. The owner of the company is
Required
going to retire in two months and turn
the company over to his son. Identify whether each item would appear on the
balance sheet, the income statement, or the state-
Required ment of retained earnings.
Fill in the blank with the appropriate principle or
assumption. 13. Classify Cash Flows
A company entered into the following cash transac-
9. Identify Income Statement Accounts tions:
The following accounts are taken from a company’s 1. Cash paid to suppliers
financial statements: 2. Cash received from issuing new common stock
1. Rent expense 3. Cash paid to purchase new office furniture
2. Service revenue 4. Cash paid in dividends to owners
3. Dividends 5. Cash received from customers
4. Interest revenue
5. Interest expense Required
6. Accounts receivable Indicate the section of the statement of cash flows in
which each item would appear: operating activities (O),
Required
investing activities (I), or financing activities (F).
Indicate whether each account is a revenue (R),
expense (E), or neither (N).
14. Accounting Terms
10. Accounting Terms Consider the following information:
Consider the following information: a. Revenues during the period
a. Accounts receivable b. Supplies on hand at the end of the year
b. Salaries payable c. Cash received from borrowings during the year
c. Office supplies d. Total liabilities at the end of the period
d. Land e. Dividends paid during the year
e. Contributed capital f. Cash paid for a building
f. Notes payable g. Cost of buildings owned at year end

18 Chapter 1: Financial Accounting

 Required Required
Indicate whether you would find each of the Use the accounting equation to fill in the missing
above items on the income statement (IS), the amounts.
balance sheet (BS), the statement of retained
earnings (SRE), or the statement of cash flows 18. Balance Sheet Equation
(SCF). Consider the following information:
a. Jenkins Company starts the year with `5,00,000 in
15. Financial Statements assets and `4,00,000 in liabilities. Net income for
Listed below are questions posed by various users of the year is `1,25,000, and no dividends are paid.
a company’s financial statements. How much is Jenkins’ equity at the end of the year?
b. McCay Inc. doubles the amount of its assets from
Financial the beginning to the end of the year. At the end
User Questions Statement of the year, liabilities are `5,00,000, and equity is
Stockholder How did this year’s sales `3,00,000. What is the amount of McCay’s assets
figures compare with at the beginning of the year?
last year’s sales figures? ___________ c. During the year the liabilities of Hudson Corp.
Banker How much in borrowings triple. At the beginning of the year, assets were
does the company `4,00,000, and equity was `2,00,000. What is the
currently owe? ___________ amount of liabilities at the end of the year?
Supplier How much does the Required
company owe its suppliers Use the accounting equation to answer each of the
in total? ___________ independent questions above.
Stockholder Did the company have any
dividends in the prior year? ___________ 19. Statement of Retained Earnings
Advertising How much advertising War Eagle Company’s retained earnings on January
agent did the company incur 1 is `2,45,800. The following information is available
in order to generate sales? ___________ for the first two months of the year:
Banker What was the company’s January February
total interest cost last year? ___________ Revenues `80,000 `1,02,000
Expenses 85,000 80,000
Required
Dividends 0 7,000
Fill in the blank with the financial statement(s)
(income statement, balance sheet, statement Required
of ­retained earnings, and/or statement of cash Prepare a statement of retained earnings for the
flows) the user would most likely use to find this month ending February 28.
information.
20. Statement of Cash Flows
16. Net Income and Retained Earnings The following information is for Pasture Corp.:
Nova Corporation reports the following as of Cash received from customers `65,000
­December 31:
Cash received from lenders 20,000
Revenues `1,00,000 Cash paid to suppliers 20,000
Beginning retained earnings `2,00,000 Cash paid for new equipment 50,000
Expenses `8,00,000 Cash paid for dividends 4,000
Dividends `1,00,000
Required
Required Indicate on what section of the statement of
Calculate net income and ending retained earnings cash flows each item would appear and calculate
for the year ending December 31. ­Pasture’s net change in cash.

21. Statement of Cash Flows

17. Balance Sheet Equation Dividend received
Consider the following information: Dividend paid
Assets Liabilities Equity Sale proceed from Fixed Assets
50,000 25,000 ? Profit from sale of Fixed Assets
Short Term Borrowing
30,000 ? 17,000
Interest received
  ? 45,000 15,000
Required
68,000 ? 13,000 Indicate on what section of the cash flow will the
  ? 14,000 6,000 above appear.

Chapter 1: Financial Accounting 19

22. Links Between Financial Statements Statement of Retained Earnings
Below are incomplete financial statements for Beginning retained earnings `2,00,000
­Sterling Inc.: Net income (e)
Balance Sheet Dividends (f)
Assets Ending retained earnings `4,00,000
  Cash ` 8,000
  Inventory 22,000 Required
  Building 40,000 Calculate the missing amounts.

   Total assets `70,000

24. Qualitative Characteristics
Liabilities The following qualitative characteristics of
  Accounts payable `7,000 accounting were discussed in the chapter:
Equity •  Consistency •  Relevance
  Contributed capital (a) •  Understandability •  Comparability
  Retained earnings (b) •  Conservatism •  Materiality
   Total liabilities & equity `70,000 •  Reliability
_________ 1. The ability of accounting information
Income Statement to be comprehensible to those who
Service revenue `90,000 have a reasonable understanding
Salaries expense (c) of business and are willing to study
Utilities expense 20,000 the information with reasonable
diligence.
Net income ` (d)
_________ 2. The capacity to affect business
Statement of Retained Earnings decisions.
_________ 3. The dependability of accounting
Retained earnings, beginning balance `20,000
information.
Net income (e) _________ 4. The ability to compare and contrast
Dividends 10,000 the financial activities of the same
Retained earnings, ending balance `60,000 company over a period of time.
_________ 5. The threshold over which an item
Required
begins to affect decision making.
Calculate the missing amounts.
_________ 6. The way in which accountants deal
with uncertainty.
23. Complete Financial Statements
The following are incomplete financial statements _________ 7. The ability to compare and contrast
for Mackabee Inc.: the financial activities of different
companies.
Balance Sheet
Required
Assets
Fill in the blank with the appropriate
  Cash ` 60,000 characteristic.
  Inventory 2,00,000
  Building (a) 25. Assumptions and Principles
   Total assets `6,40,000 Harbor Corp. had the following situations during
the year:
Liabilities
a. Inventory with a cost of `1,86,400 is reported at
  Accounts payable ` 70,000 its market value of `2,35,600.
Equity b. Harbor added four additional weeks to its
  Contributed capital (b) fiscal year so that it could make its income look
  Retained earnings (c) stronger. Past years were 52 weeks.
c. Harbor’s CEO purchased a yacht for personal use
   Total liabilities and equity `6,40,000
and charged it to the company.
Income Statement d. Revenues of `25,000 earned in the prior year
were recorded in the current year.
Service revenue `12,00,000
Salaries expense 7,00,000 Required
Administrative expense 3,00,000 In each situation, identify the assumption or
principle that has been violated and discuss how
Net income ` (d) Harbor should have handled the situation.

20 Chapter 1: Financial Accounting

 Required
Problems List all of the deficiencies that you can identify in this in-
come statement and prepare a proper income statement.
26. Prepare Financial Statements 29. Identify and Correct Balance Sheet Errors
This information relates to York Inc. for the year:
Bizilia’s Inc. was organized on January 1. At the end
Advertising expense ` 24,000 of the year, an employee with a mathematics degree
Dividends paid 70,000 prepared the following balance sheet:
Rent expense 1,04,000 Bizilia’s Inc.
Retained earnings, January 1 5,70,000 Balance Sheet
For the Year Ending December 31
Salaries expense 2,80,000
Resources:
Service revenue 6,10,000
  Cash ` 3,00,000
Utilities expense 18,000
  Stuff we can sell 4,00,000
Required   Land 5,30,000
Prepare an income statement and a statement of
  Retained earnings 1,70,000
retained earnings for the year.
  Grand total `14,60,000
27. Prepare Financial Statements Debts:
The following items are available from the records   Money we owe to vendors ` 4,30,000
of Honky Tonk Records Inc. at the end of the year:
  Contributed capital 6,30,000
Accounts payable `2,70,000   Grand total `10,60,000
Accounts receivable 2,10,000
Required
Advertising expense 60,000
List all of the deficiencies that you can identify in this
Buildings 7,60,000 balance sheet and prepare a proper balance sheet.
Contributed capital 3,00,000
Cash 63,200 30. Errors in Accounting
Notes payable 7,00,000 The Mock Corporation was formed on January 1. At
Salaries expense 95,000 December 31, William Mock, CEO and sole owner,
prepared the company’s balance sheet as follows:
Service revenue 1,68,200
Equipment 2,50,000 Mock Corporation
Balance Sheet
Required
December 31
Prepare Honky Tonk’s income statement and
statement of retained earnings for the year and its Assets
balance sheet at the end of the year. Cash `2,50,000
Accounts receivable 4,00,000
28. Identify and Correct Income Statement Errors Inventory 3,50,000
Muncie Group was organized on January 1. At the end
Building 2,00,000
of the year, the company used a first-year ­accounting
student to prepare the following income statement: Liabilities and Equity
Accounts payable `4,00,000
Muncie Group
Income Statement Building loan 1,50,000
December 31 Retained earnings 3,70,000
Income from services `17,00,000 William is not an accountant by trade, and he
Accounts receivable 4,00,000 believes there may be some mistakes in his ­balance
  Total income `21,00,000 sheet. He has provided you with the following
Less: Expenses ­additional information:
1. The building is William’s personal beach house.
  Salaries ` 5,70,000
However, he plans on using it for company
  Advertising (1,40,000) retreats and for hosting some large clients. He
  Dividends 1,00,000 decided to list the asset and the corresponding
  Utilities 2,20,000 liability for this reason.
  Total expenses ` 7,50,000 2. The inventory was originally purchased at
`1,20,000, but due to a recent increase in demand,
Net income `13,50,000
he believes he could sell it for at least `3,50,000.

Chapter 1: Financial Accounting 21

 He thought that `3,50,000 would best portray the Profit on sale of fixed assets 100
economic reality of his inventory. Depreciation 9,600
3. William included `50,000 in accounts receivable Dividend received 400
and retained earnings for a service that he will Dividend paid 1,500
provide next year. Since he is an honest man and Purchase of fixed asset 1,000
will provide the service, he decided to record the Loss of foreign exchange 600
amount in this year’s balance sheet. Short term borrowing 8,400
Repayment of borrowings 10,000
Required
Cash and cash equivalents (opening) 1,700
Comment on what accounting assumptions or
Tax paid 4,750
principles are violated, briefly describe how each
Provision for doubtful debt 50
item should be accounted for, and prepare a correct
balance sheet. Required
Prepare a cash flow statement from the above
31. Preparing Financial Statements information.
On June 1 you begin an ocean tour business for
the summer by contributing `60,000 of contributed
capital and borrowing `60,000 from your parents.
With your money, you pay `48,000 in June to rent a Cases
boat and supplies consisting of snorkels, fins, masks,
and life-jackets. You also purchase advertising in a 34. Read, Locate, and Compare Financial
local paper for `2,500 and gasoline for `13,500. You ­Statements
decide to charge `2,500 per passenger. At the end of Access the financial statements in the 2013 annual
the month of June, you have serviced 240 customers report for Hindustan Unilever Limited by clicking on
and purchased and used an additional `20,000 in the Investors and Annual Reports links at www.hul.
gasoline. Included in those 240 customers were two co.in.
neighbors who promised future payment which you
Required
have not received (totaling `22,500). You also pay
a. For Hindustan Unilever Limited current year,
your parents `500 for monthly interest.
identify the amounts reported for net rev-
Required enues, net earnings, total assets, and cash
Prepare an income statement and a statement of flows from operating activities. Also, identify
retained earnings for the month ending June 30 and the date on which the financial statements are
a balance sheet at June 30. prepared.
b. Locate P&G India financial statements for the
32. Preparing Financial Statements same year. Identify the same information as in
During the month of April, you conduct art seminars the previous requirement.
for children. On April 1, you borrow `50,000 from c. Compare P&G and HUL. Identify which
your parents, buy `40,000 of supplies, and pay company is (1) the largest, (2) the most
`5,000 for advertising on the radio and `2,500 to profitable, and (3) the best able to generate
rent a room in a local recreation center. You charge cash from its operations.
`2,000 per child per seminar. At the end of the
month, you have held seminars for 80 children, of 35. Ethics in Accounting
which you have received payment for 76. You have As the top accountant at Blaire’s Costume Jewelry
`3,000 of supplies remaining, and you pay your Company, you discover that net income in each of
parents `500 for the use of their money during the the previous five years has been overstated due to
month. an error in accounting. After much thought, you
decide to approach the company president. His
Required ­response is, “What the public doesn’t know won’t
Prepare an income statement and a statement of hurt them. We’ll just adjust this year’s income to
retained earnings for the month ending April 30 make up for the mistakes. We had a pretty good
and a balance sheet at April 30. year, and I think our income for this year can absorb
the errors.”
33. Preparing Cash Flow Statements Required
` lakhs Identify the ethical dilemma of this situation,
Net profit before tax 30,000 identify the ways that you could respond, and
Sale of fixed asset 450 explain the possible consequences of your responses.

22 Chapter 1: Financial Accounting

36. Written Communication Skills Required
Your Uncle Ted just won the lottery. He is Prepare a written response to your Uncle Ted
trying to find companies in which to invest explaining what information is contained in each
his winnings. However, he is having trouble financial statement and how it is relevant to
reading the financial statements because he has investors.
no idea what they are saying. Knowing you are
in an accounting class, Uncle Ted asks for your
advice.

Chapter 1: Financial Accounting 23

reviewcard
CHAPTER 1
Financial Accounting

Learning Objectives Key Concepts Key Definitions

LO1 Describe the four When communicating accounting information, Accounting The process of identifying,
assumptions made when accountants assume that the activities of a company measuring, and communicating economic
communicating accounting can be separated from those of the owners, information to permit informed judgments and
information. that economic information can be effectively decisions.
communicated in rupees over short periods of Asset An economic resource that is objectively
time, and that the business will continue into the measurable, results from a prior transaction, and
foreseeable future. will provide future economic benefit.
Balance sheet A financial statement that
LO2 Describe the purpose and An income statement reports a company’s revenues reports a company’s assets, liabilities, and equity
structure of an income and expenses over a period of time. A revenue is an at a specific point in time
statement and the terms and inflow of resources from providing services, while an Comparability The ability to use accounting
principles used to create it. expense is an outflow of resources from providing information to compare or contrast the financial
services. Revenues are recorded when they are activities of different companies.
earned (revenue recognition principle), and expenses Conceptual framework of accounting
are recorded when they are incurred (matching The collection of concepts that guide the manner
principle). When revenues exceed expenses, a in which accounting is practiced.
company generates net income. Conservatism The manner in which
accountants deal with uncertainty regarding
LO3 Describe the purpose and A balance sheet reports a company’s assets, economic situations.
structure of a balance sheet liabilities, and equity accounts at a point in time.
and the terms and principles An asset is a resource of a business. A liability is an Consistency The ability to use accounting
information to compare or contrast the financial
used to create it. obligation of a business. Equity is the difference
activities of the same entity over time.
between assets and liabilities. Assets are recorded at
their costs (cost principle). Assets are always equal to Contributed capital The resources that
liabilities plus equity. investors contribute to a business in exchange for
ownership interest
LO4 Describe the purpose and A statement of retained earnings reports the change in Cost principle The principle that assets
structure of a statement of a company’s retained earnings balance over a period of should be recorded and reported at the cost paid
retained earnings and how it time. The statement links the income statement and to acquire them.
links the income statement the balance sheet. Net income reported on the income Dividends Profits that are distributed to
and the balance sheet. statement is used to calculate the retained earnings owners.
balance reported on the balance sheet. Economic entity assumption
Accountants assume that the financial activities
LO5 Describe the purpose and A statement of cash flows reports a company’s of a business can be separated from the financial
structure of a statement of sources and uses of cash over a period of time. Cash activities of the business’s owner(s).
cash flows and the terms and inflows and outflows are categorized into operating, Equity The difference between a company’s
principles used to create it. investing, or financing activities. assets and liabilities, representing the share of assets
that is claimed by the company’s owners.
LO6 Describe the qualitative Accounting information is useful only if it possesses
Expense A decrease in resources resulting from
characteristics that make several qualitative characteristics. It should the sale of goods or provision of services.
accounting information be understandable, relevant, reliable, easily
useful. comparable, and consistent across time. Going concern assumption Accountants
assume that a company will continue to operate into
the foreseeable future.
LO7 Describe the conceptual The conceptual framework is the collection of
framework of accounting. concepts that guide the practice of accounting. It Income statement A financial statement
includes the principles followed, the assumptions that reports a company’s revenues and expenses
made, and the terms and statements used to over a specific period of time.
communicate accounting information. It also Liability An obligation of a business that results
includes the qualitative characteristics that make the from a past transaction and will require the sacrifice
information useful. of economic resources at some future date.

24
24
Chapter 1: Financial Accounting
Part 00: Part Title
 Key Definitions (continued) Key Formulas

Matching principle The principle that expenses

should be recorded in the period resources are used to Income Statement Revenues – Expenses = Net Income or Net Loss
generate revenues. Balance Sheet Assets = Liabilities + Equity
Materiality The threshold at which a financial item
Retained Earnings, Beginning Balance
begins to affect decision making.
Statement of +/– Net Income/Loss
Monetary unit assumption Accountants assume Retained Earnings – Dividends
that the dollar is the most effective means to communicate = Retained Earnings, Ending Balance
economic activity.
Cash Flows Provided (Used) by Operating Activities
Relevance The capacity of accounting information to
Statement of +/– Cash Flows Provided (Used) by Investing Activities
make a difference in decisions.
Cash Flows +/– Cash Flows Provided (Used) by Financing Activities
Reliability The extent to which accounting information = Net Increase (Decrease) in Cash
can be depended upon to represent what it purports to
represent, both in description and in number.
Retained earnings Profits that are retained in the
business.
Revenue An increase in resources resulting from the sale Demonstration Problem Solution
of goods or the provision of services.
Revenue recognition principle The principle that Sarah’s Tutoring Service
a revenue should be recorded when a resource has been Income Statement
earned. For One Month Ending August 31
Statement of cash flows A financial statement that Revenues: `2,000
reports a company’s sources and uses of cash over a specific Expenses:
period of time. Depreciation (textbook) ` 300
Supplies 130
Statement of retained earnings A financial
Interest 10
statement that reports the change in a company’s retained
Total expenses 440
earnings over a specific period of time.
Net income `1,560
Time period assumption Accountants assume that
economic information can be meaningfully captured and
Sarah’s Tutoring Service
communicated over short periods of time.
Statement of Retained Earnings
Understandability The ability of accounting For One Month Ending August 31
information to “be comprehensible to those who have a
reasonable understanding of business…and are willing to Retained earnings, August 1 ` 0
study the information with reasonable diligence.” Add: Net income 1,560
Less: Dividends 0
Retained earnings, August 31 `1,560

Demonstration Problem Sarah’s Tutoring Service

Balance Sheet
On August 1, Sarah begins a tutoring service that she will August 31
operate for four months. With `400 borrowed from a friend
Cash `1,210
and `1,000 of her own money, she purchases a `1,200
Accounts receivable 800
accounting textbook and `80 of school supplies. Sarah
Textbook 900
promises to pay her friend `10 at the end of each month and
Supplies 50
to pay back the full `400 at the end of December.
Total assets `2,960
Sarah charges `200 per tutoring session. During August, she
Note payable ` 400
conducted ten sessions and bought `100 of additional school
Total liabilities ` 400
supplies. At the end of the month, Sarah has not collected on four
of the ten sessions, and she has `50 of school supplies left over. Contributed capital `1,000
Prepare Sarah’s income statement and statement of retained Retained earnings 1,560
earnings for the month ending August 31 and her balance sheet Total equity 2,560
on August 31. Total liabilities and equity `2,960

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