Using the integrated financial statement framework shown in Exhibit 1, we will illus- trate the recording of transactions for a corporation’s first period of operations. We will assume that on September 1, 2007, Lee Landry, M.D., organizes a professional corporation to practice general medicine. The business is to be known as Family Health Care, P.C, where P.C. refers to professional corporation. We describe each stockholders’ equity on the balance sheet. If at the end of the period this equality does not hold, then an error has occurred in either recording or summarizing transactions.
For example, if a $10,000 purchase of equipment for cash is incorrectly recorded as an increase in both equipment and cash, the total assets will exceed the total liabilities and stockholders’ equity by $20,000 at the end of the period. Likewise, if equipment was increased by $10,000, but cash was not decreased by $10,000, the total assets will ex- ceed total liabilities and stockholders’ equity by $10,000 at the end of the period. In both cases, the inequality of the equation will indicate that an error has occurred in the recording process.
The equality of the equation at the end of the period doesn’t necessarily mean that no errors have occurred. For example, assume that a business purchased $10,000 of equipment on credit and recorded the transaction as an increase in equipment of
$10,000. However, instead of increasing the liabilities by $10,000, the transaction was recorded as a $10,000 decrease in cash. In this case, the accounting equation still bal- ances, even though cash and liabilities are understated by $10,000.
The integrated financial statement approach provides two additional controls.
First, the ending cash amount shown in the statement of cash flows column must agree with the end of the period cash amount shown under assets in the balance sheet col- umn. Second, the net income or loss from the income statement column must agree with the net effects of revenues and expenses on retained earnings.2
2 We discuss additional accounting controls in Chapter 7.
Q. When $3,000 of cash was received for fees earned, it was erroneously recorded as an increase in cash of $300 and an increase in retained earn- ings (fees earned) of
$3,000. Will the accounting equation balance?
A. No. Total assets will be less than total liabilities plus stockholders’ equity by $2,700.
Got the Flu? Why Not Chew Some Gum?
HOW BUSINESSES MAKE MONEY
Facing a slumping market for sugared chewing gum, such as Juicy Fruit and Doublemint, Wm. Wrigley Jr.
Company is reinventing itself by expanding its product lines and introducing new chewing gum applications. Wrigley’s new products include sug- arless breath mints and more powerful flavored mint chewing gum, like Extra Polar Ice. In addition, Wrigley is experimenting with health-care applica- tions of chewing gum. Wrigley’s Health Care Division has already developed Surpass, an antacid chewing gum to compete with Rolaids and
Mylanta. Wrigley is also developing a cold-relief chewing
gum and a gum that would provide dental benefits, such as whitening teeth and reducing plaque. Given that the U.S. population is aging, the company figures that people might prefer chewing gum to taking pills for sore throats, colds, or the flu. The effects of these new initiatives will ultimately be reflected in Wrigley’s financial statements.
Source:Adapted from “A Young Heir Has New Plans at Old Company,” by David Barboza, The New York Times, August 28, 2001.
Analyze, record, and sum- marize transactions for a corporation’s first period of operations.
2
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Cash ⴝ ⴙ Capital Stock
6,000 6,000
Statement of Cash Flows
a. Financing 6,000
Statement of Cash Flows
Income Statement
a. Investment by Dr. Landry
transaction or group of similar transactions during September, the first month of operations. We then illustrate how Exhibit 1 can be used to analyze, record, and summarize the effects of these transactions on the financial statements. We begin with Dr. Landry’s investment to estab- lish the business.
Transaction a. Dr. Landry deposits $6,000 in a bank account in the name of Family Health Care, P.C., in return for shares of stock in the corporation. We refer to stock issued to owners (stockholders) such as Lee Landry as capital stock. The effect of this transaction is to increase cash from financing activities by $6,000 under the statement of cash flows column.
Increases are recorded as positive numbers, while decreases are recorded as negative numbers. In addition, the transaction increases assets (cash) in the left side of the ac- counting equation under the balance sheet column by $6,000. To balance the equation, the stockholders’ equity (capital stock) on the right side of the equation is increased by the same amount. Since no revenues or expenses are affected, there are no entries un- der the income statement column. The effect of this transaction on Family Health Care’s financial statements is shown below:
Note that the equation relates only to the business, Family Health Care, P.C. Lee Landry’s personal assets (such as a home or a personal bank account) and personal liabilities are excluded from the equation. The business is treated as a separate entity, with cash of $6,000 and stockholders’ equity of $6,000.
Transaction b. Family Health Care’s next transaction is to borrow $10,000 from First National Bank to finance its operations. To borrow the $10,000, Lee Landry signed a note payable in the name of Family Health Care. The note payable is a liability or a claim on assets that Family Health Care must satisfy (pay) in the future. In addition, the note payable requires the payment of interest of $100 per month until the note is due in full on September 30, 2012. At the end of September, we will record the pay- ment of $100 of interest.
The effect of this transaction is to increase cash from financing activities by $10,000 under the statement of cash flows column. In addition, cash is increased and liabilities (notes payable) are increased under the balance sheet columns. Observe how this transaction changed the mix of assets and liabilities on the balance sheet but did not change Family Health Care’s stockholders’ equity. That is, assets minus liabili- ties still equals stockholders’ equity of $6,000 on the balance sheet. Since no rev- enues or expenses are affected, no entries are made under the income statement column. The effect of this transaction on Family Health Care’s financial statements follows.
©BERIT MYREKROK/DIGITAL VISION/ GETTY IMAGES
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Cash ⴝ Notes Payable ⴙ Capital Stock
6,000 6,000
10,000 10,000
16,000 10,000 6,000
Statement of Cash Flows
b. Financing 10,000
Statement of Cash Flows
Income Statement
Balances b. Loan from bank
Balances
Transaction c. Next, Family Health Care buys land for $12,000 cash. The land is located near a new suburban hospital that is under construction. Lee Landry plans to rent office space and equipment for several months. When the hospital is completed, Family Health Care will build on the land.
The effect of this transaction is an outflow of cash as an investing activity. Thus, a negative $12,000 is entered in the statement of cash flows column as an investing ac- tivity. On the balance sheet, the purchase of the land changes the makeup of the as- sets, but it does not change the total assets. That is, cash is decreased and land is increased by $12,000. The effect of this transaction on Family Health Care’s financial statements is shown below:
A History of Ethical Conduct
The Wrigley Company has a long history of integrity, ob- jectivity, and ethical conduct. When pressured to become part of a cartel, known as the Chewing Gum Trust, the company founder, William Wrigley Jr., said, “We prefer to do business by fair and square methods or we prefer not to do business at all.” In 1932, Phillip K. Wrigley, called “PK” by his friends, became president of the Wrigley Company after his father, William Wrigley Jr., died. PK also was president of the Chicago Cubs, which played in Wrigley Field. He was financially
generous to his players and frequently gave them advice on and off the field. However, as a man of integrity and high eth- ical standards, PK docked (reduced) his salary as president of the Wrigley Company for the time he spent working on Cubs related activities and business.
Source:St. Louis Post-Dispatch, “Sports—Backpages,” January 26, 2003.
INTEGRITY, OBJECTIVITY, AND ETHICS IN BUSINESS
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Cash ⴙ Land ⴝ Notes Payable ⴙ Capital Stock
16,000 10,000 6,000
12,000 12,000
4,000 12,000 10,000 6,000
Statement of Cash Flows
c. Investing 12,000
Statement of Cash Flows
Income Statement
Balances c. Purchase of land
Balances
Transactions (b) and (c) have not improved the stockholders’ equity of Family Health Care. They have simply changed the mix of assets and increased the liability, notes payable. However, the objective of businesses is to improve stockholders’ equity through operations.
Transaction d. During the first month of operations, Family Health Care earns pa- tient fees of $5,500, receiving the amount in cash. The effect of this transaction is an in- flow of cash flows from operating activities of $5,500. Thus, a positive $5,500 is entered in the statement of cash flows column as an operating activity. Since cash has been received, cash is increased by $5,500 under the balance sheet column for assets.
Fees earned of $5,500 is a revenue item that is entered in the income statement col- umn as a positive amount. Since net income retained in the business increases stock- holders’ equity (retained earnings) and since revenues contribute to net income,
$5,500 is also entered as an increase in retained earnings in the stockholders’ equity column of the balance sheet. Entering the increases of $5,500 for cash and retained earnings in the balance sheet columns retains the equality of the accounting equation.
The effect of this transaction on Family Health Care’s financial statements is summa- rized below:
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Notes Capital Retained
Cash ⴙ Land ⴝ Payable ⴙ Stock ⴙ Earnings
4,000 12,000 10,000 6,000
5,500 5,500
9,500 12,000 10,000 6,000 5,500
Statement of Cash Flows
d. Operating 5,500
Statement of Cash Flows
Income Statement
d.
Income Statement d. 5,500 Fees earned Balances
d. Fees earned Balances
Transaction e. For Family Health Care, the expenses paid during the month were as follows: wages, $1,125; rent, $950; utilities, $450; interest, $100; and miscellaneous,
$275. Miscellaneous expenses include small amounts paid for such items as postage due and newspaper and magazine purchases.
The effect of this transaction is an outflow of cash of $2,900 for operating activi- ties. Thus, a negative $2,900 is entered in the statement of cash flows column as an op- erating activity. Expenses have the opposite effect as revenues on net income and retained earnings. As a result, each of the expenses is listed as a negative amount in the income statement column. Finally, a negative $2,900 is also entered in the cash and retained earnings columns of the balance sheet. The effect of this transaction on Family Health Care’s financial statements is summarized on the next page.
Transaction f. At the end of the month, Family Health Care pays $1,500 to stock- holders (Dr. Lee Landry) as dividends. Dividends are distributions of business earn- ings to stockholders.
The effect of this transaction is an outflow of cash of $1,500 for financing activities.
Thus, a negative $1,500 is entered in the statement of cash flows column as a financ- ing activity. In addition, the cash and retained earnings are decreased under the bal- ance sheet column, by $1,500. The effect of this transaction on Family Health Care’s financial statements is summarized below.
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Notes Capital Retained
Cash ⴙ Land ⴝ Payable ⴙ Stock ⴙ Earnings
6,600 12,000 10,000 6,000 2,600
1,500 1,500
5,100 12,000 10,000 6,000 1,100
Statement of Cash Flows
f. Financing 1,500
Statement of Cash Flows
Income Statement
Balances f. Paid dividends
Balances
You should be careful not to confuse dividends with expenses. Dividends do not rep- resent assets consumed or services used in the process of earning revenues. The de- crease in stockholders’ equity from dividends is listed in the equation under
“Retained Earnings.” This is because dividends are considered a distribution of earn- ings to the owners.
The transactions of Family Health Care are summarized in Exhibit 2. The transac- tions are identified by letter, and the balances are shown as of the end of September.
You should note that under the balance sheet columns the accounting equation bal- ances. That is, total assets of $17,100 ($5,100 $12,000) equals total liabilities plus stockholders’ equity of $17,100 ($10,000 $6,000$1,100).
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Notes Capital Retained
Cash ⴙ Land ⴝ Payable ⴙ Stock ⴙ Earnings
9,500 12,000 10,000 6,000 5,500
2,900 2,900
6,600 12,000 10,000 6,000 2,600
Statement of Cash Flows
Income Statement
Balances e. Paid expenses
Balances
Statement of Cash Flows
e. Operating 2,900
Income Statement e.1,125 Wages expense
950 Rent expense 450 Utilities expense 100 Interest expense 275 Misc. expense
e.
f.
In reviewing the preceding illustration and Exhibit 2, you should note the follow- ing, which apply to all types of businesses:
1. The balance sheet reflects the accounting equation (assets liabilitiesstockholders’
equity).
2. The two sides of the balance sheet (accounting equation) are always equal.
3. Every transaction affects (increases or decreases) one or more of the balance sheet elements—assets, liabilities, or stockholders’ equity.
4. A transaction may or may not affect (increase or decrease) an element of the state- ment of cash flows or the income statement. Some transactions affect elements of both statements, some transactions affect only one statement and not the other, and some transactions affect neither statement.
5. The effect of every cash transaction increases or decreases the asset cash on the balance sheet. Every cash transaction also increases or decreases an operating, investing, or financing activity on the statement of cash flows.
6. The net increase or decrease in cash for the period shown in the statement of cash flows ($5,100 in Exhibit 2) agrees with the ending cash balance shown on the balance sheet. In this illustration, this resulted because it was the entity’s first pe- riod of operations. In future periods, the net increase (decrease) in cash will be
Exhibit 2
Family Health Care Summary of Transactions for September
Statement of Cash Flows
a. Financing 6,000
b. Financing 10,000
c. Investing 12,000
d. Operating 5,500
e. Operating 2,900
f. Financing 1,500
Increase in cash
and Sept. 30 cash 5,100 Statement of
Cash Flows
Income Statement
Income Statement d.5,500 Fees earned e.1,125 Wages expense
950 Rent expense 450 Utilities expense 100 Interest expense 275 Misc. expense 2,600 Net income
d.
e.
INTEGRATED FINANCIAL STATEMENT FRAMEWORK
a. Investment by Dr. Landry b. Loan from bank c. Purchase of land d. Fees earned e. Paid expenses f. Paid dividends
Balances, Sept. 30
Balance Sheet
Assets ⴝ Liabilities ⴙ Stockholders’ Equity
Notes Capital Retained
Cash ⴙ Land ⴝ Payable ⴙ Stock ⴙ Earnings
6,000 6,000
10,000 10,000
12,000 12,000
5,500 5,500
2,900 2,900
1,500 1,500
5,100 12,000 10,000 6,000 1,100
International Perspective International Accounting Standards (IASs) require the same four general financial statements that are required under U.S. GAAP. How- ever, IAS only requires one year of historical financial information, while public companies in the United States are required to present three years of comparative financial infor- mation (two years for balance sheet information).
added to (subtracted from) the beginning cash balance to equal the ending cash bal- ance. This ending cash balance will appear in both the statement of cash flows and balance sheet.
7. The stockholders’ equity is increased by amounts invested by stockholders (capi- tal stock).
8. Revenues increase stockholders’ equity (retained earnings) and expenses decrease stockholders’ equity (retained earnings). The effects of revenue and ex- pense transactions are also shown in the income statement column.
9. Stockholders’ equity (retained earnings) is decreased by dividends distributed to stockholders.
10. The change in retained earnings for the period is the net income minus dividends.
For a net loss, the change in retained earnings is the net loss plus dividends.
11. The statement of cash flows is linked to the balance sheet through cash (an asset).
12. The income statement is linked to the balance sheet through revenues and ex- penses (net income or loss), which affects retained earnings.
Exhibit 3 summarizes the effects of the various transactions affecting stockholders’
equity.
ST O C K H O L D E R S ’ EQ U I T Y Exhibit 3
Effects of Transactions on Stockholders’ Equity