1 introduction to accounting and business 1 principles of financial accounting, 11e reeve warren...

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Introduction toAccounting and Business

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Principles of Financial Accounting, 11eReeve • Warren • Duchac

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After studying this chapter, you should be able to:

Introduction to Accounting and Business

3State the accounting equation and define each element of the equation.

2Summarize the development of accounting principles and relate them to practice.

1Describe the nature of a business, the role of accounting, and ethics in business.

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Introduction to Accounting and Business (continued)

4 Describe and illustrate how business transactions can be recorded in terms of the resulting change in the elements of the accounting equation.

5 Describe the financial statements of a proprietorship and explain how they interrelate.

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Describe the nature of a business, the role of accounting, and ethics in business.

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Types of Businesses

Delta Air Lines Transportation servicesThe Walt Disney Company Entertainment services

Service Business Service

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Merchandising Business Product

Wal-Mart General merchandiseAmazon.com Internet books, music, videos

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Types of Businesses

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Manufacturing Business Product

General Motors Corp. Cars, trucks, vansDell Inc. Personal computers

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Types of Businesses

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The Role of Accounting in Business

Accounting can be defined as an information system that provides reports to users about the economic activities and condition of a business.

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• Identify users.

• Assess users’ informational needs.

• Design the accounting information system to meet users’ needs.

• Record economic data about business activities and events.

• Prepare accounting reports for users.

The process by which accounting provides information to users is as follows:

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Exhibit 1 Users of Accounting Information

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The area of accounting that provides internal users with information is called managerial accounting.

Managerial Accounting

The objective of managerial accounting is to provide relevant and timely information for managers’ and employees’ decision-making needs.

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The area of accounting that provides external users with information is called financial accounting.

Financial Accounting

The objective of financial accounting is to provide relevant and timely information for the decision-making needs of users outside of the business.

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Ethics are moral principles that guide the conduct of individuals.

Role of Ethics in Accounting and Business

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Exhibit 3 Guideline for Ethical Conduct

1. Identify an ethical decision by using your personal ethical standards of honesty and fairness.

2. Identify the consequences of the decision and its effect on others.

3. Consider your obligations and responsibilities to those that will be affected by your decision.

4. Make a decision that is ethical and fair to those affected by it.

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Summarize the development of accounting principles and relate them to practice.

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• Financial accountants follow generally accepted accounting principles (GAAP) in preparing reports.

Generally Accepted Accounting Principles

• Within the United States, the Financial Accounting Standards Board (FASB) has the primary responsibility for developing accounting principles.

(continued)

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• The Securities and Exchange Commission (SEC), an agency of the U.S. government, has authority over the accounting and financial disclosures for companies whose shares of ownership are traded and sold to the public.

• Many countries outside the United States use generally accepted accounting principles adopted by the International Accounting Standards Board (IASB).

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Under the Under the business entity concept, the activities of a the activities of a business are recorded business are recorded separately from the activities separately from the activities of its owners, creditors, or of its owners, creditors, or other businesses.other businesses.

Business Entity Concept

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• Easy and cheap to organize.• Resources are limited to those of the

owner.• Used by small businesses.

A proprietorship is owned by one individual.


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• Combines the skills and resources of more than one person.

A partnership is similar to a proprietorship except that it is owned by two or more individuals.


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• Ownership is divided into shares called stock.• Can obtain large amounts of resources by issuing

stocks.• Used by large businesses.

A corporation is organized under state or federal statutes as a separate legal taxable entity.


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Under the cost concept, amounts are initially recorded in the accounting records at their cost or purchase price.

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Cost Concept

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The objectivity concept requires that the amounts recorded in the accounting records be based on objective evidence.

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Objectivity Concept

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The unit of measure concept requires that economic data be recorded in dollars.

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Unit of Measure Concept

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Cost Concept

On August 25, Gallatin Repair Service extended an offer of $125,000 for land that had been priced for sale at $150,000. On September 3, Gallatin Repair Service accepted the seller’s counteroffer of $137,000. On October 20, the land was assessed at a value of $98,000 for property tax purposes. On December 4, Gallatin Repair Service was offered $160,000 for the land by a national retail chain. At what value should the land be recorded in Gallatin Repair Service’s records?

Example Exercise 1-12

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$137,000. Under the cost concept, the land should be recorded at the cost to Gallatin Repair Service.

For Practice: PE 1-1A, PE 1-1B

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Follow My Example 1-1

Example Exercise 1-1 (continued)

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State the accounting equation and define each element of the equation.

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The resources owned by a

business

Assets = Liabilities + Owner’s Equity

The Accounting Equation

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The rights of the creditors are

the debts of the business.



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The rights of the owners



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Accounting Equation

John Joos is the owner and operator of You’re A Star, a motivational consulting business. At the end of its accounting period, December 31, 2009, You’re A Star has assets of $800,000 and liabilities of $350,000. Using the accounting equation, determine the following amounts:

a. Owner’s equity, as of December 31, 2009.

b. Owner’s equity, as of December 31, 2010, assuming that assets increased by $130,000 and liabilities decreased by $25,000 during 2010.


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Example Exercise1-2 continued For Practice: PE 1-2A, PE 1-2B1-35

a. Assets = Liabilities + Owner’s Equity $800,000 = $350,000 + Owner’s Equity

Owner’s Equity = $450,000



b. First, determine the change in Owner’s Equity during 2010 as follows:

Assets = Liabilities + Owner’s Equity $130,000 = –$25,000 + Owner’s Equity

Owner’s Equity = $155,000

Next, add the change in Owner’s Equity on December 31, 2009 to arrive at Owner’s Equity on December 31, 2010, as shown below:

$605,000 = $450,000 + $155,000

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Describe and illustrate how business transactions can be recorded in terms of the resulting change in the elements of the accounting equation.

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A business transaction is an economic event or condition that directly changes an entity’s financial condition or its results of operations.

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Business Transaction

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On November 1, 2009, Chris Clark deposits $25,000 in a bank account in the name of NetSolutions.

Transaction A

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CHRIS CLARK, CAPITAL

25,000 Investment by Chris Clark

CASH

25,000 a. =

Assets Owner’s Equity=

Transaction A (continued)

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Transaction B

On November 5, 2009, NetSolutions paid $20,000 for the purchase of land as a future building site.

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CASH + LAND

25,000 Bal.

Assets =

=

Bal. 5,000 20,000 25,000

b. –20,000 +20,000

CHRIS CLARK, CAPITAL

25,000

Owner’s Equity

Transaction B (continued)

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On November 10, 2009, NetSolutions purchased supplies for $1,350 and agreed to pay the supplier in the near future.

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Transaction C

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CASH + SUPPLIES + LAND 5,000 20,000 25,000Bal.

Assets =

=

ACCOUNTS CHRIS CLARK, PAYABLE + CAPITAL

Liabilities + Owner’s Equity

Transaction C (continued)

c. +1,350 +1,350

Bal. 5,000 1,350 20,000 1,350 25,000

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Beginning with Transaction D the asset section will be shown

first, then the liabilities and owner’s equity will be shown in

the following slide.

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On November 18, 2009, NetSolutions received cash of $7,500 for providing services to customers. A business earns money by selling goods or services to its customers. This amount is called Revenue.

Transaction D

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CASH + SUPPLIES + LAND 5,000 1,350 20,000 Bal.

Assets

Transaction D (continued)

d. +7,500

Bal. 12,500 1.350 20,000

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Transaction D (continued)

ACCOUNTS CHRIS CLARK, FEES PAYABLE + CAPITAL + EARNED 1,350 25,000 Bal.


d. +7,500

Bal. 1,350 25,000 7,500

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During the month, NetSolutions spent cash or used up other assets in earning revenue. Assets used in this process of earning revenue are called expenses.

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Expenses

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On November 30, 2009, NetSolutions paid the following expenses during the month: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275.

Transaction E

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Assets

Transaction E (continued)

e. –3,650

Bal. 8,850 1.350 20,000

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Transaction E (continued)

ACCOUNTS CHRIS CLARK, FEES WAGES RENT UTIL. MISC. PAYABLE + CAPITAL + EARNED – EXP. – EXP. – EXP. – EXP. 1,350 25,000 7,500 Bal.


e. –2,125 –800 –450 –275

Bal. 1,350 25,000 7,500 –2,125 –800 –450 –275

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On November 30, 2009, NetSolutions paid creditors on account, $950.

Transaction F

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Assets

Transaction F (continued)

f. –950

Bal. 7,900 1.350 20,000

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ACCOUNTS CHRIS CLARK, FEES WAGES RENT UTIL. MISC. PAYABLE + CAPITAL + EARNED – EXP. – EXP. – EXP. – EXP. 1,350 25,000 7,500 –2,125 –800 –450 –275 Bal.


f. –950

Bal. 400 25,000 7,500 –2,125 –800 –450 –275

Transaction F (continued)

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On November 30, 2009, Chris Clark determined that the cost of supplies on hand at the end of the period was $550.

Transaction G

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Assets

Transaction G (continued)

g. –800

Bal. 7,900 550 20,000

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ACCOUNTS CHRIS CLARK, FEES WAGES RENT SUP. UTIL. MISC. PAYABLE + CAPITAL + EARNED – EXP. – EXP. – EXP. – EXP. – EXP. 400 25,000 7,500 –2,125 –800 –450 –275

Bal.


g. –800

Bal. 400 25,000 7,500 –2,125 –800 –800 –450 –275

Transaction G (continued)

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On November 30, 2009, Chris Clark withdrew $2,000 from NetSolutions for personal use.

Transaction H

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CASH + SUPPLIES + LAND 7,900 550 20,000 Bal.

Assets

Transaction H (continued)

h. –2,000

Bal. 5,900 550 20,000

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Transaction H (continued)

ACCTS. CLARK, CLARK, FEES WAGES RENT SUP. UTIL. MISC. PAY. + CAPITAL – DRAW. + EARNED – EXP. – EXP. – EXP. – EXP. – EXP. 400 25,000 7,500 –2,125 –800 –800 –450 –275 Bal.


h. –2,000

Bal.400 25,000 –2,000 7,500 –2,125 –800 –800 –450 –275

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Summary

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Exhibit 5 Effects of Transactions on Owner’s Equity

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Transactions

Salvo Delivery Service is owned and operated by Joel Salvo. The following selected transactions were completed by Salvo Delivery Service during February:

1. Received cash from owner as additional investment, $35,000.

2. Paid creditors on account, $1,800.

3. Billed customers for delivery services on account, $11,250.

4. Received cash from customers on account, $6,740.

5. Paid cash to owner for personal use, $1,000.(Continued)


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Indicate the effect of each transaction on the accounting equation elements (Assets, Liabilities, Owner’s Equity, Drawing, Revenue, and Expense) by listing the numbers identifying the transactions, (1) through (5). Also, indicate the specific item within the accounting equation element that is affected. To illustrate, the answer to (1) is shown below.

(1) Asset (Cash) increases by $35,000; Owner’s Equity (Joel Salvo, Capital) increases by $35,000.

Example Exercise 1-3 (continued) 4

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(2) Asset (Cash) decreases by $1,800; Liability (Accounts Payable) decreases by $1,800.

(3) Asset (Accounts Receivable) increases by $11,250; Revenue (Delivery Service Fees) increases by $11,250.

(4) Asset (Cash) increases by $6,740; Asset (Accounts Receivable) decreases by $6,740.

(5) Asset (Cash) decreases by $1,000; Drawing (Joel Salvo, Drawing) increases by $1,000.


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Describe the financial statements of a proprietorship and explain how they interrelate.

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After transactions have been recorded and summarized, reports are prepared for users. The accounting reports providing this information are called financial statements.

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Financial Statements

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The income statement reports the revenues and expenses for a period of time, based on the matching concept.

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Income Statement

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The matching concept is applied by matching the expenses with the revenue generated during a period by those expenses.

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Matching Concept

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The excess of revenue over the expenses is called net income or net profit. If the expenses exceed the revenue, the excess is a net loss.

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Net income is carried to the statement of

owner’s equity.

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Exhibit 6 Financial Statements for NetSolutions

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Income Statement

The assets and liabilities of Chick Travel Service at April 30, 2010, the end of the current year, and its revenue and expenses for the year are listed below. The capital of the owner, Adam Cellini, was $80,000 at May 1, 2009, the beginning of the current year.

Accounts payable $ 12,200 Miscellaneous expense $ 12,950Accounts receivable 31,350 Office expense 63,000Cash 53,050 Supplies 3,350Fees earned 263,200 Wages expense 131,700Land 80,000

Prepare an income statement for the current year ended April 30, 2010.


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CHICK TRAVEL SERVICEINCOME STATEMENT

For the Year Ended April 30, 2010

Fees earned $263,200Expenses:

Wages expense $131,700Office expense 63,000Miscellaneous expense 12,950 Total expenses 207,650

Net income $ 55,550



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Follow My Example 1-3 Follow My Example 1-4

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The statement of owner’s equity reports the changes in the owner’s equity for a period of time.

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Statement of Owner’s Equity

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From the income statement

To the balance sheet

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Exhibit 6 Financial Statements for NetSolutions (continued)

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Statement of Owner’s Equity

Using the data for Chick Travel Service shown in Example Exercise 1-4, prepare a statement of owner’s equity for the current year ended April 30, 2010. Adam Cellini invested an additional $50,000 in the business during the year and withdrew cash of $30,000 for personal use.


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CHICK TRAVEL SERVICESTATEMENT OF OWNER’S EQUITYFor the Year Ended April 30, 2010

Example Exercise 1-5 continued


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Adam Cellini, capital, May 1, 2009 $ 80,000 Additional investment by owner during year$ 50,000Net income for the year 55,550

$105,550Less withdrawals 30,000 Increase in owner’s equity 75,550Adam Cellini, capital, April 30, 2010 $155,550

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A balance sheet is a list of the assets, liabilities, and owner’s equity as of a specific date.

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Balance Sheet

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The account form of a balance sheet lists the assets on the left and the liabilities and owner’s equity on the right—similar to the design of an account.

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Account Form

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This amount is compared to the net cash flow on the statement of cash flows.

From the statement of owner’s equity

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Exhibit 6 Financial Statements for NetSolutions (continued)

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Balance Sheet

Using the data for Chick Travel Service shown in Example Exercises 1-4 and 1-5, prepare the balance sheet as of April 30, 2010.


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CHICK TRAVEL SERVICEBALANCE SHEET

April 30, 2010 Assets Liabilities

Cash $ 53,050 Accounts payable $ 12,200Accounts receivable 31,350Supplies 3,350 Owner’s EquityLand 80,000 Adam Cellini, capital 155,550Total assets $167,750 Total liab. & owner’s eq. $167,750

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A statement of cash flows is a summary of the cash receipts and payments for a specific period of time. It consists of three sections: (1) operating activities, (2) investing activities, and (3) financing activities.

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Statement of Cash Flows

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This amount should match Cash on the balance sheet.

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Financial Statements for NetSolutions (continued)Exhibit 6

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The cash flows from operating activities section reports a summary of cash receipts and cash payments from operations.

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Operating Activities

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The cash flows from investing activities section reports the cash transactions for the acquisition and sale of relatively permanent assets.

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Investing Activities

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The cash flows from financing activities section reports the cash transactions related to cash investments by the owner, borrowings, and withdrawals by the owner.

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Financing Activities

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Statement of Cash Flows

A summary of cash flows for Chick Travel Service for the year ended April 30, 2010, is shown below.

Cash receipts:Cash received from customers $251,000Cash received from additional investment of owner 50,000

Cash payments:Cash paid for expenses 210,000Cash paid for land 80,000Cash paid to owner for personal use 30,000

The cash balance as of May 1, 2009, was $72,050.

Prepare a statement of cash flows for Chick Travel Service for the year ended April 30, 2010.


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Cash flows from operating activities:Cash received from customers $251,000Deduct cash payments for expenses 210,000Net cash flows from operating activities $ 41,000

Cash flows from investing activities:Cash payments for purchase of land (80,000)

Cash flows from financing activities:Cash received from owner as investment $ 50,000Deduct cash withdrawals by owner 30,000Net cash flows from financing activities 20,000

Net decrease in cash during year $(19,000)Cash as of May 1, 2009 72,050Cash as of April 30, 2010 $ 53,050


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• The income statement and the statement of owner’s equity are interrelated.

Net income or net loss appears on both statements.

Interrelationships Among Financial Statements

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• The statement of owner’s equity and the balance sheet are interrelated.

The owner’s capital at the end of the period on the statement of owner’s equity also appears on the balance sheet as owner’s capital.


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• The balance sheet and the statement of cash flows are interrelated.

The cash reported on the balance sheet is also reported as the end-of-period cash on the statement of cash flows.


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Financial Analysis and Interpretation

Ratio of Liabilities to Owner’s Equity =

Total Liabilities

Total Owner’s Equity (or Total

Stockholders’ Equity)For NetSolutions:

Ratio of Liabilities to Owner’s Equity =

$400

$26,050 = 0.015

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