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Chapter 1 Corporate and Partnership Structures in Healthcare iStock/Thinkstock Learning Objectives eps81189_01_c01.indd 1 • Discuss the advantages and disadvantages of alternative entity forms. • Understand the various organizational structures in a healthcare environment. • Understand equity differences among organizational types. 12/20/13 8:47 AM Introduction CHAPTER 1 Chapter Outline 1.1 1.2 1.3 1.4 Introduction The Corporation Nonprofit Corporations Governmental Entities Limited Liability Company (LLC) The Partnership The Sole Proprietorship Introduction Y ou may think accounting is a necessary evil that you must learn, even though it is not your primary professional goal. In reality accounting is critical to any decision maker in the healthcare field. A strong understanding of accounting will help you manage your department or division as you move up the ranks of healthcare institutions. In this text you will learn how to use accounting strategies, such as managerial and financial accounting, to address healthcare issues from a financial perspective. While accounting is not the only skill you need to manage in a healthcare environment, it is a critical skill for making decisions that will enable you to manage more cost effectively and improve your institution’s profit potential. First, let’s take a look at how healthcare facilities organize their business. In today’s medical field, few physicians starting out organize as a one-person business called a sole proprietorship. While they do exist, it is more likely they will join a partnership or a major medical organization. That organization could be a for-profit or nonprofit hospital, clinic, medical group practice, emergency care facility, surgery center, or other ambulatory care organization, or maybe some other organization that hires physicians. Many of these organizations operate as for-profit or nonprofit corporations. Some states allow medical groups to form as professional corporations or limited liability companies. In addition, you may find yourself working for a governmental healthcare institution, such as the medical facilities run by the Veterans Administration or community-based hospitals. Generally, they all follow the same basic accounting rules, but there are two organizations with the responsibility to develop rules in accounting, called generally accepted accounting principles (GAAP). The organization that develops rules for private entities is called the Financial Accounting Standards Board (FASB) (, and the one for governmental entities is called the Governmental Accounting Standards Board (GASB) ( As a non-accountant, you will likely never read a GAAP. These are highly technical documents that specify the rules accountants must follow when collecting accounting data and preparing financial reports. There are technical accounting differences between governmental and nongovernmental organizations, but these are beyond the scope of this course. eps81189_01_c01.indd 2 12/20/13 8:47 AM Section 1.1 The Corporation CHAPTER 1 Given the risks today of being sued, many doctors, even if they plan to open an individual practice, will seek an organizational structure that will give them some liability protection. While only medical malpractice insurance will cover the doctor for lawsuits involving professional negligence, as a business owner, a limited liability organizational structure can give the doctor protection from personal liability for business debts or legal matters, such as employment discrimination lawsuits. Partnerships without liability protection are extremely rare in the medical professional because physicians in the group can be held liable for the actions of other physicians in the group. When more than one physician is involved, the medical group is more likely to organize as a limited liability company or professional corporation. The actual structure chosen will differ by state because states do restrict how physician groups can incorporate or seek limited liability protection. 1.1 The Corporation L et’s begin by thinking about the advantages and disadvantages of a corporate structure, whether it is a for-profit, nonprofit, or a governmental entity. A corporation is a legal entity having existence separate and distinct from its stockholders. Corporations exist only in the legal sense and cannot exist unless specific actions are taken. However, one does not have to form a corporation to conduct business. Business can also be conducted via a sole proprietorship or partnership. As you read on, you will quickly find that one should only use the sole proprietorship or partnership by design, not by accident. Why would you want to consider forming your business as a corporation? For starters, it permits otherwise unaffiliated persons to join together in mutual ownership of a business. Funds can be accumulated and concentrated into one organization. Significant pooling of resources can occur that might not otherwise be possible. A corporate strategy often might entail a large amount of risk with highly uncertain outcomes. Probably you are willing to risk a small amount of your wealth on speculative investments with the potential for a high payoff, but you are unlikely to bet everything you have. This is often the dilemma faced by new healthcare businesses. Think about the financial investment required to build the medical facility and buy medical equipment and medical supplies. Few physicians can afford to buy everything needed to start a medical practice on their own. Some ventures are so large that shared ownership is essentially required. Therefore, the stock of the corporation provides a perfect vehicle for mutual ownership of a business. When new doctors are added to a practice, negotiations for ownership can be based on the number of shares awarded as an incentive to join the practice or the number of shares bought to become part of the practice. Each shareholder can invest at a level that matches his or her wealth and risk tolerance attributes. An important aspect of the corporate form of organization is that shareholders are usually only at risk for the amount they invest in the company’s stock. Creditors cannot pursue shareholders for additional claims beyond the shareholder investments. eps81189_01_c01.indd 3 12/20/13 8:47 AM Section 1.1 The Corporation CHAPTER 1 Most corporations allow shareholders to vote in proportion to their shares, with one vote per share. This democratic process allows shareholders to participate in corporate governance based on the level of their investment. Shareholders vote on matters set forth in the bylaws. The voting is usually conducted on a ballot that is termed the proxy. Another advantage of the corporate form of organization is the relative ease with which shares of stock can be transferred to another. Stockholders can normally sell their shares to others or buy more shares without direct involvement by the corporation. Transferability of ownership makes stock a relatively liquid asset to its holder. Further, companies can often access additional capital by issuing more shares to current and new shareholders. In some cases, a company may go public, meaning that it lists its shares on one of the popular stock exchanges, such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (NASDAQ) system. This is not common for medical practices, but it is common for for-profit hospital organizations. An initial public offering (IPO) of shares is an exciting (and costly) decision and is sometimes accompanied by so-called road shows and various other promotions designed to market the offering. Road shows are company-sponsored events where corporate executives present their business case in the hopes of developing interest among potential investors. A corporation is presumed to have a perpetual existence. Changes in stock ownership do not cause operations to cease. The death of a shareholder does not bring about a need to dissolve the company. Instead, the beneficiaries of the estate of the deceased become new owners. A corporation will continue to exist and operate until it is merged in with another, it fails, or a corporate action is undertaken to liquidate the company. When the latter happens, all bills must be paid, and common shareholders are entitled to final distributions of any residual funds in proportion to shares held. Perhaps one of the most significant advantages of a corporation, especially when compared to partnerships and sole proprietorships, is the feature of limited liability. The liability of stockholders is normally limited to the amount of their investment. Stockholders are not personally liable for debts and losses of the company, except to the extent of their investment, or any additional guarantee of corporate debt. However, you should be aware that a corporate entity is not a perfect shield against all liability. If affairs of the shareholders are comingled with the corporation or there is malfeasance by shareholders or officers, a lawsuit may be filed by damaged parties against the shareholder or officer. It is not always possible to avoid these types of claims, but taking care to meet good legal and accounting practices is a good start. This underscores the need for you to be well versed in proper accounting procedures and internal controls in managing your departments. Corporations also suffer under the weight and cost of added regulatory oversight, especially when the stock is publicly traded. Agencies such as the Securities and Exchange Commission (SEC) impose stringent reporting guidelines, including mandatory and expensive audits. Additional rules require companies to have strong internal controls and ethical training. The financial statements must also be certified by senior officers who do so under the risk of prosecution for perjury. To be sure, if you were an officer being required to sign such documents, you would undoubtedly expend ample funds to ensure that the statements were reliable. Suffice it to say, the cumulative cost of meeting regulatory stipulations is high. eps81189_01_c01.indd 4 12/20/13 8:47 AM Section 1.2 Limited Liability Company (LLC) CHAPTER 1 Nonprofit Corporations In addition to for-profit corporations, healthcare organizations also organize as nonprofit corporations. Generally, the accounting for these organizations is similar, except for profit distribution. Nonprofits do not distribute profits, but instead the profits are kept for future use by the institution. Often these organizations grow by raising funds from donations and grants. The equity (or ownership) portion of the nonprofit differs significantly. Rather than its equity being stated in shares of stock, the equity is tracked by asset classes: 1. Unrestricted: resources with no restrictions on how they can be used. 2. Temporarily restricted: resources that must be used for a particular purpose at some point in the future. Once the terms are met, the assets can become unrestricted. 3. Permanently restricted: resources that must be used for the stated purpose in perpetuity, such as a resource donated for a cancer wing must always be used for that cancer wing. Nonprofit corporations do not have owners. Instead they are run by a board of directors. The appointment or election of these directors is specified in the documents upon which the organization is created. Governmental Entities In addition to nonprofit private corporations, some healthcare facilities are chartered by local, state, or federal governmental agencies. The Veterans Administration administers the largest organization of governmental healthcare facilities. This text will be focused on accounting rules for private and public entities. If you work for a governmental entity, you will find most of the accounting rules are the same. As with nonprofits, the key difference is the management of the equity portion of the business. The governmental entity owns the medical facility and will absorb any profits or losses. Accounting rules are similar to those for private and public companies, but there are different technical rules for assets, liabilities, and equity that will not be covered in this text. These are highly technical accounting provisions related to assumptions and principals unique to governmental accounting rules. 1.2 Limited Liability Company (LLC) S ome states allow medical groups to be organized as limited liability companies, a company structure that provides liability protection similar to that of a corporation. The amount of liability protection does vary by state, as do the structures allowed. The designation falls between a corporation and a partnership or sole proprietorship. Most states do give the same liability protections as a corporation. The key advantage is that the legal and accounting requirements are not as expensive as those for corporations. The decision to set up as an LLC rather than a corporation should be made after consultation with an accountant and an attorney familiar with the laws in the owner’s state. eps81189_01_c01.indd 5 12/20/13 8:47 AM Section 1.4 The Sole Proprietorship CHAPTER 1 The equity portion of the business can be more flexible with an LLC because the ownership can be proportioned by percentage rather than by shares, if the owners prefer that arrangement. Both partnerships and sole proprietorships can organize as an LLC. Accounting practices will depend upon whether the LLC is a partnership or a sole proprietorship. 1.3 The Partnership A partnership is another form of business organization that brings together multiple parties. The specific definition of a partnership is an association of two or more persons to carry on a business for profit as co-owners. However, in some ways, this also seems to describe a corporation. What is it that uniquely pertains to a partnership and sets it apart from a corporation? For starters, a partnership is not a separate legal entity. It is an association of persons. Partnerships are formed quite easily, without the necessity of any specific legal action. Indeed, by default, the mere joining together of persons for a profit-oriented business purpose is a partnership, unless some alternative action is undertaken to set up a corporation (or other entity type, such as a joint-venture agreement). Since partners can be held responsible for the actions of other partners, it is rare to see this form of ownership in the healthcare field today. Unlike a corporation, a partnership has a limited life. In other words, the partnership passes with the death of a partner, and the partnership is legally dissolved. A new one may be immediately formed; written agreements usually make provisions for the dissolution and reformation upon the death of a partner. At other times, where a deceased partner was crucial to business operations, the dissolution may also trigger a cessation of business operations and formal liquidation of the entity. Clearly, this complicating feature is yet another limitation on the desirability of doing business as a partnership, especially in the healthcare industry. 1.4 The Sole Proprietorship I n simple terms, you can think of a sole proprietorship as a one-person partnership. It is not a partnership, but the legal and technical requirements operate in much the same way. No specific legal action is necessary to start the business, although there are a number of good practices. For instance, if an individual began doing business under an assumed name such as Jan’s Assisted Living, she would likely want to file an assumed-named certificate, register an appropriate Internet site, notify licensing and tax agencies, and so forth. However, she does not need specific authorization to create an entity. Indeed, she is the entity. When doing business under an assumed name, procurement of the assumedname certification is a very good business practice. This provides protection against other persons “copying” your business identity and is often required to conduct banking and other similar transactions. In many states, obtaining an assumed-name certificate is easily done through a county clerk’s office, takes only a few minutes, and requires paying a small fee. eps81189_01_c01.indd 6 12/20/13 8:47 AM CHAPTER 1 Section 1.4 The Sole Proprietorship Sole proprietors are obviously responsible for their own debts. If the business fails, the business owner cannot just apologize and tell creditors the business no longer exists. Governance issues are nonexistent, for perhaps rather obvious reasons. There are no partners or shareholders; thus, sole proprietors answer only to themselves. Many sole proprietors in the healthcare profession organize as LLCs, if allowed in their state, to gain limited liability protection. Table 1.1 highlights the key features of various forms of business organization. The features and observations are broad generalizations but provide a frame of reference to consider when selecting an entity structure. Table 1.1: Features of various business organizations Sole Proprietorship Partnership LLC Corporation Nonprofit Corporation Ease of formation Yes Yes No No No Multiple owners No Yes Yes Yes Board of directors, no owners Transferability Not easily done Not easily done Not easily done Easily done Not applicable Double taxation No No No Yes No Liability protection No No Yes Yes Yes Separate tax return No Yes Yes, if partnership Yes Yes Operating agility High Medium Medium Low Low Perpetual life No No No Yes Yes Degree of regulation Low Medium Medium High High As a manager or supervisor in a healthcare organization, it will be important to understand the types of organizational structures you may encounter. Since you will not likely be responsible for dividing equity or filing taxes, we will not discuss those topics in this text. Instead we focus on the accounting skills you need to manage in the healthcare field. In the next chapter, we begin by looking at the basics of accounting and its language. eps81189_01_c01.indd 7 12/20/13 8:47 AM CHAPTER 1 Review Questions Key Terms dissolution The breakup of a partnership. generally accepted accounting principles (GAAP) Rules accountants follow when preparing financial statements. initial public offering (IPO) A privately held company’s offering of the first sales of its stock to the public. limited liability A principle of corporations stating that stockholders can only lose the amount of their investment to creditors. limited liability companies A company structure that provides liability protection similar to that of a corporation. limited life The nature of partnership in that partnership passes with the death of a partner. liquidation The formal termination of an entity. perpetual existence A characteristic of a corporation, meaning that it will continue to exist and operate until it is merged with another, it fails, or a corporate action is undertaken to liquidate the company. Review Questions The following questions relate to several issues raised in the chapter. Test your knowledge of these issues by selecting the best answer. (The odd-numbered answers appear in the answer appendix.) 1. Which is not a type of corporate entity? a. b. c. d. governmental nonprofit for-profit partnership 2. Why do many health organizations choose the corporate structure? a. b. c. d. limited liability ease of transferring ownership earn more money both a and b 3. Partnerships can be risky in the healthcare environment because a. b. c. d. partners must take responsibility for the actions of their partners. there are no limits to the liability they take in opening the business. the partnership must be dissolved if a partner dies. all of the above 4. Which type of organization divides equity by percentage of ownership? a. b. c. d. eps81189_01_c01.indd 8 corporation partnership sole proprietorship none 12/20/13 8:47 AM Review Questions CHAPTER 1 5. Which type of organization divides equity by shares held? a. b. c. d. corporation partnership sole proprietorship none 6. What is a corporation? Discuss the advantages of the corporate form of organization. 7. Briefly explain the disadvantages of the corporate form of organization. 8. What is a partnership? Discuss why partnerships can be risky in medical organizations and how to reduce the risk. 9. How does the accounting differ for nonprofit organizations? eps81189_01_c01.indd 9 12/20/13 8:47 AM eps81189_01_c01.indd 10 12/20/13 8:47 AM Chapter 2 Introduction to Accounting Siri Stafford/Iconica/Getty Images Learning Objectives eps81189_02_c02.indd 11 • Differentiate between financial and managerial accounting. • Acquire knowledge about basic accounting concepts. • Learn the fundamental accounting equation and the impact of transactions. • Discover career paths within the accounting profession. 12/20/13 8:48 AM Introduction CHAPTER 2 Chapter Outline 2.1 2.2 2.3 2.4 2.5 Introduction The Language of Accounting Disciplines of Accounting Financial Accounting Key Concepts The Financial Reporting Model Sources of Capital Comprehensive Illustration Usefulness of Accounting in Careers and Life The Importance of Ethics Introduction T he stereotypical accountant is characterized as a boring number cruncher, charged with maintaining the books and accounts of a business. This image may be traced back to the 1843 book by Charles Dickens entitled A Christmas Carol. In that tale, Ebenezer Scrooge is a penny-pinching miser who cares nothing for the people around him. His sole purpose is making money, and his trusted but suffering accountant is Bob Cratchit, who painstakingly tracks every penny. Mr. Scrooge eventually sees the light, but that’s another story. Today’s accountant is also another story. The mundane aspects of accounting are now largely accomplished by sophisticated computer software. For small businesses, the software may reside on a simple personal computer. Larger businesses may use elaborate enterprise resource packages that integrate accounting with all other aspects of managing the business. Such complex business systems may be maintained internally by a specific business or may be contracted for through a third-party “cloud computing” service provider. However your healthcare organization manages its accounting function, you will need to understand the numbers generated by this function, as well as the numbers you will be sending to accounting to add to its books. You will work with accounting to pay bills, and you will need to use the numbers reported monthly to be sure your department in staying on budget. If it is not, you will need to be able to analyze these numbers and find the problem. The changed environment has redefined what it means to be an accountant, as well as what it means to be a manager or other decision maker. Although accountants certainly need to have comprehensive understanding of the fundamental practices, rules, and procedures constituting the foundation of accounting, they are oftentimes more focused on broader measurement, reporting, and managerial tasks. Less time is spent on data capture, and more time is devoted to analyzing information and helping with sound business decisions. eps81189_02_c02.indd 12 12/20/13 8:48 AM Section 2.1 The Language of Accounting CHAPTER 2 Furthermore, to understand and monitor results produced by sophisticated information systems, accountants need to be knowledgeable and vigilant. If their organizations solely rely on the data produced by their computers, decision making can be quickly handicapped by erroneous output. The accountant must have a keen “forensic” eye to make sure that reported information is logical and correct. As a healthcare manger or decision maker, you will also need to review the output from accounting for the sections you lead, so you can identify cases in which reported information is not logical or is incorrect. Indeed, the role of accounting has grown more complex, and with that complexity, the value of the accountant has increased. A large proportion of business leaders start out as accountants. 2.1 The Language of Accounting A s noted, accounting is the collective concepts and techniques used to measure and report financial information about an entity. Managers and business executives are generally expected to possess at least rudimentary knowledge of this language. It is not essential that they know every nuance or specific rule, but they must be at least functionally literate in basic concepts. Indeed, it is very difficult to intelligently read and understand essential accounting reports without a firm grasp of accounting principles. No matter what career you pursue, you will come to appreciate the material you will learn in this course. Disciplines of Accounting At its core, accounting is a tool for providing information for decision making. Decision makers include owners, managers, creditors, employees, government, and other interested parties. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity, and each may have different ideas about the information they seek. This leads to a natural division of specialties within the accounting field. Some accountants focus on taxation. Tax returns must be prepared according to established laws, rules, and regulations. Tax accountants are also heavily involved in planning and strategy. The tax ramifications of significant transactions must be carefully evaluated. Businesses must consider complex implications of doing business in multiple states and countries. Other accountants focus on managerial accounting. Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire specialized reports, budgets, product-costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be developed. Another major area of accounting emphasis is financial accounting and auditing. Financial accounting is targeted toward reporting financial information about a business to external users such as the owner(s) and creditors. These parties often lack direct access to underlying details about day-to-day operations of the business and depend on summarized (frequently audited) financial statements to form their opinions about whether eps81189_02_c02.indd 13 12/20/13 8:48 AM Section 2.2 Key Concepts CHAPTER 2 to invest in or lend to the business. As a result, their ability to understand and have confidence in reports directly depends on the standardization of principles and practices used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare. Auditors provide independent oversight and assurance about the fairness and accuracy of reported financial accounting information. This introductory course is largely about financial accounting. It is the right place to begin your studies of accounting because understanding core financial accounting principles is essential for business success. Furthermore, many tax and managerial accounting processes are derivatives of the financial accounting model. Financial Accounting Financial accounting focuses on correctly measuring and reporting information about a business’s transactions and events. This information must be captured and summarized into reports that are used by persons interested in the entity. This task is far more complex than most people appreciate. It involves a talented blending of technical knowledge and applied judgment. Understanding financial accounting begins with an understanding of the overall structure of accounting and the fundamental reporting model that is common to all business entities. As noted, standardization of reporting is a hallmark of financial accounting. Such standardization derives from certain well-organized processes and organizations. As Chapter 1 explained, in the United States, a private-sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. For governmental entities, the rules are developed by the Governmental Accounting Standards Board (GASB). The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB (http://www.iasb .org/Home.htm) and FASB ( work cooperatively on many projects, and a single harmonious set of international financial reporting standards (IFRS) might eventually emerge. This effort to establish consistency in global financial reporting is motivated by the increase in global business. Financial reports prepared under the GAAP promulgated by such standard-setting bodies are intended to be general purpose in orientation. This means that they are not prepared especially for owners, creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups. 2.2 Key Concepts T he development of GAAP has occurred over many decades, and serious attempts have been made to base individual rules on thoughtful conceptual guideposts. Foremost is the idea of decision usefulness. Financial accounting information is intended to facilitate decisions about investing and lending. At a macro level, accounting information is the basis upon which capital is allocated in a free market economy. Investors like to invest where profits are best, and creditors like to loan when they foresee that they are apt to be repaid. The best businesses and business opportunities attract capital via signals about their performance, and those signals emanate from the financial reporting model. Without this flow of information and capital, a modern economy would stutter. eps81189_02_c02.indd 14 12/20/13 8:48 AM Section 2.2 Key Concepts CHAPTER 2 To be useful for decision making, accounting information should be relevant and reliable. Relevance means the degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance. Information is also seen as relevant if it possesses predictive value. Reliability relates mostly to truthfulness but also contemplates freedom from bias (neutral). Accounting information should also possess the qualities of comparability and consistency. Comparability generally relates to the ability to make relative assessments of companies. Investors and creditors all have limited resources and will clearly seek to place their funds with companies offering the best returns commensurate with understandable risk levels. This necessarily entails the need to compare companies. Accounting should facilitate such comparisons. This does not mean that all companies must use identical accounting techniques. Accounting disclosures, however, should possess sufficient detail so that careful users can discern differences in firms that are based on economic differences rather than accounting choice. Consistency is a concept that relates to performance assessments over time. Basically, if a firm’s economic activity is consistent from period to period, its accounting measures should also be consistent. Differences in measured outcomes from period to period should be indicative of deviations in business results. Despite accounting’s appearance as concrete and absolute, this is not quite true. Accounting information is often based on arbitrary allocations, assumptions, and individual judgment. Although rooted in mathematics, it nevertheless remains a social science. This concept is often misunderstood, resulting in perhaps excessive fixation on reported results for a single period of time. For example, how much profit is earned in a particular month or quarter when a cell phone is sold for less than cost, but the purchaser is also required to subscribe to a profitable 2-year service plan? There are no absolute answers to such questions; instead, accountants routinely embrace estimates and assumptions in the development of periodic financial reports. It is also important to note that it has not been accounting’s historic role to value a business. Accounting information may be useful in supporting this objective, but it is not a primary objective. As such, many transactions and events are reported based on their historical cost. For example, land is typically recorded and carried in the accounting records at its purchase price. The historical cost principle is based on the concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions. An often-debated alternative to historical cost is the fair value (in contrast to historical cost), or fair market value (FMV), approach. Under this technique, assets and liabilities are periodically revalued based on assessments of current worth, or FMV. Although problematic to implement, proponents of this view argue that it provides more relevant information for decision making. The competing viewpoint holds that FMV accounting is entirely too subjective to form a reliable basis for reporting. Currently, selected financial instruments may be valued at fair value. Otherwise, most U.S. companies adhere fairly well to historical cost measurement principles. Some global firms deploy more extensive fair value reporting, and it is possible that fair value accounting will gain more traction in years to come. The accountant of the future may be called on to develop added skills in valuation methods. This observation is consistent with the ever-changing role of the accounting profession. eps81189_02_c02.indd 15 12/20/13 8:48 AM Section 2.3 The Financial Reporting Model CHAPTER 2 There are many other guiding principles that you will be exposed to throughout this course. Table 2.1 provides a very high-level view of additional selected concepts and principles that drive accounting practice and judgment. Table 2.1: Selected concepts and principles Basic Concepts, Principles, and Assumptions Materiality Accountants are only concerned with decisions about how to account for matters that would bear on a decision-making process about the entity. Monetary unit Accountants describe the amounts reported on financial statements in measures of money rather than some other basis (e.g., land in acres). Going concern In the absence of evidence to the contrary, accountants assume that the business will continue to operate into the future. Periodicity Accountants assume that business activity can be divided into measurement intervals, such as months, quarters, and years. Economic entity Accountants present information along the lines of distinct economic units. Full disclosure Accountants hold to the principles that all relevant information is adequately described and presented within financial statements and related notes. Stable currency Accountants presume that the currency used to measure financial statement elements is not significantly changed over time because of inflationary effects. 2.3 The Financial Reporting Model D espite major advances in accounting technology and significant growth in the controlling rule set (there are well in excess of 20,000 specific accounting rules), the intrinsic model has changed little over the course of more than 500 years. The model traces its roots to the Renaissance era. A monk named Luca Pacioli developed a method for tracking the success or failure of ocean-going trading ventures. Capitalists of that era pooled their money to invest in ships that circled significant parts of the globe to trade goods. These returning ships then sold the collected wares. What was lacking was a way to track the costs and benefits of these efforts. Friar Pacioli met the challenge by developing a mathematical model that is still central to even the most sophisticated accounting systems of the modern age. Central to the model is the concept that a business entity can be described as a collection of assets and corresponding claims against those assets. Some claims belong to creditors eps81189_02_c02.indd 16 12/20/13 8:48 AM Section 2.3 The Financial Reporting Model CHAPTER 2 of the business, and the residual claims belong to the owner(s). This gives rise to the following accounting equation: Assets 5 Liabilities 1 Owner’s Equity Depending on your life’s experiences, this may or may not seem intuitive. If you own your home or car (an asset) but bought it with a loan on which you still owe some amount, you can probably relate. For example, assume that you bought a house for $200,000 but still owe $125,000 on the loan. Your fundamental accounting equation would be as follows: $200,000 (your asset) 5 $125,000 (your liability) 1 $75,000 (your equity) You would report that you have equity in your home of $75,000. This is the amount you would get to keep if you sold the home for $200,000. In general, assets are the economic resources of the entity and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets such as patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner. As previously noted, many assets are measured and reported at their historical cost in the accounting records. Liabilities are the amounts owed to others. Such obligations arise from loans, extensions of credit, and other obligations that occur in the normal course of business. Owner’s equity is the owner’s “interest” in the business. Because it is equivalent to assets minus liabilities, it also referred to as the net assets of a particular business. For a sole proprietorship, the equity would typically consist of a single owner’s capital account. With a partnership, a separate capital account is maintained for each investor. A corporation’s ownership is represented by divisible units called shares of capital stock. These shares are easily transferable, with the current holder(s) of the stock being the owner(s). The total owner’s equity (i.e., stockholders’ equity) of a corporation usually consists of several amounts. This generally corresponds to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends. (Dividends are distributions to shareholders as a return on their investment.) These undistributed earnings are customarily termed the retained earnings of the business. Knowledge of the fundamental accounting equation is key to understanding one of the most basic financial statements: the balance sheet. A balance sheet reveals the assets, liabilities, and equity of a business at a particular time. Examine Exhibit 2.1, the balance sheet for Kaplan’s Medical Clinic. Note that the balance sheet’s date is as of a particular time, as indicated by the specific date attached to the statement. eps81189_02_c02.indd 17 12/20/13 8:48 AM CHAPTER 2 Section 2.3 The Financial Reporting Model Exhibit 2.1: Balance sheet for Kaplan’s Medical Clinic Kaplan’s Medical Clinic Balance Sheet December 31, 20X3 Assets Cash Accounts receivable Supplies Land Liabilities $ 54,000 Accounts payable 135,000 Loan payable 4,500 Total liabilities 95,000 Total assets $ 288,500 57,000 $ 61,500 Stockholders’ equity Capital stock – $ 4,500 Retained earnings $ 52,000 175,000 Total liabilities and equity 227,000 $ 288,500 Notice that the balance sheet reveals a listing of assets totaling $288,500. The business owes various creditors a total of $61,500, leaving $227,000 of residual equity attributable to the shareholders of the business. The fundamental accounting equation for Kaplan’s Medical Clinic is $288,500 (total assets) 5 $61,500 (total liabilities) 1 $227,000 (total stockholders’ equity) The equity of $227,000 does not mean that the business is worth $227,000. Remember that many assets are not reported at current value. For example, although the land is reported at its cost of $95,000, it could be worth more. Similarly, the business likely has unrecorded resources such as its brand name and patient base. In a contrary fashion, the business may face business risks or pending litigation that might restrict its value. Thus, accounting statements are important in investment and credit decisions, but they are not the sole source of information for evaluating a business. Sources of Capital Kaplan’s Medical Clinic reported total equity of $227,000. What was the source of that capital? One would generally conclude that it was invested by the company’s shareholders. However, there is another important source of capital to consider, and that is the earnings of the business. Hopefully, over time, a business will prove to be profitable for its owners. The shareholders might receive periodic dividends; however, much of the income will likely be left in the business and be reinvested in additional business assets. Thus, equity arises from two principal sources: capital investments and retained earnings. eps81189_02_c02.indd 18 12/20/13 8:48 AM CHAPTER 2 Section 2.3 The Financial Reporting Model Before proceeding further, it is important to consider concepts of business income. Income can be thought of as the enhancement to the business as a result of providing goods (for example, medical equipment, medications, inoculations, or other medically necessary procedures that require goods to be sold) and health services to its patients. Mathematically, it is the result of subtracting expenses from revenues. Revenues are the gross inflows from patients, and expenses are the costs incurred in the process of producing those revenues. It is important to note that income and revenue are not synonymous. Very simply, income is revenues minus expenses. Some refer to revenue as the top line and income as the bottom line. You have already seen a balance sheet for Kaplan’s Medical Clinic. Exhibit 2.2 is an income statement. Note, in particular, the date range shown on the income statement. It is important to identify carefully the period of time during which the revenues and expenses were generated. These revenues are adjusted by contractual allowances (i.e., discounts negotiated by insurance companies and governmental entities), charity care, and other administrative adjustments. Most companies will show the revenues as Net Revenues minus these adjustments. Some companies will show the Gross Revenues and include one or more line items for adjustments to revenue. Exhibit 2.2: Income statement for Kaplan’s Medical Clinic Kaplan’s Medical Clinic Income Statement For the Month Ending December 31, 20X3 Revenues Services to customers $ 90,000 Expenses Wages Supplies Total expenses Net income $ 37,000 13,000 50,000 $ 40,000 Perhaps it goes without saying that a business can also lose money. In other words, expenses can exceed revenues. When this happens, the business is said to have a net loss, and this will reduce retained earnings. Severe losses can erode owner investments and result in negative retained earnings, or accumulated deficit. When a business pays dividends to stockholders, such amounts are not reported as expenses. Granted, they are an outflow from the business, but they are reported separate from the income statement. Dividends are a distribution of income, not a reduction in income. Often, a statement of retained earnings is prepared. This statement builds a eps81189_02_c02.indd 19 12/20/13 8:48 AM CHAPTER 2 Section 2.3 The Financial Reporting Model bridge between the retained earnings that existed at the beginning and end of a particular period. Exhibit 2.3 is an example of the statement of retained earnings for Kaplan’s Medical Clinic. Exhibit 2.3: Statement of retained earnings for Kaplan’s Medical Clinic Kaplan’s Medical Clinic Statement of Retained Earnings For the Month Ending December 31, 20X3 Beginning balance—December 1, 20X3 Plus: Net income $ 130,000 40,000 $ 170,000 Less: Dividends Ending balance—December 31, 20X3 5,000 $ 175,000 If you take time to review the financial statements for a public company that you are familiar with (they are often found on a company’s website under “Investor Relations”), you might find an expanded statement of stockholders’ equity in lieu of the statement of retained earnings. The expanded statement not only explains the periodic change in retained earnings but also shows all other sources of changes in equity. Examples include issuing additional shares of stock, dividends paid in shares of stock, and other unique events. These topics will be covered in a later chapter. For now, let’s stick with the basic statement of retained earnings. It is important to note that the income statement, statement of retained earnings, and balance sheet mesh together in a self-balancing fashion. Exhibit 2.4 shows how income flows from the income statement into the statement of retained earnings. Additionally, note how the ending retained earnings from the statement of retained earnings also appear in the balance sheet. This final tie-in causes the balance sheet to balance. eps81189_02_c02.indd 20 12/20/13 8:48 AM CHAPTER 2 Section 2.3 The Financial Reporting Model Exhibit 2.4: Flow of income Kaplan’s Medical Clinic Balance Sheet December 31, 20X3 Assets Cash $ 65,000 Accounts receivable 75,000 Inventories 35,000 Land 300,000 Building 100,000 Equipment 50,000 Other assets 10,000 Total assets $ 635,000 Liabilities Salaries payable Accounts payable $ 34,000 66,000 $ 100,000 Total liabilities Stockholders’ equity Capital stock Retained earnings $ 360,000 175,000 Total stockholders’ equity 535,000 Total liabilities and equity $ 635,000 How the articulation of the income statement, statement of retained earnings, and balance sheet occurs may at first seem mysterious, but the following discussion regarding Kaplan’s Medical Clinic will begin to clarify the logic of the self-balancing nature of the core financial statements. You can also find financial statements online for nonprofit healthcare facilities. For example, review the 2012 annual report with its financial statements for the Mayo Clinic at You will see a link for the annual report at the left. The financial statements are included in that annual report. You will find the Consolidated Statement of Activities (also known as the Income Statement) on page 10 and the Consolidated Statements of Financial Position (also known as the Balance Sheet) on page 11. Note the various types of revenue the clinic receives in addition to medical service revenue: grants and contracts, investment return, contributions, and premium revenue. If you want, you can find out more about each of these types of revenue by reading the annual report. Another section common to nonprofits is noncurrent income in the form of “Contributions not available for current activities.” Many times this money is set aside for a construction of a specific facility (often for the purpose specified by the donor) or a eps81189_02_c02.indd 21 12/20/13 8:48 AM Section 2.3 The Financial Reporting Model CHAPTER 2 specific type of long-term research. There is also a line item for “Unallocated investment return” in the noncurrent income section. This would be money maintained in various investment accounts for future use. On the balance sheet, notice there is just one item for net assets and none for equity. These would be the assets on hand to use in future years, such as multiyear gifts and trusts built from years of donations. In Chapter 1, we discussed the types of equity held by a nonprofit. The Mayo Clinic does not detail its equity holdings on its Balance Sheet, but you can find out more about donors and donations in the other parts of the annual report. Remember, a nonprofit does not have any owners. Many major nonprofit healthcare facilities do post their annual reports online to make it easier for their donors to access the information. Compare the nonprofit financial statements of the Mayo Clinic to those of a for-profit hospital organization that must report to the SEC. Download the 2012 annual report of Health Management Associates (HMA) at -reportsannual. The Consolidated Statements of Income can be found on page 74 of the downloaded PDF, and the Consolidated Balance Sheets are on page 75. The term consolidated is used because these are the combined results of all the hospitals owned by HMA. Note how different the revenue section is from that of a nonprofit. There is just one net revenue line item and then a provision for “doubtful accounts.” These are essentially accounts for which HMA does not expect to collect payment. These could include charity cases or other types of nonpayers. Also note at the bottom of the statement that there is an earnings per share calculation for common stockholders. You will not see this on a nonprofit statement because there are no stockholders. On the Balance Sheet you will see a line item called “Goodwill” that is unique to for-profit organizations. Essentially, this includes money that was paid to buy hospitals over and above the worth of the net assets owned by those hospitals. Often when one company buys another, extra money is paid for nontangible assets, such as customer base, reputation, or location. The Goodwill line item is a cumulative account of all money paid above the net assets purchased over the years. Another major difference is the Stockholders’ equity section that details the ownership of stockholders. More details about ownership can be found on page 76 in the Consolidated Statements of Stockholders’ Equity. A statement not normally prepared by nonprofits called the Consolidated Statement of Cash Flows can be found for HMA on page 77 of the PDF download. This statement shows the cash flows from operating activities (day-to-day activities of the company), investing activities (purchases of other hospitals, proceeds of sales of assets, and purchases of other assets, such as stocks and bonds), and financing activities (proceeds from new types of debt or the sale of newly issued stock). The bottom line of this statement is the change in the net cash on hand. You can see that on the line item near the bottom called “Cash and cash equivalents at the end of the year.” HMA’s cash has been going down. The company started 2010 with $106,018,000 and ended 2012 with just over half that—$59,173,000. An investor would take a closer look at where the cash went using this statement. We won’t delve into those details here. That’s beyond the scope of this class. Comprehensive Illustration A primary objective of this chapter is to examine business transactions using the accounting equation. You now have a basis for meeting this objective. Recognize that eps81189_02_c02.indd 22 12/20/13 8:48 AM CHAPTER 2 Section 2.3 The Financial Reporting Model every business transaction has the potential to impact the assets, liabilities, and equity of a business. That impact will not undermine the self-balancing nature of the accounting equation. The reason should become apparent as you review the following example for Kaplan’s Medical Clinic. The following example includes a summary of transactions and events for Kaplan’s for the month of December, followed by a spreadsheet showing how each transaction impacts the overall accounting equation. The beginning-of-month amounts are all assumed, and the ending balances were used to prepare the financial statements illustrated earlier. Table 2.2 lists December’s transactions. Table 2.2: December’s transactions for Kaplan’s Medical Clinic eps81189_02_c02.indd 23 Description Amount Discussion of How Balance Is Maintained Provided medical services for cash $10,000 Cash (an asset) and Revenues both increase; revenues increase income, which increases equity. Provided medical services to be billed to insurance companies $30,000 The asset, Accounts Receivable (representing amounts due from insurance companies), is increased, which is matched with an increase in Revenues, Income, and Equity. Collected amounts due from insurance companies for services previously rendered $20,000 Cash is increased and Accounts Receivable is decreased, resulting in no change in total assets. Bought additional supplies on account $ 2,500 Supplies increase, which increases the expenses of the organization, as does the Accounts Payable liability account, which increases the liabilities of the organization. Expenses are shown on the Income Statement, and Liabilities are shown on the Balance Sheet. Issued additional shares of stock $12,000 Cash and the Capital Stock account are both increased by the same amount. Paid amounts due on outstanding Accounts Payable $ 6,000 Cash and Accounts Payable are both decreased. These accounts are only shown on the Balance. The purchase of supplies (an expense) is tracked when the initial purchase is made. Purchased land for cash ($20,000) and incurred a $55,000 loan $75,000 Land (an asset) goes up by $75,000. This is offset by a $20,000 reduction in Cash. The balancing amount of $55,000 is reflected as an increase in the liability account Loan Payable. Paid wages to employees $ 7,000 Cash is decreased, as is Income/Equity via the recording of Wages Expense. This is only an expense and is shown only on the Income Statement. Paid dividends to shareholders $ 5,000 Cash is decreased and the Dividends account is increased by the same amount (which causes a decrease in Retained Earnings and Equity). 12/20/13 8:48 AM CHAPTER 2 Section 2.3 The Financial Reporting Model You should carefully review each transaction’s impact within the spreadsheet shown in Exhibit 2.5. This will not be immediately intuitive; you will need to think carefully and slowly about each entry, noting in particular how (1) the transaction impacts the various accounts and (2) the equality of the fundamental accounting equation is preserved. We will take a closer look at the issues specific to collecting for services in a medical environment in Chapter 4. Exhibit 2.5: Spreadsheet for Kaplan’s Medical Clinic for December Assets Description Cash Beginning balances $ 50,000 Services for cash + 10,000 Accounts receivable $ 125,000 + Services on account Collect account + 20,000 5,000 $ 20,000 $ Stockholders’ Equity Loan payable 8,000 $ 2,000 Capital stock Dividends Revenues Expenses (increase equity) $ 50,000 (decrease equity) (increase income, thus equity) + 2,500 (6,000) + 2,500 – (6,000) 12,000 Pay wages – (7,000) Dividends – (5,000) 54,000 (decrease income, thus equity) Retained Earnings $ 140,000 + 10,000 + 30,000 – (3,000) + 3,000 + 7,000 + 12,000 Buy land with – (20,000) cash and loan Ending balance $ Accounts payable 30,000 Buy supplies on account Additional investment + $ Land – (20,000) Record use of supplies Pay on account – Liabilities Supplies + 75,000 – $ 135,000 $ – – 4,500 $ 95,000 + 55,000 – $ 4,500 $ – – + 5,000 57,000 $ 62,000 $ 5,000 – – $ 40,000 $ 10,000 $30,000 Net Income $30,000 – $5,000 = $25,000 Increase in retained earnings Plus beginning retained earnings $140,000 Ending retained earnings $165,000 $288,500 Total Assets eps81189_02_c02.indd 24 $61,500 Total Liabilities $227,000 Total Equity 12/20/13 8:48 AM Section 2.4 Usefulness of Accounting in Careers and Life CHAPTER 2 One challenge of accounting is to evaluate each transaction correctly and make sure that it is properly recorded into the accounts. If recording is not done correctly, the fundamental accounting equation will be violated, and it will not be possible to prepare logically “balanced” financial statements. The ability to evaluate and record transactions becomes routine—with practice—much like learning to play a musical instrument. Don’t fret that it is at first a bit confusing. In addition, an actual business would not want to rely on the spreadsheet in Exhibit 2.5 as the heart of its accounting system. Such a system suffers from a number of limitations, which are described in Chapter 3. That chapter will introduce a much better way to record transactions and process them into correct financial statements. 2.4 Usefulness of Accounting in Careers and Life Y ou have probably heard that accounting is a great subject to study, maybe because it is one of the better academic pathways to a good job. If you enjoy accounting and want to stay in the health field, every healthcare institution needs accountants. Even if you aren’t interested in accounting as a profession, you will need to understand the role of accounting as a manager in a healthcare organization in order to manage the finances of your department or division. In addition, the skills you will learn will prove helpful in managing your personal finances and investments. These are lifelong skills that will continue to serve you for many years to come. If you decide to become an accountant, you will find that there are many specialty areas. Many accountants specialize in public accounting, which involves providing audit, tax, and consulting services to the general public. Specializing in public accounting usually requires licensing. Individual states issue a license called a certified public accountant (CPA). Auditing involves the examination of transactions and systems that underlie an organization’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically and include such diverse activities as information systems engineering and evaluation of production methods. Many accountants are privately employed by small and large businesses (i.e., industry accounting) and nonprofit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may serve as internal auditors, who look at controls and procedures in use by their employers. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations. It probably goes without saying that many accountants also work in the governmental sector, whether at the local, state, or national level. Many accountants are employed at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commission, and even the Federal Bureau of Investigation (see Table 2.3). eps81189_02_c02.indd 25 12/20/13 8:48 AM CHAPTER 2 Section 2.5 The Importance of Ethics Table 2.3: Examples of careers in accounting Career Types Example Titles Public-sector accounting Audit and assurance services Tax preparation and planning Business consulting and systems design Private-sector accounting Staff accountant Controller Chief financial officer Tax manager Information technology manager Internal auditor Federal government Internal Revenue Service General Accounting Office Securities and Exchange Commission Federal Bureau of Investigation Nonprofit and state/local governmental sector Staff accountant Tax auditor Chief accounting officer/director Budget officer 2.5 The Importance of Ethics I nvestors and creditors greatly rely on financial statements in making their investment and credit decisions. It is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion. To help ensure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, governmental oversight, and the ever-vigilant plaintiff’s attorney all serve a vital role in providing additional safeguards against the errant accountant. Those who are preparing to enter the accounting profession should do so with the intention of behaving with honor and integrity. Others will likely rely on accountants in some aspect of their personal or professional lives. They have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, they will be entrusting them with financial resources and confidential information. Being ethical can sometimes be more challenging than you might presume. Accounting tasks naturally relate to money. This is especially true for public companies that have share prices prone to fluctuation based on reported income numbers. Sometimes millions of dollars are ultimately at stake based on what the accountants ultimately report. It is easy for accountants to fall into a trap of trying to cover what is seen as a temporary eps81189_02_c02.indd 26 12/20/13 8:48 AM Key Terms CHAPTER 2 shortfall in income by some type of accounting gimmick. These stories usually end badly because participants tend to get sucked into an ever-worsening pattern of financial deception. In retrospect, participants in these schemes usually report that they initially acted in haste and under pressure. Nevertheless, the consequences tend to be career ending and worse. You must prepare yourself for ethical challenges in advance, so you can be firm and ready to act in an appropriate manner at all times. Accountants are fiduciaries for others and must act accordingly. In closing, many students cannot envision themselves as accountants. That’s okay. There are two important things to remember. First, accountants often move on to significant business leadership roles. This is true because their accounting training and experience provide the foundation for understanding and being successful in business. Second, people in business often remark that they wish they had studied more and knew more about accounting. In business, they quickly discover that accounting knowledge is essential— indeed paramount. Accounting truly is the language of business. Key Terms assets The economic resources of the entity that include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangibles such as patents and other legal rights and claims. auditing The examination of transactions and systems that underlie an organization’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. balance sheet A basic financial statement that reveals the assets, liabilities, and equity of a business at a particular time. certified public accountant (CPA) A license issued by states that allows an accountant to specialize in public accounting. eps81189_02_c02.indd 27 comparability The ability to make relative assessments of companies. consistency A concept that relates performance assessments over time. dividends Distributions to shareholders as a return on their investment. expenses The costs incurred in the process of producing revenues. fair value An assessment based on current worth. financial accounting Targeted toward reporting financial information about a business to external users such as the owner(s) and creditors. Financial Accounting Standards Board (FASB) A private-sector group primarily responsible for developing the rules that form the foundation of financial reporting. 12/20/13 8:48 AM Key Terms Governmental Accounting Standards Board (GASB) An independent organization that establishes and improves standards for financial reporting by local, state, and federal entities. historical cost The concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions. managerial accounting Information intended to serve the specific needs of management. net assets Another term for owner’s equity. owner’s equity The owner’s “interest” in the business; the equivalent to assets minus liabilities. income The enhancement to the business as a result of providing goods and services to its customers; mathematically, it is the result of subtracting expenses from revenues. relevance The degree that accounting information bears on the decision process, primarily by providing timely feedback on an enterprise’s financial condition and performance. income statement A statement that reports income for a particular time period. reliability The degree that accounting information is truthful and free from bias, or neutral. internal auditors Those professionals who look at controls and procedures in use by their employer. retained earnings Earnings of a business that are not distributed. International Accounting Standards Board (IASB) The international counterpart to the FASB; the IASB and FASB work cooperatively on many projects. international financial reporting standards (IFRS) The effort to establish consistency in global financial reporting. liabilities The amounts owed to others, such as obligations to loans, extensions of credit, and other debts that occur in the normal course of business. eps81189_02_c02.indd 28 CHAPTER 2 revenues The gross inflows from customers. statement of retained earnings A statement that builds a bridge between the retained earnings that existed at the beginning and end of a particular period. statement of stockholders’ equity An expanded statement that explains not only the periodic change in retained earnings but also shows all other sources of changes in equity. tax services Provide help in preparing and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. 12/20/13 8:48 AM Review Questions CHAPTER 2 Review Questions The following questions relate to several issues raised in the chapter. Test your knowledge of these issues by selecting the best answer. (The odd-numbered answers appear in the answer appendix.) 1. The principle of historical cost a. holds that acquisitions of goods and services should be entered in the accounting records at acquisition cost. b. results in the development of subjective financial statements. c. is ideal for use in periods of high inflation. d. is not acceptable when constructing general-purpose financial statements. 2. Miller’s Clinic had owner’s equity of $32,000 on January 1, 20X2. During January, owner investments and withdrawals amounted to $15,000 and $9,000, respectively. In addition, the company generated revenues of $50,000 and expenses of $48,000. What was the amount of owner’s equity on January 31? a. b. c. d. $8,000 $36,000 $40,000 $58,000 3. John Davis recently withdrew $1,000 cash from the Davis Health Services, a sole proprietorship. This transaction would a. b. c. d. decrease both assets and liabilities. decrease both assets and owner’s equity. decrease assets and increase owner’s equity. increase both assets and owner’s equity. 4. A company’s ending accounts receivable balance and the period’s advertising expense would be found on which financial statements, respectively? a. b. c. d. balance sheet and statement of owner’s equity balance sheet and income statement income statement and balance sheet income statement and statement of owner’s equity 5. X Company had revenues, expenses, owner investments, and owner withdrawals of $45,000, $35,000, $4,000, and $1,000, respectively. What was the firm’s net income? a. b. c. d. eps81189_02_c02.indd 29 $9,000 $10,000 $13,000 $14,000 12/20/13 8:48 AM CHAPTER 2 Exercises 6. How does financial accounting differ from managerial accounting? 7. What are several limitations of accounting information? 8. Paul Martin is contemplating an investment in the Howard Health Clinic. He has secured the firm’s audited financial statements, which have been examined by a certified public accountant. How can Martin be satisfied that the statements do not present false and incorrect information to purposely mislead investors? 9. Discuss the use of historical cost in the accounting process. Why is historical cost used, and what is one of its chief limitations? 10. Consider the income statement, the statement of owner’s equity, and the balance sheet. Which of these statements cover(s) a period of time as opposed to a specific date? Exercises 1. Basic concepts. Sam’s Medical Equipment specializes in the sale of medical equipment and accessories. Identify the items that follow as an asset (A), liability (L), revenue (R), or expense (E) from the firm’s viewpoint. a. b. c. d. e. f. g. h. the inventory of medical supplies owned by the company monthly rental charges paid for clinic space a loan owed to Citizens Bank new computer equipment purchased to handle daily record keeping daily sales made to patients amounts due from insurers land owned by the company to be used as a future store site weekly salaries paid to clinic staff 2. Basic computations. The following selected balances were extracted from the accounting records of Rossi Medical Equipment on December 31, 20X3: Accounts payable Accounts receivable Auto expense Building Cash Fee revenue $ 3,200 14,800 1,900 30,000 7,400 56,900 Interest expense $ 2,500 Land 18,000 Loan payable 40,000 Tax expense 3,300 Utilities expense 4,100 Wage expense 37,500 a. Determine Rossi’s total assets as of December 31. b. Determine the company’s total liabilities as of December 31. c. Compute 20X3 net income or loss. eps81189_02_c02.indd 30 12/20/13 8:48 AM CHAPTER 2 Exercises 3. Impact of business transactions. The following items describe the impact of a business transaction or event on the components of the accounting equation. Present an example of a transaction or event that correctly matches the described impact. a. Increase an asset and increase a liability. b. Increase one asset and decrease another asset. c. Increase an asset and increase owner’s equity from a transaction or event not related to income-producing activities. d. Increase an asset and increase owner’s equity from a transaction or event related to income-producing activities. e. Decrease an asset and decrease a liability. f. Decrease an asset and decrease owner’s equity from a transaction or event not related to income-producing activities. 4. Analysis of transactions. Set up the following headings across a piece of paper: Assets 5 Liabilities 1 Owner’s Equity Indicate the effect of each of the following transactions on total assets, liabilities, and owner’s equity: a. Processed a $5,000 cash withdrawal for the owner. b. Recorded the receipt of May’s utility bill, to be paid in June. c. Provided services to patients on account. d. Paid the current month’s advertising charges. e. Purchased a $27,000 vehicle by paying $5,000 down and securing a loan for the remaining balance. f. Received $11,000 cash from the owner as an investment in the business. g. Returned a new computer and printer purchased earlier in the month on account. The bill had not as yet been paid. h. Paid the utility bill recorded previously in part (b). 5. Accounting equation; analysis of owner’s equity. Medical Equipment Repair revealed the following financial data on January 1 and December 31 of the current year. January 1 December 31 Assets Liabilities $45,000 $20,000 49,000 31,000 a. Compute the change in owner’s equity during the year by using the accounting equation. b. Assume that there were no owner investments or withdrawals during the year. What is the probable cause of the change in owner’s equity from part (a)? c. Assume that there were no owner investments during the year. If the owner withdrew $17,000, determine and compute the company’s net income or net loss. Be sure to label your answer. d. If owner investments and withdrawals amounted to $13,000 and $2,000, respectively, determine whether the company operated profitably during the year. Show appropriate calculations. eps81189_02_c02.indd 31 12/20/13 8:48 AM CHAPTER 2 Exercises 6. Balance sheet preparation. The following data relate to Preston Clinic as of December 31, 20XX: Building $44,000 Accounts Receivable $24,000 Cash 17,000 Loan Payable 30,000 J. Preston, Capital 65,000 Land 21,000 Accounts Payable ? Prepare a balance sheet in good form as of December 31, 20XX. 7. Income statement concepts. Evaluate the following comments as being true or false. If the comment is false, briefly explain why. a. An income statement reveals the net income or net loss of an entity for a period of time as opposed to a specific date. b. Withdrawals are properly classified as an expense of doing business. c. If a company has $50,000 of revenues for March, it stands to reason that cash receipts for March must total $50,000. d. If expenses exceed revenues, a net loss has been generated. e. A computer acquired late in the year for use in the business should be disclosed on a firm’s income statement. 8. Financial statement relationships. The following information appeared on the financial statements of the Johnson’s Medical Clinic: Income statement Total expenses Net income $ 64,900 7,200 Statement of owner’s equity Beginning owner’s equity balance $113,200 Owner withdrawals 61,300 Ending owner’s equity balance 70,800 Balance sheet Total liabilities $ 97,000 By picturing the content of and the interrelationships among the financial statements, determine the following: a. total revenues for the year. b. total owner investments. c. total assets. eps81189_02_c02.indd 32 12/20/13 8:48 AM CHAPTER 2 Problems 9. Financial statement presentation. The accounting records of Robson’s Healthcare revealed the following selected information for the year ended December 31, 20X6. Cash investments by the owner Services rendered to patients Cash withdrawals by the owner Total year-end assets $ 59,000 86,000 12,000 177,800 Salaries, advertising, and utilities for the year totaled $68,500. The year-end asset total included a parcel of land that had cost the company $45,000. Robson’s accountant used this amount for valuation purposes rather than the land’s current market value of $75,000 (as determined by a recent real estate appraisal). a. Determine the net income to be disclosed on the company’s income statement. b. Compute the increase or decrease in owner’s equity during 20X6. On which financial statement would this information appear? c. Determine and justify the proper valuation for Robson’s year-end assets. Problems 1. Identification of transactions. The following tabulation summarizes several transactions of the Hartford Healthcare Company: Cash $5,000 Balances a. Assets Accounts 1 Receivable $13,000 Liabilities Owner’s Equity Computer Accounts (Investments 2 1 Withdrawals) 1 1 5 Payable (Revenues 2 Expenses) $29,000 $17,000 $30,000 2800 b. 11,900 c. 22,000 d. 23,000 e. 2800* 21,900 22,000 110,000 17,000 11,500 f. 11,500* 12,500 g. $1,100 $12,600 $41,500 12,500 1900 $24,900 2900* $30,300 Transactions in the Owner’s Equity column designated with an asterisk (*) were caused by the company’s income-producing activities. The $2,000 and $2,500 figures are unrelated to such activities. eps81189_02_c02.indd 33 12/20/13 8:48 AM CHAPTER 2 Problems Instructions Write a brief explanation of each transaction. 2. Basic transaction processing. On November 1 of the current year, Dr. Richard Parker established a sole proprietorship. The following transactions occurred during the month: 1: Received $19,000 from Parker as an investment in the business. 2: Paid $9,000 to acquire a used minivan. 3: Purchased $1,800 of office furniture on account. 4: Rendered $2,100 of consulting services on account. 5: Paid $300 of repair expenses. 6: Received $800 from insurers who were previously billed in item 4. 7: Paid $500 on account to the supplier of office furniture in item 3. 8: Received a $150 electric bill, to be paid next month. 9: Processed a $600 withdrawal for Parker. 10: Received $250 from patients for services rendered. 11: Returned a $450 office desk to the supplier. The supplier agreed to reduce the balance due. Instructions a. Arrange the following asset, liability, and owner’s equity elements of the accounting equation: Cash, Accounts Receivable, Office Furniture, Van, Accounts Payable, Investments/Withdrawals, and Revenues/Expenses. b. Record each transaction on a separate line. After all transactions have been recorded, compute the balance in each of the preceding items. c. Answer the following questions for Parker: (1) How much does the company owe to its creditors at month-end? On which financial statement(s) would this information be found? (2) Did the company have a “good” month from an accounting viewpoint? Briefly explain. 3. Statement preparation. The following information is taken from the accounting records of Grimball Cardiology at the close of business on December 31, 20X1. Accounts payable $ 14,700 Surgical expenses 80,000 Cash Surgical equipment 37,000 Office Equipment Salaries expense 30,000 Rent Expense 15,000 135,000 Loan Payable 10,300 Accounts receivable Utilities expense eps81189_02_c02.indd 34 Surgery Revenue $175,000 60,000 118,000 5,000 12/20/13 8:48 AM CHAPTER 2 Problems All equipment was acquired just prior to year-end. Conversations with the practice’s bookkeeper revealed the following data: Rose Grimball, capital (January 1, 20X1) $300,000 19X1 owner investments 2,000 19X1 owner withdrawals 22,000 Instructions a. Prepare the income statement for Grimball Cardiology in good form. b. Prepare a statement of owner’s equity in good form. c. Prepare Grimball’s balance sheet in good form. 4. Transaction analysis and statement preparation. The transactions that follow relate to Frisco Medical Center for March 20X1, the company’s first month of activity. 3/1: Received $20,000 cash from Joanne Burton, the owner, as an investment in the business. 3/4: Rendered $2,400 of services on account. 3/7: Acquired a small parcel of land by paying $6,000 cash. 3/12: Received $700 from an insurer, who was billed previously on March 4. 3/15: Paid $800 to the Journal Herald for advertising that ran during the first half of the month. 3/18: Acquired $9,000 of equipment from Miller Medical Equipment by paying $7,000 down and agreeing to remit the balance owed within the next 2 weeks. 3/22: Received $300 cash from clients for services performed on this date. 3/24: Paid $1,500 on account to Miller Medical Equipment in partial settlement of the balance due from the transaction on March 18. 3/28: Rented a car from United Car Rental for use on March 28. Total charges amounted to $75, with United billing Frisco for the amount due. 3/31: Paid $900 for March wages. 3/31: Processed a $600 cash withdrawal from the business for Joanne Burton. Instructions a. Determine the impact of each of the preceding transactions on Frisco’s assets, liabilities, and owner’s equity. Use the following format: eps81189_02_c02.indd 35 Assets 5 Liabilities 1 Owner’s Equity Accounts Land Cash Receivable Equipment Accounts Payable (1) Investments (1) Revenues (–) Withdrawals (–)   Expenses 12/20/13 8:48 AM CHAPTER 2 Problems Record each transaction on a separate line. Calculate balances only after the last transaction has been recorded. b. Prepare an income statement, a statement of owner’s equity, and a balance sheet in good form. 5. Financial statement preparation. On October 1, 20X6, Susan Thompson opened Thompson Nursing Services, a sole proprietorship. Susan began operations with $50,000 cash, 60% of which was acquired via an owner investment. The remaining amount was obtained from a bank loan. A review of the accounting records for October revealed the following: • • • Asset purchases: van, $16,000; office equipment, $4,000; and furnishings, $17,000. These amounts were paid in cash except for $2,100 that is still owed for the furnishings acquisition. Services performed: total billings on account, $18,300. Patients have remitted a total of $14,200 in settlement of their balances due. Expenses incurred: salaries, $8,700; advertising, $2,500; taxes, $150; postage, $1,800; utilities, $100; interest, $450; and miscellaneous, $200. These amounts had been paid by month-end with the exception of $700 of the advertising expenditures. Further information revealed that Thompson withdrew $5,500 of cash from the business on October 31. Instructions a. Prepare an income statement for the month ending October 31, 20X6. b. Prepare a statement of owner’s equity for the month ending October 31, 20X6. c. Prepare a balance sheet as of October 31, 20X6. eps81189_02_c02.indd 36 12/20/13 8:48 AM Chapter 3 The Accounting System Martin Barraud/OJO Images/Getty Images Learning Objectives eps81189_03_c03.indd 37 • Understand the need for and general characteristics of a proper accounting system. • Understand accounts and how they are impacted by the debit/credit rules. • Know how to prepare journal entries to describe the effects of transactions and events. • Post accounts to the general ledger and prepare a trial balance. • Apply features and tools that are used to enhance and improve accounting systems and processes. 12/20/13 8:49 AM Section 3.1 Exploring Accounting Systems CHAPTER 3 Chapter Outline 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 Introduction Exploring Accounting Systems Chart of Accounts Accounts and Debits/Credits Debit and Credit Rules T-Accounts Transaction Analysis Critical Thinking About Transaction Analysis An Applied Example of Transaction Analysis General Journal Posting the General Ledger Review of the Sequence of Transaction Recording A Balanced Trial Balance: No Guarantee of Correctness Special Journals Source Documents Thinking About Automation Critical Thinking About Debits and Credits Introduction E xhibit 2.5 shows how transactions systematically impact the accounting equation and resulting financial statements. Although this system works fine as an introduction to the accounting equation, it is not adequate for managing an actual business. Too many transactions originate in too many places for a single tabulation to capture all business activity reliably. Many small businesses have tried to use a simple schedule or spreadsheet to record and process all their activities; however, chaos quickly rules. A more complete and controlled accounting system is needed to manage today’s complex businesses. In this chapter, we will explore the design and use of modern accounting practices. 3.1 Exploring Accounting Systems L arge and successful healthcare businesses have invariably developed robust accounting information systems. This suggests that the pathway to business success entails more than just providing excellent medical services. It also entails thoughtful development of well-designed accounting information systems. It is far better to establish a proper system at the outset of launching a healthcare business than to come back later and try to repair an inadequate system. By the time a business discovers that its system is deficient, it is often too late. The business may well have lost control of necessary information for proper business management. The results are often disastrous. eps81189_03_c03.indd 38 12/20/13 8:49 AM Section 3.2 Chart of Accounts CHAPTER 3 This naturally leads you to wonder about the core elements of a proper system. Clearly, the accounting system must provide a basis for preparing financial statements. This is the end objective and reflects the aggregation of all activity. Thus, the goal of an accounting system is to process transactions and events reliably into useful financial statements and reports. However, the system must also maintain retrievable documentation for every transaction. An important feature is to allow a user to query the system for the purpose of retrieving, verifying, or examining individual details of any specific business transaction. Computerized accounting systems summarize and interpret all business transactions. The result is useful financial data for purposes of investment and business management. Much of the data input can actually originate with the transaction’s execution. For instance, while recording a patient’s payment, accounting records can be updated to reflect the transaction. This can additionally trigger adjustments of the company’s inventory records (for example, if medical samples or inoculations were given) and even generate an order to replace depleted stock on hand. In addition, bills for insurance companies can also be generated from the information gathered at the time the patient pays their deductibles and co-payments. While this level of sophistication can simplify the data entry process and increase accuracy of subsequent processing, it also entails considerable risk of “invisible” manipulation of data and file destruction. Thus, a good accounting system must take into consideration the need to control access, verify input, and back up essential records. Even with these important controls, a well-trained accountant must be knowledgeable and vigilant. A basic understanding of debits/credits, journals, and other basic topics is essential to interpret computerized reports and spot errors that may have been inadvertently (or worse, deliberately) introduced into the system. Computerized accounting information systems are typically built around a database structure. This means that data are stored in an electronic array, including a variety of descriptive codes and indices. This coding process allows you to query the database to extract desired information instantaneously, based on parameters established by the person initiating the request of the accounting system. The long-standing structure of the core financial statements and the basic tools used in their construction are generally preserved in even the most sophisticated electronic environments. Indeed, it is difficult to understand or work within an automated accounting environment without first being moderately familiar and comfortable with the basic accounting tools. This chapter introduces these important tools and helps you understand how they can be effectively used to capture and process information. 3.2 Chart of Accounts Y ou may be wondering if there is a fixed set of accounts used to develop these accounting systems. The answer is clearly no. Each company’s unique business circumstances will dictate the particular accounts that are logical and useful to support its accounting system. Should the need for a new account arise, it is a simple matter to add an additional account. Furthermore, it is common to assign a unique number to each account. The numbering system is usually called a chart of accounts. It is common for the numbering scheme to communicate information about the nature of accounts. For example, all assets may be numbered in the 1,000s, liabilities in the 2,000s, and so on. This allows logical eps81189_03_c03.indd 39 12/20/13 8:49 AM CHAPTER 3 Section 3.3 Accounts and Debits/Credits sorting of data. Every company’s number system is likely to be unique. The assigned numbers are arbitrary, like zip codes, and are merely a tool of convenience for classifying data. For example, when you code bills to be paid for your department, you are likely using a code related to the Chart of Accounts so the accounting department knows which account to charge. Assume that Kaplan’s chart of accounts appears as Table 3.1 shows. Table 3.1: Kaplan’s chart of accounts Account Code Cash 1,000 Accounts receivable 1,010 Supplies 1,020 Land 1,030 Accounts payable 2,010 Loan payable 2,020 Capital stock 3,000 Retained earnings 3,100 Dividends 6,000 Revenue 4,010 Supplies expense 5,010 Wage expense 5,020 3.3 Accounts and Debits/Credits A n account is the master record that is maintained for each individual financial statement asset, liability, equity, revenue, expense, or dividend component. Every financial statement element (cash, accounts receivable, inventory, land, accounts payable, etc.) would have its own account and show the impact of all transactions causing a change to that account. The collection of all accounts is known as the general ledger. Importantly, the collective balance of all accounts should conform to the accounting equation, meaning that the sum of all asset accounts will equal the sum of all liability and equity components. Of course, in considering this equation, you need to be mindful that the revenue account increases equity, and expenses and dividends decrease equity. Beginning students are typically mystified about how this equality is consistently preserved. There is an answer to this, and the answer’s brilliance helps explain how the fundamental accounting model has persevered for more than 500 years. Indeed, that the model continues to be programmed into today’s highly sophisticated computerized systems speaks volumes about the integrity of the model. The key ingredient is the concept of debits and credits. eps81189_03_c03.indd 40 12/20/13 8:49 AM CHAPTER 3 Section 3.3 Accounts and Debits/Credits Debits and credits are often misunderstood. You may have had your account credited at the bank, you might use a debit card to make a purchase, and you might prepare a credit application! The terms debit and credit are tossed around rather casually in day-to-day activities. At this point, the best thing to do is clear your mind of any meanings that you might already associate with the terms and start anew. Debits and credits are accounting tools, and you should focus on this important point: Every business transaction can be described in terms of debit/credit impacts on specific accounts so that debits will always equal credits. That is an amazing concept! By preserving this equality at the transaction level, the overall equality of the fundamental accounting equation is also preserved. Are you perhaps skeptical? Let’s look closer at this model. Debit and Credit Rules It is best to begin by memorizing certain “rules” about debits and credits. These rules are not necessarily intuitive, but at least they are not hard to learn. Think of learning them in the same way that you might memorize a few key words in a unfamiliar language, prior to taking a trip to a place where that is the only language spoken. Accountants and businesspeople routinely speak about transactional effects in the context of debits and credits. Debit (often abbreviated “dr” and sometimes taken to mean “to record on the left-hand side of an account,” as will become apparent shortly) is simply the action of recording an increase to an asset, expense, or dividend account. Conversely, credit (abbreviated “cr” and sometimes taken to mean “to record on the right-hand side of an account”) is the action of recording a decrease to those same accounts. For example, if Cash (an asset) is increased, we say that we are debiting Cash. If Accounts Receivable (another asset) is decreased, we say that we are crediting Accounts Receivable. Therefore, if a transaction involves collecting $1,000 cash from a customer who owes us the money (i.e., we have a previously established account receivable on our balance sheet), then we simply say that we are debiting Cash and crediting Accounts Receivable for $1,000. By their nature, asset, expense, and dividend accounts usually have more debits than credits and are said to have a normal debit balance (see Figure 3.1). Figure 3.1: Assets, expenses, and dividend accounts Increased With Debits Decreased With Credits Assets Expenses Dividends Normal Balance Is Debit eps81189_03_c03.indd 41 12/20/13 8:49 AM CHAPTER 3 Section 3.3 Accounts and Debits/Credits Liability, revenue, and equity accounts behave in an opposite fashion. They are increased with credits and decreased with debits. By their nature, these accounts usually have more credits than debits and are said to have a normal credit balance (see Figure 3.2). Table 3.2 lists many typical accounts, showing the application of the debit and credit rules. Figure 3.2: Liability, revenue, and equity accounts Decreased With Debits Increased With Credits Liabilities Revenues Equity Normal Balance Is Credit Table 3.2: Schedule of debit and credit rules for typical accounts Normal Balance Increased With Decreased With Cash Debit Debit Credit Accounts receivable Debit Debit Credit Inventory Debit Debit Credit Land Debit Debit Credit Buildings Debit Debit Credit Equipment Debit Debit Credit Accounts payable Credit Credit Debit Salaries payable Credit Credit Debit Notes and loans payable Credit Credit Debit Capital stock Credit Credit Debit Retained earnings Credit Credit Debit Typical Assets Typical Liabilities Typical Equities (continued) eps81189_03_c03.indd 42 12/20/13 8:49 AM CHAPTER 3 Section 3.3 Accounts and Debits/Credits Table 3.2: Schedule of debit and credit rules for typical accounts (continued) Normal Balance Increased With Decreased With Service revenue Credit Credit Debit Sales Credit Credit Debit Salaries and wages Debit Debit Credit Utilities Debit Debit Credit Interest Debit Debit Credit Rent Debit Debit Credit Supplies Debit Debit Credit Taxes Debit Debit Credit Debit Debit Credit Typical Revenues Typical Expenses Dividends Dividends In addition to the preceding rules, a few select accounts are known as contra accounts. You will be exposed to these accounts in future chapters related to accounts receivable, plant assets, and certain long-term indebtedness. A contra account is an offset to another account and has opposite debit and credit rules. For example, matching the expenses of a building asset with an organization’s revenue over the passage of time can result in a reduction in the asset’s reported cost. This impact is reflected as accumulated depreciation, which is netted against (i.e., reported as contra to) the building asset. Thus, the accumulated depreciation is reported within the asset section but has opposite debit and credit rules (e.g., increased with a credit and vice versa). This concept will be covered in more sufficient depth later. T-Accounts No introduction to accounting would be complete without mentioning T-accounts. A T-account is not part of an accounting system; it is only a device that is used to demonstrate the impact of certain transactions and events. T-accounts are useful teaching tools. Accountants also use them when chatting about accounting effects. You can think of T-accounts as accounting on a napkin—a quick and informal way to look at an account. A T-account is shaped like a “T,” with debits on the left and credits on the right. Exhibit 3.1 illustrates T-accounts showing the effects of purchasing $50,000 of equipment for $10,000 cash and a $40,000 note payable. In this case, Equipment (an asset) is increased via the debit; Cash (an asset) is decreased via the credit; and Note Payable (a liability) is increased with the credit. When you meet with the accounting department liaison about your reports, your liaison may use T-accounts to review transactions you may be questioning. eps81189_03_c03.indd 43 12/20/13 8:49 AM CHAPTER 3 Section 3.4 Transaction Analysis Exhibit 3.1: Example T-accounts Equipment Dr. Cash Cr. Dr. Note Payable Cr. 50,000 Dr. 10,000 Cr. 40,000 The only limit to what can be illustrated within T-accounts is the size of the paper on which they are drawn. Exhibit 3.2 shows a T-account for Cash corresponding to all activity that impacted this particular account. Notice that the excess of debits over credits equals the ending cash balance. Later in this chapter, you will see a comprehensive example for Kaplan’s Medical Clinic, and this particular T-account will correspond to the cash transactions described therein. Exhibit 3.2: Sample T-account for Cash Cash Dr. Cr. Beginning balance $ 50,000 $ 6,000 Payable Services for cash 10,000 20,000 Collection 20,000 7,000 Wages Stock issue 12,000 5,000 Dividends Total debits 92,000 38,000 Resulting balance $ 54,500 Land Total credits Note that on a T-account there will only be a balance shown on one side of the “T.” In this sample of a Cash account, which is usually an account that has a debit balance, the balance is only shown in the debit column. 3.4 Transaction Analysis T he process of maintaining accountability over a business’s affairs begins with an analysis of each transaction. You must determine what accounts are impacted and how they are impacted (increased or decreased). These increase/decrease impacts are then translated into the accounting language of debits and credits. You may be wondering why it is not possible to just use increase and decrease to describe effects on accounts. Simply put, increases will not always equal decreases. eps81189_03_c03.indd 44 12/20/13 8:49 AM CHAPTER 3 Section 3.4 Transaction Analysis For example, if one purchased inventory (an asset) with an account payable (a liability), both sides of the balance sheet increase. In other words, Inventory increases on the asset side, and Accounts Payable increases on the liability side. When converted to debit/ credit consequence, the same transaction is described as a debit to Inventory (assets are increased with debits) and a credit to Accounts Payable (liabilities are increased with credits). Identifying a transaction where debits do not appropriately equal credits is impossible. Conversely, it is possible to identify a mishmash of transactions that display every conceivable combination of increases and decreases, some of which are offsetting and some of which are not. Is it starting to make sense why accountants stick with debit and credit nomenclature? Critical Thinking About Transaction Analysis Perhaps one of the more frustrating parts of learning accounting is developing the skills necessary to evaluate transactions and describe the debit/credit impacts on all affected accounts. This is akin to learning a new language. For most people, practice and repetition is required. If you try to skip over this part of the learning process, you will find yourself increasingly frustrated with future chapters. If you don’t take the time to learn these basics, you will have great difficulty working with your organization’s accountants when developing budgets and analyzing transactions for your department or division. Table 3.3 is not exhaustive but is intended to provide you with some added guidance and pra…

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