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CHAPTER 1

THE NATURE AND PURPOSE OF ACCOUNTING
Changes from Eleventh Edition
The chapter has been updated. The Maria Hernandez & Associates case has been replaced with the
Ribbons an’ Bows Inc. case.
Approach
On the first day the usual ob!ecti"e is to create interest in the sub!ect to set the scene and to #i"e an
o"er"iew of the course. The first part of the chapter does this. The second part of the chapter #i"es a fairly
specific introduction to the nature of financial accountin#. Instructors probably $ay want to brin# in
$aterial fro$ their own readin# or e%perience to $a&e the introductory points.
Cases
The cases are intended to #et the student to start thin&in# li&e accountants and users of accountin#
infor$ation without &nowled#e of any of the techni'ues. Ribbons an’ Bows #i"es students an
opportunity to construct a si$ple set of financial state$ents. Kim Fuller can be used as a sprin#board for
any type of discussion( uses of infor$ation by "arious parties the cost of record)&eepin# or e"en the
de"elop$ent of a co$plete accountin# syste$. Baron Coburg illustrates practically all of the basic
accountin# concepts without na$in# the$. It is a difficult case but enli#htenin# e"en for those with
so$e prior accountin# trainin#.
Problems
Problem 1-1
CHARLES COMPA!
"ALACE SHEE# AS O$ %ECEM"ER &1' ----(
Assets Liabilities and O)ners* E+,it-
*ash........................................................................................................................................................................................ + ,-... Ban& loan............................................................................................................................................................................... + /....
In"entory................................................................................................................................................................................ 01... Owners’ 2'uity
Other assets............................................................................................................................................................................ ,3... Owners’ e'uity.................................................................................................................................................................... 4....
Total assets............................................................................................................................................................................. +,-....
Total liabilities and
owners’ e'uity........................................................................................................................................................................ +,-....
This proble$ can be used to e%plain certain accountin# presentation con"entions. 5or e%a$ple the use of
double lines to underscore a total the position of the dollar si#n at the top of a colu$n of nu$bers and
the datin# of the balance sheet.
The purpose of this proble$ is to illustrate the e'uality of the basic accountin# e'uation( assets e'ual
liabilities plus owners’ e'uity.
,
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
Problem 1-.
The $issin# nu$bers are(
6ear ,
7oncurrent assets................................................................................................................................................................................. +/,.089
7oncurrent liabilities............................................................................................................................................................................ -/.1,4
6ear -
*urrent assets....................................................................................................................................................................................... + 0.//-
Total assets........................................................................................................................................................................................... -44/19
7oncurrent liabilities............................................................................................................................................................................ 84141
6ear 3
Total assets........................................................................................................................................................................................... +-/8,31
*urrent liabilities.................................................................................................................................................................................. ,1143
Total liabilities and owners’ e'uity...................................................................................................................................................... -/8,31
6ear /
*urrent assets....................................................................................................................................................................................... + 90.0.
*urrent liabilities.................................................................................................................................................................................. ,8130
The basic accountin# e'uation is
Assets : ;iabilities < Owners’ e'uity
The instructor $i#ht want to e%plain how this e'uation is used =as it is in this proble$> to calculate ?plu#@
nu$bers when $ana#ers construct pro!ected balance sheets. The $ana#er does not ha"e to co$plete
e"ery balance because the $ana#er can plu# certain balances.
The instructor $ay also draw attention to the other e'uations illustrated in the proble$. These include(
*urrent assets < 7oncurrent assets : Total assets
*urrent liabilities < 7oncurrent liabilities : Total liabilities
Aaid)in capital < Retained earnin#s : Owners’ e'uity.
;ater in the course the instructor should e%plain that the additional paid)in capital account is a special
account to record the e%cess of capital recei"ed o"er par "alue in co$$on stoc& issuances. At this sta#e
in the course it is better to si$ply use a descripti"e ter$ li&e paid)in capital to describe capital recei"ed
fro$ stoc&holders. Also it a"oids the use of the ter$ co$$on stoc& which so$e students $any not
understand.
-
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
Problem 1-&
The $issin# nu$bers are(
6ear ,
Cross $ar#in........................................................................................................................................................................................ +0...
Ta% e%pense......................................................................................................................................................................................... ,,-.
6ear -
Dales..................................................................................................................................................................................................... +,,094
Arofit before ta%es................................................................................................................................................................................ -1/8
6ear 3
*ost of #oods sold
.................................................................
.............................................................................................................................................................................................................
+-449
Other e%penses..................................................................................................................................................................................... 9-09
Other accountin# e'uations such as the followin# are also illustrated by this proble$(
Cross $ar#in : Dales ) *ost of #oods sold
Arofit before ta%es : Cross $ar#in ) Other e%penses
7et inco$e : Arofit before ta%es ) Ta% e%pense
The instructor $ay want to point out to the students that ratios are often used by $ana#ers to construct
pro!ected financial state$ents. 6ear / is an e%a$ple of this application.
In order to esti$ate 6ear / the &ey ratios to co$pute are(
!ear 1 !ear . !ear & Average
Dales..................................................................................................................................................................................................... ,....E ,....E ,....E ,....E
Cross $ar#in........................................................................................................................................................................................ 81.. 81.. 81.. 81..E
Arofit before
ta%es..................................................................................................................................................................................................... -3.3 -,.3 -..1 -,.8E
7et inco$e........................................................................................................................................................................................... ,/.. ,-.4 ,-.- ,3..E
Ta% rate................................................................................................................................................................................................ /... /... /... /...
6ear /
Dales..................................................................................................................................................................................................... +,....
*ost of #oods sold................................................................................................................................................................................ -1..
Cross $ar#in =81E of sales>................................................................................................................................................................ + 81..
Other e%penses..................................................................................................................................................................................... 133.
Arofit before ta%es =-,.8E of sales>...................................................................................................................................................... + -,8.
Ta% e%pense......................................................................................................................................................................................... 48.
7et inco$e =,3E of sales>................................................................................................................................................................... + ,3..
The basic accountin# e'uation used is( 7et inco$e : Re"enues ) 2%penses
3
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
Problem 1-/
The e%planation of these ,, transactions is(
,. Owners in"est +-.... of e'uity capital in Ac$e *onsultin#.
-. 2'uip$ent costin# +8... is purchased for +1... cash and an account payable of +-....
3. Dupplies in"entory costin# +,... is bou#ht for cash.
/. Dalaries of +/1.. are paid in cash.
1. Re"enues of +,.... are earned of which +1... has been reco"ered in cash. The re$ainin# +1...
is owed to the co$pany by its custo$ers.
9. Accounts payable of +,1.. are paid in cash.
8. *usto$ers pay +,... of the +1... they owe the co$pany.
4. Rent 2%pense of +81. is paid in cash.
0. Ftilities of +1.. are paid in cash.
,.. A +-.. tra"el e%pense has been incurred but not yet paid.
,,. Dupplies in"entory costin# +-.. are consu$ed.
ACME COS0L#12
"ALACE SHEE# AS O$ 30L! &1' ----(
Assets Liabilities and O)ners* E+,it-
*ash..................................................................................................................................................................................................... +,-81. Accounts payable................................................................................................................................................................................. + 8..
Accounts recei"able............................................................................................................................................................................. /...
Dupplies in"entory................................................................................................................................................................................ 4.. GGGGGG
*urrent assets................................................................................................................................................................................. ,811. *urrent liabilities.................................................................................................................................................................................. 8..
2'uip$ent............................................................................................................................................................................................ 8... Owners’ e'uity..................................................................................................................................................................................... -341.
Total assets........................................................................................................................................................................................... +-/11.
Total liabilities
and owners’ e'uity............................................................................................................................................................................... +-/11.
ACME COS0L#12
1COME S#A#EME# 30L! 1 - &1' ----(
Re"enues.............................................................................................................................................................................................. +,....
2%penses
Dalaries............................................................................................................................................................................................ /1..
Rent................................................................................................................................................................................................. 81.
Ftilities............................................................................................................................................................................................ 1..
Tra"el.............................................................................................................................................................................................. -..
Dupplies........................................................................................................................................................................................... -.. 9,1.
7et inco$e.................................................................................................................................................................................. + 341.
/
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
ACME COS0L#12
CASH RECE1P#S A% %1S"0RSEME#S' 30L! 1 - &1' ----(
Receipts
Owners’ in"est$ent......................................................................................................................................................................... +-....
*ash sales........................................................................................................................................................................................ 1...
*ollection of accounts recei"able.................................................................................................................................................... ,...
Total receipts.............................................................................................................................................................................. +-9...
Hisburse$ents
2'uip$ent purchase........................................................................................................................................................................ +1...
Dupplies purchase............................................................................................................................................................................ ,...
Dalaries paid.................................................................................................................................................................................... /1..
Aay$ents to "endors........................................................................................................................................................................ ,1..
Rent paid......................................................................................................................................................................................... 81.
Ftilities paid.................................................................................................................................................................................... 1..
Total disburse$ents.................................................................................................................................................................... +,3-1.
Increase in cash.......................................................................................................................................................................... +,-81.
The chan#e in this cash account includes the owners’ in"est$ent which is not an inco$e state$ent ite$.
The inco$e state$ent includes re"enues and e%penses that ha"e not yet been recei"ed in cash or paid in
cash. The cash paid to purchase the e'uip$ent is not reflected in the inco$e state$ent. =It is probably
best if the instructor does not discuss depreciation at this point in the course.>
This proble$ illustrates se"eral i$portant points that $ana#ers should understand. These are(
a. 2"ery transaction in"ol"es at least two accounts.
b. 7et inco$e is not e'ui"alent to the net chan#e in the cash account durin# an accountin# period.
c. *ash is influenced by both balance sheet and inco$e state$ent e"ents.
d. The basic accountin# e'uation =Assets : ;iabilities < Owners’ e'uity> can be used to capture
illustrate and e%plain the accountin# conse'uences of $any =but not all> transactions and e"ents that
in"ol"e a co$pany.
The cash receipts ) disburse$ents display is used since it would be pre$ature to introduce the cash flow
state$ent display at this point in the course.
Problem 1-4
Cash 5
Acco,nts
Receivable 5
S,pplies
1nventor- 5 E+,ipment 6
Acco,nts
Pa-able 5
O)ners*
E+,it-
,. < +-1... < +-1... In"est$ent
-. ) 1.. ) 1.. Rent
3. < +4... < +4...
/. ) 1.. < +1..
1. ) 81. ) 81. Ad"ertisin#
9. ) 3... ) 3... Dalaries
8. < -... < +4... < ,.... *o$$issions
4. ) 1... ) 1...
0. ) ,.. ) ,..
,.. < ,... ) ,... 2%penses
1
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
"O 7O!A2E #RA7EL
"ALACE SHEE# AS O$ 30E &8' ----(
Assets Liabilities and O)ners* E+,it-
*ash..................................................................................................................................................................................................... +,8-1. Accounts payable................................................................................................................................................................................. + /...
Accounts recei"able............................................................................................................................................................................. 4... *urrent liabilities............................................................................................................................................................................. /...
Dupplies in"entory................................................................................................................................................................................ /.. Owners’ e'uity..................................................................................................................................................................................... -091.
*urrent assets.................................................................................................................................................................................. -191.
2'uip$ent............................................................................................................................................................................................ + 4... GGGGGG
Total Assets................................................................................................................................................................................ +3391.
Total liabilities
and owners’ e'uity...................................................................................................................................................................... +3391.
"O 7O!A2E #RA7EL
1COME S#A#EME# 30E 1-&8' ----(
*o$$issions........................................................................................................................................................................................ +,....
2%penses..............................................................................................................................................................................................
Rent................................................................................................................................................................................................. +1..
Ad"ertisin#...................................................................................................................................................................................... 81.
Dalaries............................................................................................................................................................................................ 3...
Dupplies........................................................................................................................................................................................... ,..
Misc. 2%penses................................................................................................................................................................................ ,... 131.
7et Inco$e................................................................................................................................................................................. + /91.
"O 7O!A2E #RA7EL
CASH RECE1P#S A% %1S"0RSEME#S 30E 1-&8' ----(
Receipts
Owners’ in"est$ent....................................................................................................................................................................... +-1...
*ollection of co$$issions............................................................................................................................................................. -...
Total receipts........................................................................................................................................................................... +-8...
Hisburse$ents
Aaid rent......................................................................................................................................................................................... + 1..
Bou#ht supplies............................................................................................................................................................................. 1..
Bou#ht ad"ertisin#......................................................................................................................................................................... 81.
Aaid salaries
..................................................................................
.......................................................................................................................................................................................................
3...
Aaid "endors.................................................................................................................................................................................. 1...
Total disburse$ents................................................................................................................................................................. + 081.
Increase in cash.......................................................................................................................................................................... +,8-1.
Dee Aroble$ ,)/ for why chan#e in cash account and the $onth’s inco$e are not the sa$e.
The proble$’s purpose and lessons for $ana#ers are si$ilar to those in Aroble$ ,)/.
9
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
Case 1-1: Ribbons an’ Bows, Inc.
ote9 This is a ne# case *or the T#el*th +dition,
Approach
This is an introductory case and it should be tau#ht as an introductory case. There will be
plenty of ti$e in the course for the students to learn the correct for$ of financial state$ents and
details of accountin# standards. In short the instructor should be prepared to allow a "ariety of
for$ats for the financial state$ents and tolerate so$e ?not 'uite correct@ accountin#.
The instructor $ay want to ha"e students discuss *ar$en’s March 3, state$ent but the
bul& of the class should focus on the three case 'uestions. Any discussion of the March 3,
state$ent should deal with the nature of the "arious accounts =i.e. prepaid rent is rent paid in
ad"ance of usin# the property and it is an asset because it has future econo$ic benefits for the
co$pany etc> rather than the for$at of the state$ent. It is better to lea"e the be#innin# of the
course’s instruction in financial state$ent for$ats to the assi#ned case 'uestion discussions.
Comments on 1nformation 2athered and Carmen*s Concerns
,. The three $onth sales total is the su$ of the cash sales =+8/..> and credit sales =+3-.>.
-. *ost of sales is deri"ed fro$ the followin# e'uation
Be#innin# $erchandise in"entory +33..
Alus Aurchases -0..
2'uals Total a"ailable $erchandise +9-..
;ess 2ndin# $erchandise in"entory /,..
2'uals *ost of sales +-,..
3. Rent e%pense is +,4.. of +9.. per $onth ti$es three $onths. Aaid in cash.
/. Aart)ti$e e$ployee e%penses =+,9..> is the su$ of cash paid =+,1,.> plus a$ount owed
=+0.>.
1. Dupplies e%pense =+4.> is be#innin# supplies in"entory =+,..> less supplies in"entory on
hand on March 3, =+-.>.
9. The prepaid ad"ertisin# =+,1.> was run by the local paper on April -. The benefit of the
asset e%pired so the asset beca$e an e%pense.
8. The co$$ercial sewin# $achine purchase led to an +,4.. asset bein# recorded =a future
benefit>. The asset’s benefit was partly consu$ed durin# May and Iune resultin# in a +9.
depreciation char#e =+,4..J 1 yearsJ ,- $onths % - $onths K strai#ht line depreciation.>
4. Do$e of the future benefits of the co$puter and related software asset were consu$ed
durin# the three $onth period. A +-1. depreciation char#e $ust be reco#nized =+-...J
-J ,-J % 3 K strai#ht line depreciation.>
0. *ash balance at the end of period lower than be#innin# balance. Dee Luestion ,
discussion.
,.. 5our $onth’s interest $ust be recorded on the cousins’ +,.... loan. =+,.... % ..9 % /J
,->. *ar$en has ?rented@ the cousins’ $oney for four $onths. =Dhe for#ot to include the
March rent in her March 3, balance sheet.>
,,. 7o depreciation is recorded on the cash re#ister loaned by the local credit)card char#e
processor and the furniture left by the for$er tenant. These ?assets@ were not reco#nized
8
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
on the financial state$ent because they were neither donated nor ac'uired in business
transactions.
,-. The uncle’s le#al wor& is neither an asset nor an e%pense of the business. It did not result
in a business transaction.
,3. *ar$en’s potential salary pay$ent in Iuly is neither an e%pense nor a liability as of
March 3,. The co$pany does not ha"e an obli#ation on March 3, to pay her any
co$pensation.
:,estion 1
2%hibit , presents the co$pany’s initial three $onth inco$e state$ent. It does not
contain a pro"ision for ta%es since *ar$en at this early date did not &now if inco$e ta%es
would be due on the annual results.
The principal reasons why the cash balance declined durin# the three $onth profitable
operatin# period are(
,. The co$$ercial sewin# $achine purchase reduced cash by +,4.. while the
related depreciation char#e only reduced inco$e by +0..
-. 2ndin# in"entory was hi#her than be#innin# in"entory and the increase was paid
for with cash. That is $ore in"entory was bou#ht for cash =+-0..> than the cost
of #oods sold =+-,..>.
2%hibit - present a cash flow analysis for the three $onth operatin# period.
:,estion .
2%hibit 3 presents the co$pany’s Iune 3. balance sheet.
:,estion &
*ar$en’s business is off to a #ood start but it will ha"e to do better o"er the rest of the
year if *ar$en plans to pay herself any $eanin#ful co$pensations and repay the cousins’ loan at
the end of the year.
Mhen discussin# Luestion 3 so$e students belie"e that *ar$en should include a
consideration of an i$puted co$pensation e%pense in decidin# how well she has done. Dtudents
accept the non reco#nition of her co$pensation in the inco$e state$ent but belie"e she should
reco#nize that personally she has incurred an opportunity cost for lost wa#es =at least four
$onths % +,3..>.
In addition students belie"e *ar$en’s nonreco#nition of any cost associated with usin#
the abandoned counters and display e'uip$ent o"erstates how well she is doin# fro$ an
econo$ic point of "iew. These students would include so$e depreciation cost based on the
asset’s fair "alue in their e"aluation of how ?successful@ the business has been to date.
4
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
Do$e students ad"ocate includin# the free le#al ad"ice’s "alue =+9..> in their assess$ent
of the co$pany’s success to date.
The instructor $ay challen#e the class to consider why these ite$s =free le#al ad"ice
i$puted salary and depreciation> are not included in the co$pany’s inco$e state$ent.
E;hibit 1
Ribbons an* "o)s
1ncome Statement for the Period
April 1 to 3,ne &8' .88<
Dales +88-.
*ost of Dales =-,..>
Cross Mar#in +19-.
2$ployee wa#es =,9..>
Rent =,4..>
Office Dupplies =4.>
Hepreciation K *o$puter =-1.>
Hepreciation K Dewin# Machine =9.>
Interest =-..>
Ad"ertisin# =,1.>
Arofit before Ta%es +,/4.
E;hibit .
Ribbons an* "o)s
Anal-sis of Cash $lo)s for the Period
April 1 to 3,ne &8' .88<
Be#innin# *ash +/...
Dales 8/..
Ma#es =,1,.>
Rent =,4..>
Merchandise In"entory =-0..>
Dewin# Machine =,4..>
2ndin# *ash +330.
0
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
E;hibit &
Ribbons an* "o)s
"alance Sheet as of 3,ne &8' .88<
Assets ;iabilities
*ash +330. Ma#es owed +0.
Accounts recei"able 3-. Interest owed -..
Merchandise In"entory /,.. *ousins’ loan ,....
Dupplies -. +,.-0.
Arepaid rent ,-.. Owner’s 2'uity
*o$puter =net> ,81. *ar$en’s e'uity +,...
Dewin# $achine =net> ,8/. 2arnin#s ,/4.
*ash re#ister deposit -1. +-/4.
Total +,-88. Total +,-88.
Case 1-2: Kim Fuller
ote 19 This case is u)dated *rom the Kim Fuller case in the +le-enth +dition,
ote .9 The instructor should be a#are that the name. Kim Fuller. could re*er either to a male or a
*emale, The case uses no )ronouns that indicate gender to re*er to Kim Fuller/ the gender o*
Kim Fuller has been le*t o)en to inter)retation b the students and!or the instructor,
Approach
This case is not as it $ay appear to be an ?ar$chair@ case. It is a real situation)the case writer is one of
?Ni$ 5uller’s@ =dis#uised na$e> sisters who in"ested in the business. The intent of the case is to #et
students to be#in thin&in# about the financial infor$ation needs of a business and what &inds of
underlyin# records $ust be $aintained in order to support those needs. Do$e instructors $ay e"en wish
to discuss the nature of the re'uired source docu$ents since we often tend to i#nore that i$portant $atter
in accountin# courses. 5inally the case can be used to be#in introducin# at an intuiti"e le"el so$e of the
,, basic concepts that will be presented in *hapters - and 3.
Comments on :,estions
An openin# 'uestion $i#ht be ?Mhat infor$ation does Ni$ 5uller need to $aintain in order to operate
this businessO@ Then as students be#in to identify infor$ation needed the instructor can press for ?Mho
needs that infor$ationO Mhat do they need it forO@ The infor$ation needed as well as the users and uses
can be recorded on the blac&board. The dia#ra$ in Illustration ,), of the te%t can be used to su$$arize
for students the "ariety of infor$ation and purposes they ha"e identified. As su##ested in the te%t this
infor$ation includes such thin#s as detailed payroll records for 5uller’s e$ployees records of deli"eries
=which are sales> to 5uller’s custo$er and for$er e$ployer the che$ical fir$ and the a$ounts owed for
these sales records concernin# purchases of used plastic bottles and the a$ounts owed to the sources of
,.
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
these bottles chec&boo& records records of the costs of the ite$s of plant and e'uip$ent owned by the
business records of the business’s $ort#a#e pay$ents and balance and records of who the fir$’s owners
are and the a$ount of each one’s ownership interests.
By this point in the discussion you will li&ely ha"e de"eloped a lon# list of infor$ation ite$s that are
re'uired. I li&e to point out that we need so$e way of or#anizin# this $assi"e a$ount of infor$ation. The
financial fra$ewor&)especially the balance sheet and the inco$e state$ent)pro"ides a con"enient way to
or#anize $uch but not all of this infor$ation. As students list the co$pany’s infor$ation needs they
should classify it as either accountin# or non)accountin# infor$ation.
This leads naturally to a discussion of which infor$ation would appear in balance sheet accounts
=Luestion -> which in turn pro"ides an opportunity to introduce the entity $oney $easure$ent cost
#oin# concern and dual aspect concepts =all described for$ally in *hapter ->. The a$ount of ti$e spent
on this discussion can be "aried #reatly at the discretion of the instructor( if assi#ned for a first session
the usual first)day ?house&eepin#@ announce$ents will necessarily cause this discussion to be briefP if
used on Hay - of the course the case can readily #enerate 9.)4. $inutes of discussion if students are
pressed to be specific in their reco$$endations.
The balance sheet called for in Luestion - $i#ht loo& li&e this(
Assets Liabilities and O)ners* E+,it-
*ash..................................................................................................................................................................................................... + 1.... Mort#a#e.............................................................................................................................................................................................. +,,-...
2'uip$ent............................................................................................................................................................................................ 91... Total paid)in capital............................................................................................................................................................................. ,91...
Buildin#............................................................................................................................................................................................... ,9-... GG GGGGG
+-88... +-88...
Luestion 3 pro"ides the opportunity to introduce the ti$e period $atchin# and $ateriality concepts
althou#h so$e of the basic concepts in *hapter 3 $ay be too difficult to introduce at this point =e.#.
conser"atis$>. It $ay also be possible to introduce the distinction between product costs and period costs.
Luestion 3 to#ether with Luestion / also naturally leads to the distinction between financial accountin#
and $ana#e$ent accountin#. Mith only a few fa$ily $e$bers as owners and with the ban&’s $ort#a#e
on the buildin# well secured =by definition> the co$pany’s financial reportin# re'uire$ents are rather
$ini$al. Indeed fa$ily)owned businesses of this s$all size and si$plicity often prepare annual financial
state$ents for ta% purposes and then distribute these sa$e state$ents to the fa$ily owners and ban&.
Howe"er 5uller would be well ad"ised to ha"e inco$e state$entsQand probably also cash flow
state$entsQprepared at least 'uarterly and perhaps $onthly to help ensure that the business is not
slippin# into any financial holes. These would be $ana#e$ent accountin# reports but they $ay of
course be shared with the in"estors. =The D$all Business Ad$inistration periodically reports that poor
$ana#e$ent accountin# records particularly inade'uate records of productJproduction costs are a $a!or
cause of s$all business failures>. Flti$ately 5uller will ha"e to !ud#e the e%tent of the need =and cost
!ustification> for preparation of for$al $ana#e$ent accountin# reports to supple$ent 5uller’s personal
obser"ation of the business. Of course the proble$ encountered by $any businesses is that reports are
not introduced as the business #rows and beco$es too co$ple% to be $ana#ed pri$arily by the personal
obser"ation of its owner)founder)#eneral $ana#er and this person slowlyQoften unwittin#lyQloses
control of the business.
In su$ students should #lean fro$ their discussion of this case the idea that there are so$e accountin#
?uni"ersals@P but at the sa$e ti$e the accountin# records of a fir$ should fit its particular situation not
"ice "ersa. This is true whether the fir$ is startin# with an entirely $anual accountin# syste$ or whether
it is purchasin# so$e ?off)the)shelf@ accountin# software for use on a personal or s$all business
co$puter.
,,
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
Case 1 -3: Baron Coburg
ote( This case is unchanged *rom the +le-enth +dition, It is ada)ted *rom an 0academic note.1 #ritten
b 2,T, Andre#s o* 'uil*ord College. #hich a))eared in the A)ril 13&4 Accounting 5e-ie#, 6arts
o* this commentar are ada)ted *rom 6ro*essor Andre#s’s note.
Approach
This case enables a student to disco"er a nu$ber of i$portant accountin# concepts that are described in
detail in *hapters - and 3. The students also disco"er intuiti"elyQand of necessityQthe relationship
between two balance sheet ?snapshots@ and the inco$e state$ent for the inter"enin# period. In #eneral
the case illustrates the usefulness of the accountin# function( It would be al$ost i$possible to co$pare
the two perfor$ances without the lo#ical structure of accountin#.
Do$e instructors will prefer to ha"e students read and briefly discuss this case near the end of one class
identifyin# the basic proble$s of the caseQwhat $easure$ent unit is to be used what the entities are and
who their owner=s> is =are> what a balance sheet shows what an inco$e state$ent shows and how
relati"e perfor$ance $i#ht be $easured. Then the ne%t class can be de"oted to discussin# proposed
state$ents. Other instructors will prefer to assi#n the case without any su##estions as to how a student
should attac& the proble$. =I personally fa"or the latter approach whereas Arofessor Andrews su##ests
the for$er.> I find that the case wor&s well not only with be#innin# students but also in $ana#e$ent
de"elop$ent pro#ra$s where there are se"eral e%perienced accountants in the #roup.
Comments on :,estions
The first issue confronted by the students is the definition of the entity. As Luestion , i$plies each plot
can be re#arded as an entity e"en thou#h both plots are owned by the Baron. =Dtudents should realize this
earlier because the Baron is referred to as a ?landlord@ or because they recall so$ethin# about feudalis$
fro$ a $edie"al history course.> The definition of separate entities is needed in order to co$pare their
econo$ic results.
The second $atter students $ust resol"e is the basis of measurement, Althou#h this is referred to as the
mone $easure$ent concept in *hapter - this case illustrates that a barter)e'ui"alent $easure$ent unit
Qhere bushels of wheatQcould also be used as a co$$on deno$inator to "alue unli&e thin#sP a
$onetary unit is si$ply easier to use in $ost instances.
Third students $ust decide the basis of "aluation. This issue arises $ost clearly in the case of the land
which is said to be ?worth@ fi"e bushels of wheat per acre. At this early sta#e $ost students will "alue
the land at this a$ount per acreP but *hapter - will e%plain that assets are usually "alued at ac7uisition
cost. not current "alue. Of course the ac'uisition cost is indeter$inable in this instance so the Baron’s
appraisal is the only a"ailable "aluation basis. Di$ilar co$$ents apply to the o%en.
At this point de"elop$ent of the balance sheet can be#in. I find it useful to de"elop an intuiti"e concept
of an asset and then say that as each asset is "alued we will also record who pro"ided the financin# for
the asset and who therefore has a clai$ =e'uity> a#ainst the entity’s assets. This leads to the be#innin#
balance sheets for the far$s as shown below.
7ote that I ha"e not called the Alot wor&ed by I"an ?I"an’s Alot@ because that $i#ht su##est to a student
that I"an owns the Alot. Also the balance sheet status report $ust show the date at which the status
?snapshot@ was ta&en. Dince the Baron has #i"en =i.e. contributed> the assets all of the e'uities are his. I
ha"e not included the plows assu$in# that the ?snapshots@ were ta&en as the far$ers left the castle. It is
useful e"en if no student raises the 'uestion to as& how the balance sheets would differ if the
?snapshots@ were ta&en after a plow had been ac'uired for each far$.
,-
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
"ALACE SHEE# $OR PLO# =OR>E% "! 17A
As of the "eginning of the 2ro)ing Season
Assets 2'uities
Deed...................................................................................................................................................................................................... -. bu. Baron’s e'uity...................................................................................................................................................................................... ,9- bu.
5ertilizer............................................................................................................................................................................................... -
O%........................................................................................................................................................................................................ /.
;and..................................................................................................................................................................................................... ,..
Total........................................................................................................................................................................................... ,9- bu. Total............................................................................................................................................................................................. ,9- bu.
"ALACE SHEE# $OR PLO# =OR>E% "! $RE%ER1C>
As of the "eginning of the 2ro)ing Season
Assets 2'uities
Deed...................................................................................................................................................................................................... ,.bu. Baron’s e'uity...................................................................................................................................................................................... ,., bu.
5ertilizer............................................................................................................................................................................................... ,
O%........................................................................................................................................................................................................ /.
;and..................................................................................................................................................................................................... 1.
Total........................................................................................................................................................................................ ,., bu. Total........................................................................................................................................................................................ ,., bu.
"ALACE SHEE# $OR PLO# =OR>E% "! 17A
As of the End of the 2ro)ing Season
Assets 2'uities
O%........................................................................................................................................................................................................ 39 bu. Aayable to 5eyador............................................................................................................................................................................... 3 bu.
;and..................................................................................................................................................................................................... ,.. Baron’s e'uity(
Mheat................................................................................................................................................................................................... --3 *ontributed capital............................................................................................................................................................................... ,9-
Alow..................................................................................................................................................................................................... . Retained earnin#s................................................................................................................................................................................. ,0/
Total..................................................................................................................................................................................................... 310 bu. Total............................................................................................................................................................................................... 310 bu.
"ALACE SHEE# $OR PLO# =OR>E% "! $RE%ER1C>
As of the End of the 2ro)ing Season
Assets 2'uities
O%........................................................................................................................................................................................................ 39 bu.
;and..................................................................................................................................................................................................... 1. Baron’s e'uity(
Mheat................................................................................................................................................................................................... ,.1 *ontributed capital............................................................................................................................................................................... ,., bu.
Alow..................................................................................................................................................................................................... - Retained earnin#s................................................................................................................................................................................. 0-
Total........................................................................................................................................................................................ ,03 bu. Total................................................................................................................................................................................................. ,03 bu.
7e%t the endin# balance sheets can be prepared. This will raise the notion of de)reciation, Most students
will intuit the write)down of each o% fro$ /. bushels to 39 bushels since each has a useful life of ,.
years. The bro&en down plow used by I"an will be $ore troubleso$e especially since it hasn’t been paid
for. I as& students to i#nore for the $o$ent how this plow was financedP does the plow ha"e any further
"alue to the far$O They then see that it should be "alued at zero thou#h it’s not a bad idea to show it on
the balance sheet since it has not yet been disposed of. The plow used by 5rederic& is treated analo#ously
to the o%en.
On the e'uities side the three bushels owed to 5eyador introduce the concept of a liability and raise the
distinction between a liability and owners’ e'uity. Aresu$ably I"an has incurred this liability as the
Baron’s a#entP i.e. it is the entity’s obli#ation not a personal debt of I"an. Me also can distin#uish
,3
Accounting: Text and Cases 12e – Instructor’s Manual Anthon!"a#$ins!Merchant
between the Baron’s initial e'uity now labeled ?contributed capital@ and the earnin#s thus far retained
on the far$ =?in the entity’’>. At this sta#e I introduce the dual as)ect concept and treat retained earnin#s
as a ?plu#@ =i.e. balancin#> a$ount. This #i"es the endin# balance sheets that appear on pa#e ,3 of this
$anual.
7e%t I su##est we try to e%plain why the Baron’s e'uity =specifically retained earnin#s> increased by
,0/ bushels and 0- bushels for the respecti"e far$s. Thus students see at the start of the course that flow
state$ents ?articulate@ with the be#innin# and endin# status reports. Our e%planation of this chan#e will
be called of course an inco$e state$ent.
It is i$portant to brin# out how production assets =as opposed to $onetary assets> beco$e e%penses as the
assets pro"ide their utility. This is strai#htforward for the seed and fertilizer but less so for o%en and
plows. Also students need to see that so$e of the wheat production has been distributed to the
plow$a&er and to the owner with the result that these production a$ounts are lar#er than those shown
for Mheat on the endin# balance sheet. I also point out that althou#h we ha"e treated the wheat produced
as re"enues in practice re"enues are usually based on #oods sold not #oods produced. =As a $atter of
fact the ?production $ethod@ is per$issible for certain readily $ar&etable co$$odity ite$s such as
wheat as described in *hapter 1.>
The case $a&es no $ention of pay$ents to the peasants for their ser"ices =?labor e%pense@>. I point out
that this would reduce Mheat and Retained earnin#s on the balance sheet and would increase production
e%penses on the inco$e state$ent.
7ote that the inco$e state$ents are labeled with the applicable time )eriod, The distinction between
e%penses and owners’ drawin#s =or ?di"idends@> should be e%plained.
=Inco$e state$ents appear on pa#e ,1 of this $anual.>
At this point we can discuss perfor$ance co$parisons. How should we deter$ine which was the ?better@
plotO The plot wor&ed by I"an produced ,.89 as $uch wheat as the plot wor&ed by 5rederic&P but the
for$er had twice as $uch acrea#e. =Dince both plots had the sa$e "alue per acre one can reasonably
presu$e that they were potentially e'ually producti"e.> This raises the concept of return on in-estment,
Treatin# be#innin# assets =which in this case also e'uals be#innin# owners’ e'uity> as the in"est$ent
base the plot wor&ed by I"an returned ,3- percent =-,/ di"ided by ,9-> whereas the plot wor&ed by
5rederic& had an ROI of ,-, percent =,-- di"ided by ,.,>. This see$s parado%ical since the first plot
returned only ,..8 bushels per acre whereas the second returned ,-.- bushels per acre. The e%planation
lies in the fact that I"an used ?his@ o% twice as producti"ely as did 5rederic&. I then as& students to
pretend that ?half an o%@ could ha"e been ac'uired for use on 5rederic&’s plot and then ad!ust the ROI
fraction. Addin# - to the nu$erator =- bushels less depreciation e%pense> and subtractin# -. fro$ the
deno$inator =half the cost of an o%> #i"es ROI of ,13 percent =,-/ di"ided by 4,>. This "i"idly illustrates
the i$pact on ROI =,-, "s. ,13 percent> of operatin# with e%cess production capacity.
If a student should raise ?profit $ar#in@ as a co$parison criterion this enables pointin# out the fallacy of
this $easure e"en in this case where the entities are en#a#ed in identical endea"ors =the sa$e industry>.
I"an’s $ar#in was 44., percent 5rederic&’s was 44./ percentP a#ain the plot wor&ed by I"an had better
perfor$ance =ROI> despite ha"in# a sli#htly lower $ar#in because of better utilization of the o%.
7ote howe"er that this o% utilization was out of the peasants’ control. Thus I"an was not necessarily a
better far$er than 5rederic&. This points up the difference between e"aluatin# the econo$ic perfor$ance
of an entity and the perfor$ance of its $ana#er a distinction e$phasized in Aart - of the te%t.
,/
B2%%& Mc'ra#("ill!Ir#in Cha)ter 1
1COME S#A#EME# $OR PLO# =OR>E% "! 17A
$OR #HE 2RO=12 SEASO
Mheat produced................................................................................................................................................................................... -/3 bu.
Aroduction e%penses(
Deed................................................................................................................................................................................................. -. bu.
5ertilizer.......................................................................................................................................................................................... -
O% usa#e.......................................................................................................................................................................................... /
Alow usa#e...................................................................................................................................................................................... 3 -0
2arnin#s............................................................................................................................................................................................... -,/
Mithdrawn by owner............................................................................................................................................................................ -.
Increase in retained earnin#s................................................................................................................................................................ ,0/ bu.
1COME S#A#EME# $OR PLO# =OR>E% "! $RE%ER1C>
$OR #HE 2RO=12 SEASO
Mheat produced................................................................................................................................................................................... ,34 bu.
Aroduction e%penses(
Deed................................................................................................................................................................................................. ,. bu.
5ertilizer.......................................................................................................................................................................................... ,
O% usa#e.......................................................................................................................................................................................... /
Alow usa#e...................................................................................................................................................................................... , ,9
2arnin#s............................................................................................................................................................................................... ,--
Mithdrawn by owner............................................................................................................................................................................ 3.
Increase in retained earnin#s................................................................................................................................................................ 0- bu.
,1

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