Test bank Financial accounting the impact on decision makers 9e

It is a statement of financial position and shows the assets, liabilities, and owners’ equity of a business at a ular point in time.. A statement of retained earnings links the income s

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Accounting as a Form

of Communication

Q U E S T I O N S

1 Business is concerned with all the activities necessary to provide the members of an

economic system with goods and services Some businesses are organized to earn a profit, whereas others are organized for some other purpose Regardless, all busi-nesses are organized to provide goods and/or services to their customers

2 An asset is a future economic benefit to a business Cash, accounts receivable,

mer-chandise inventories, and property and equipment are all examples of assets They are located on the left side of the accounting equation

3 A liability is an obligation of a business Assets and liabilities are related in that most

liabilities are satisfied by using assets, most often in the form of cash They are located

on the right side of the equation along with owners’ equity

4 The three forms of business entities are sole proprietorships, partnerships, and

cor-porations

5 The types of activities in which companies engage are financing, investing, and

operating To start a new business, such as renting bicycles and skis, requires initial financing, such as initial contributions by the owners and loans by a bank Next, the business would need to invest in the assets it will rent—that is, bicycles and skis Once investments in assets are made, the business would earn revenue by renting out bicycles and skis The business would also incur various operating expenses, such as wages, advertising, and taxes

6 Accounting is a communication process Its purpose is to provide economic

infor-mation about an organization that will be useful to those who need to make decisions regarding that entity For example, information provided by an accountant about an entity is useful to a banker in reaching a decision about whether to loan money to a business

7 Financial accounting and management accounting differ with regard to the users of

the information provided by the two branches of the discipline Management accounting is the branch of accounting that provides management with information to facilitate the planning and control functions The information provided by a manage-ment accounting system can be tailored to meet the needs of managers

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1-2 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

Alternatively, financial accounting is concerned with the preparation of pose financial statements for use by both management and outsiders Because the information provided by financial accounting must meet the needs of many different groups, it is necessary to rely on a set of generally accepted accounting prin-ciples in preparing the financial statements

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8 Many different groups rely on accounting information in making decisions For

example, investors and potential investors rely on financial statements and related

disclosures in deciding whether to sell or buy stock in a company This group is ticularly concerned with the recent profitability of the company as shown on the

par-income statement Bankers and other creditors need information to decide whether to loan money to a company or whether to extend an existing loan Many different gov-

ernment agencies have information needs that are specified by law The Internal

Rev-enue Service needs to know about a company’s profitability in levying taxes on it The Securities and Exchange Commission, the Interstate Commerce Commission, and the Federal Trade Commission also depend on the information provided by accountants

and financial position in negotiating contracts with the company for the employees

Trade associations rely on the information provided in financial statements in

compil-ing information for use by their members

and its liabilities Thus, it represents the claims of the owners to the assets of the business Therefore, it includes the contributions of the owners (e.g., capital stock) and retained earnings

and retained earnings Contributed capital, as represented by capital stock, is the inal contribution to the company by the owners Retained earnings represents the claims of the owners to the assets of the business These claims result from the earn-ings of the company that have not been paid out in dividends

11 The purpose of a balance sheet is to show the financial position of an entity as of a

particular point in time It consists of three distinct elements: assets, liabilities, and owners’ equity

12 A balance sheet should be dated as of a particular day It is a statement of financial

position and shows the assets, liabilities, and owners’ equity of a business at a ular point in time Unlike an income statement, it is not a flow statement and therefore

partic-is not dated for a particular period of time Balance sheets are typically prepared to coincide with the end of an accounting period, such as the end of the month or the end of the year

13 The cost principle is an accounting requirement to record an asset at the cost to

ac-quire it and report it on subsequent balance sheets at this amount

14 The purpose of an income statement is to summarize the revenues and expenses of

a company for a period of time It is an indicator of the profitability of an entity

15 An income statement should be dated for a particular period of time: for example, for

the month of June or for the year ended December 31, 2014 The income statement

is a flow statement because it summarizes revenues and expenses for a period of time Unlike a balance sheet, it is not an indication of position at any one particular point in time

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16 If Rogers has $55,000 in Retained Earnings to begin the year and net income for the

year of $27,000, the ending balance in Retained Earnings would be $82,000 if no dividends were paid during the year Because the ending balance in Retained Earn-ings is $70,000, the company must have paid $12,000 in dividends

17 Various groups are involved in determining the rules companies must follow in

pre-paring their financial statements In the United States, the Securities and Exchange Commission (SEC) has ultimate authority for companies whose securities are sold to the general public However, the SEC has relegated much of the standard setting to the private sector in the form of the Financial Accounting Standards Board (FASB) Standard setters in the United States continue to work closely with those in the inter-national community For instance, at one time, foreign companies that filed their finan-cial statements with the SEC were required to adjust those statements to conform to U.S accounting standards The SEC dropped this requirement, as long as foreign companies follow the standards of the IASB However, there are significant differ-ences between U.S and international standards; it may be some time before all dif-ferences are eliminated

18 In 2002, Congress passed the Sarbanes-Oxley Act The act was a direct response to

corporate scandals and was an attempt to bring about major reforms in corporate countability and stewardship, given the vast numbers of stockholders, creditors, em-ployees, and others affected in one way or another by these scandals Among the most important provisions in the act are the following: (1) the establishment of a new Public Company Accounting Oversight Board, (2) a requirement that the external au-ditors report directly to the company’s audit committee, and (3) a clause to prohibit public accounting firms who audit a company from providing any other services that could impair their ability to act independently in the course of their audit

19 The auditors may be in an excellent position to evaluate a company, but not

because they have prepared the financial statements The preparation of the ments is the responsibility of management The role of the auditor is to perform various tests and procedures as a basis for rendering an opinion on the fairness of the presentation of the statements

20 We assume in the absence of evidence to the contrary that a business will continue

indefinitely This assumption, known as the going concern assumption, helps to justify the use of historical costs in the statements For example, if we knew that a company was in the process of liquidation, it would not be appropriate to use historical costs in assigning an amount to such assets as land and buildings Instead, the current or market values of the assets would be more meaningful to a user of the balance sheet Because the normal assumption is that a business will continue indefinitely, the objectivity of historical cost makes it more attractive as a basis for valuation

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21 Inflation, as evidenced by the changing value of the dollar, poses a problem for the

accountant Accountants make the assumption in preparing a set of financial ments that the dollar is a stable measuring unit This assumption, called the monetary unit assumption, may or may not be accurate, depending on the level of inflation in the economy The higher the rate of inflation, the less reliable is the dollar as a meas-uring unit

22 Any profession must have a set of standards that govern the practice of the profession

In accounting, generally accepted accounting principles, or GAAP, are those methods, rules, practices, and other procedures that have evolved over time and that govern the preparation of financial statements Two important points are worth noting about GAAP First, these principles are not static but rather change in response to changes

in the ways companies conduct business Second, there is not a single, identifiable source of GAAP Both the private and public sectors have contributed to the develop-ment of generally accepted accounting principles

23 Although the Securities and Exchange Commission has the ultimate authority to

de-termine the rules in preparing financial statements, it has to a large extent allowed the accounting profession, through the Financial Accounting Standards Board, to estab-lish its own rules The SEC has at times taken an active role in the setting of account-ing standards It has stepped in when it has believed that the profession has not acted quickly enough or in the correct manner Since its inception in 1934, the commission has been more involved in the enforcement of GAAP as a means of protecting the rights of investors than it has been in setting standards

B R I E F E X E R C I S E S

Students will provide a number of different examples of real companies that are facturers, retailers, and service providers

When you own a share of stock in a corporation, you are part owner of that business In contrast, if you own one of the corporation’s bonds, you have made a loan to the company and you are one of its creditors

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The first activity for a new business is to secure financing Next, investing activities are needed to secure the necessary assets to then begin operating the business The order

of the activities is financing, investing, and operating

Stockholders, creditors (including banks, bondholders, and suppliers), and government agencies are all examples of external users

Assets = Liabilities + Stockholders’ Equity The two parts that make up stockholders’ uity are capital stock and retained earnings

The dollar is the monetary unit used in the United States, and the yen is used in Japan

The external auditors do not prepare the financial statements Management of the pany is responsible for preparation of the statements The auditors provide an opinion as

com-to the fairness of the financial statements

The four steps in the model presented in the chapter to help in making ethical decisions are:

1 Recognize an ethical dilemma

2 Analyze the key elements in the situation

3 List alternatives and evaluate the impact of each on those affected

4 Select the best alternative

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CHAPTER 2

Financial Statements and the Annual Report

invest-ment However, this does not mean that the cash flows of the company that has been invested in are not relevant A relationship exists between the cash flows to the inves-tor and those to the company For example, a company that does not consistently generate sufficient cash flows from its operations will not be able to pay cash dividends

to the investors over a sustained time

2 The understandability characteristic does not imply that someone must have an

extensive accounting background to be able to use financial statements However, accounting information should be understandable to those who are willing to learn to use it properly In other words, the information should make sense to someone who spends the time required to have a basic understanding of accounting

3 Relevance is the capacity of accounting information to make a difference in a financial

decision For example, an income statement is relevant when the use of it has at least the potential to make a difference in an investment decision

4 Comparability is the quality of accounting information that allows comparisons to be

made between or among companies Without it, financial statements would be very limited in their value Financial decisions require choices to be made about the investment of limited resources Investors need assurance that the financial statements of companies that they are considering as investments are comparable

5 Comparability is the quality of information that allows for comparisons to be made

between two or more companies, whereas consistency is the quality that allows for comparisons to be made within a single entity from one accounting period to the next

6 The concept of materiality is closely related to the size of a company For example,

assume that a company must decide whether a $500 expenditure that will benefit future periods should be expensed immediately or capitalized (i.e., recorded as an asset) The decision cannot be made without considering the amount in relation to the size of the company An amount that is immaterial for a large multinational corporation may be material for a smaller business

7 The IASB recognizes the same qualitative characteristics for useful information as

does the FASB The two groups are working together on a joint conceptual framework project, of which the chapter on qualitative characteristics is completed

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plies all meet this definition and are classified as current assets By their nature, the benefits from each of these assets will be realized during the normal operating cycle

of the business

9 The note payable will be classified on the balance sheet as long term until one year

from its maturity date At that time, it should be reclassified from long term to current because it will be paid within the next year Any liability that will mature within one year

of the date of the balance sheet should be classified as current, regardless of the original term of the loan (five years in this case)

10 Both capital stock and retained earnings represent claims of the stockholders on the

assets of the business They differ, however, in the source of those claims Capital stock represents the claims of the stockholders that arise from their contributions of cash and other assets to the business Retained earnings represent the accumulated earnings, or net income, of the business since its inception less all dividends declared during that time

11 Working capital is an absolute measure of liquidity That is, it is the total dollar amount

of current assets minus current liabilities One of the problems with working capital as

a measure of liquidity is that it does not allow someone to compare the relative liquidity

of two companies of different sizes Even within a single company, it may be difficult

to compare the relative liquidity of the company over time if the company has grown The current ratio (current assets divided by current liabilities) overcomes these defi-

assets and current liabilities

12 Capital structure refers to the right side of a balance sheet All items on the right side

of the balance sheet represent claims against the assets of the business: liabilities are the claims of outsiders, and stockholders’ equity is the claim of the owners on the assets of the business The capital structures of all companies differ in that some companies rely more on outsiders to provide assets, whereas others rely more on the owners to provide the necessary assets to run the business

13 The single-step income statement shows a subtotal for all expenses and deducts this

amount from total revenues The weakness of the single-step form for the income statement is that relationships between key items on the statement are not highlighted For example, the relationship between sales revenue and the cost of the products sold

is very important for a product-oriented company The difference between the two amounts is called gross profit and would appear on a multiple-step statement but not

in the single-step form

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14 A statement of retained earnings links the income statement and the balance sheet in

the following way A statement of retained earnings shows the beginning balance in the account, the addition (deduction) to the account for the net income (loss) of the period, and any deduction from the account for dividends The beginning balance in Retained Earnings is taken from the balance sheet at the end of the prior period The income statement indicates the net income for the period The ending balance in Retained Earnings appears on the balance sheet at the end of the period

15 An audit of a set of financial statements does not ensure that the statements contain

no errors Because of the sheer number of transactions entered into during a period

of time, it would be impossible for an auditor to check every single transaction to determine that it was correctly recorded Instead, through various types of tests, the auditor renders an opinion as to whether the statements are free of material mis-statement

16 The first note is the summary of significant accounting policies As the name implies,

the purpose of this note is to summarize all of the company’s important accounting policies, such as those relating to the method of depreciating assets and the method for valuing inventories

The overriding objective of financial reporting is to provide financial information to permit users of the information to make informed decisions Financial statements do not report the value of the reporting entity, but should provide useful information to allow users to make estimates of the value of the entity

INFORMATION

The two fundamental qualities that make accounting information useful are relevance and faithful representation Financial information is enhanced when it is understandable, com-parable, and consistent

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Accounts receivable—CA Furniture and fixtures—NCA

Cash—CA

Working Capital = Current Assets – Current Liabilities

Working Capital: $80,000 – $60,000 = $20,000

Current Ratio = Current Assets/Current Liabilities

Current Ratio: $80,000/$60,000 = 1.33 to 1

Lines that will appear on a multiple-step income statement, but not on a single-step come statement, are Gross profit, Total operating expenses, Income from operations, Excess of other revenues over other expenses, and Income before income taxes

Profit Margin = Net Income/Sales =

($100,000 – $60,000 – $15,000 – $10,000)/$100,000 = $15,000**/$100,000* = 15%

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LO 7 BRIEF EXERCISE 2-7 RETAINED EARNINGS

Ending retained earnings = $200,000 + $80,000 – $50,000 = $230,000*

$280,000

The amount borrowed from the bank, $100,000, would be reported on the statement of cash flows as an inflow from financing activities The amount used to buy a new piece of equipment, $80,000, would be shown on the statement of cash flows as an outflow from investing activities

In addition to the financial statements, an annual report usually includes the following items: a letter to the stockholders from either the president or the chair of the board of directors, a section describing the company’s products/services and markets, the auditors’ report, management discussion and analysis, and notes to the financial statements

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CHAPTER 3 Processing Accounting Information

1 Both external and internal events affect an entity An external event involves inter-

action with someone outside of the entity For example, the purchase of land is an external event An internal event takes place entirely within the entity, with no interaction with anyone outside of the company The transfer of raw materials into production is an internal event

2 Source documents are the basis for recording transactions They provide the

evi-dence, or documentation, needed to recognize an event for accounting purposes chase invoices, time cards, and cash register tapes are all examples of source docu-ments

3 Cash can take many different forms One of the most common forms is a checking

account Other forms include coin and currency on hand, savings accounts, money orders, certified checks, and cashier’s checks

4 An account receivable is an open account with a customer That is, the customer is

not required to have prior written approval each time a purchase is made, and no interest is charged Most open accounts must be paid in a short period of time, such

as 30 or 60 days A note receivable, however, involves a written promise from the customer to repay a specified amount, with interest, at a specified date Companies usually require customers to sign promissory notes for relatively large dollar amounts

of purchases

5 Assets and liabilities are opposites An asset represents a future benefit, and a liability

is an obligation to relinquish benefits in the future Therefore, an account payable is the opposite of an account receivable If Ace Corp provides a service to Blue Corp., Ace records an account receivable on its books Blue will record an account payable

on its books

6 The term double-entry system of accounting means that every transaction is entered

in at least two accounts on opposite sides of T accounts In this system, every action is recorded in such a way that the equality of debits and credits is maintained, and in the process the accounting equation is kept in balance (Appendix)

7 The right side of the accounting equation is merely a representation of the claims of

various groups on the assets of an entity The claims of the owners, as represented

by owners’ equity, are divided into two types: capital stock and retained earnings

Capital stock arises from amounts contributed by the owners to the business

Retained earnings represents the claims of the owners on the assets from the

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undistributed income of the business That is, it represents the accumulated earnings

over the life of the business that have not been returned to the owners in the form of dividends

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increased with a credit Keep in mind that debits and credits are tools to record creases and decreases in accounts To summarize, debits increase asset accounts, and credits increase liability and stockholders’ equity accounts Additionally, debits

9 Assets are positive in that they represent future economic benefits It is merely a

matter of convention that an asset is increased with a debit An expense is negative

in the sense that it reduces net income, which in turn reduces retained earnings, one

of the two elements of owners’ equity Because owners’ equity is on the opposite side

of the accounting equation from assets, it is increased with a credit Therefore, any item that reduces owners’ equity, like an expense, is itself increased with a debit You

should try to resist the temptation to associate the terms debit or credit with something good or something bad In accounting, debit means one thing: an entry made on the left side of an account A credit means an entry made on the right side of an account

(Appendix)

10 There are two sides to every transaction The two sides of the transaction when a

dividend is paid are the decrease in cash and the decrease in owners’ equity (owners’ equity is reduced because money is being returned to owners, and they have a smaller claim on the assets of the business) Assets are increased with debits and decreased with credits Cash is an asset and is therefore decreased with a credit Retained Earn-ings is on the opposite side of the accounting equation from assets and is therefore increased with a credit Retained Earnings is decreased with a debit Because divi-dends are a decrease in retained earnings, they are increased with a debit (Appendix)

11 When you deposit money in your account, the bank has a liability The entry on the

bank’s books consists of a debit to Cash and a credit to some type of liability account, such as Customers’ Deposits Therefore, when you make a deposit, the bank “credits” your account; that is, it increases its liability (Appendix)

12 A business actually saves time by first recording transactions in a journal and then

posting them to the ledger Because of the sheer volume of transactions, it would be impractical to prepare financial statements directly from the journal For example, with-out the use of ledger accounts, it would be necessary at the end of the period to go back and scan the journal to find every debit and credit to the Cash account in order

to prepare a balance sheet Whereas the journal serves as a book of original entry, the ledger accounts are the basis for preparing a trial balance, which in turn is used

to prepare the financial statements (Appendix)

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13 The T account is a simple device used in the study of accounting as well as by

accountants in analyzing transactions The left side of the account is used to record debits and the right side to record credits The running balance form for an account is more formal and includes not only columns for increases and decreases, but also a column for the balance in the account Another important element of the running balance form is a Posting Reference column The accountant places the page number

of the general journal in this column so that each entry in the account can be traced back to the relevant page in the journal (Appendix)

14 At the time of posting, the Posting Reference column of the account in the ledger is

filled in with the page number of the journal entry At the same time, the account ber is placed in the Posting Reference column of the journal This cross-referencing system used in posting allows the accountant to trace an entry made in the journal to the account it was posted to, or, conversely, to trace from an account back to the entry

num-in the journal (Appendix)

15 There is no standard rule about the frequency of posting entries from the journal to

the ledger The size of the company and the extent to which the accounting system is computerized will affect how often entries are posted For example, in a computerized system, it is possible for entries to be posted instantaneously to the ledger at the time they are recorded in the journal (Appendix)

16 A trial balance proves the equality of debits and credits It does not prove that the

correct accounts were debited and credited or that the correct amounts were sarily recorded It simply ensures that the balance of all of the debits in the ledger accounts is equal to the balance of all of the credits at any point in time (Appendix)

neces-B R I E F E X E R C I S E S

An external event involves interaction between an entity and its environment, such as a sale to a customer, a purchase from a supplier, or payment of wages to an employee An internal event occurs entirely within the company such as the use of furniture and fixtures within the company

Purchase invoice: acquisition of goods or services from a supplier

Sales invoice: sale of goods or services to a customer

Cash register tape: cash sale of goods or services to a customer

Time cards: payment of periodic payroll

Promissory note: borrowing money in return for promise to repay in future with interest

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The three elements in the accounting equation are assets, liabilities, and stockholders’ equity Stockholders’ equity consists of capital stock and retained earnings Net income,

as reported on the income statement, is an addition to retained earnings, which appears

on the balance sheet This connection between net income and retained earnings vides a link between the income statement and the balance sheet

Accounts Payable: credit

Office Supplies: debit

Interest Revenue: credit

Income Tax Expense: debit

Income Tax Payable: credit

Cash: debit

Common Stock: credit

Land: debit

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LO 6 BRIEF EXERCISE 3-6 JOURNALIZING TRANSACTIONS (Appendix)

Journal 1/10 Cash 150,000

Entry Capital Stock 150,000

Analysis Issued capital stock

Stock 150,000

Journal 1/12 Cash 100,000

Entry Notes Payable 100,000

Analysis Borrowed $100,000 at local bank

ASSETS = LIABILITIES +

STOCKHOLDERS’

NET INCOME Cash 100,000 Notes Payable 100,000

Journal 1/15 Land 200,000

Entry Cash 200,000

Analysis Acquired land for cash

STOCKHOLDERS’

NET INCOME Land 200,000

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CHAPTER 4

Income Measurement and Accrual Accounting

as cash and buildings Instead, what the user sees is a representation or depiction of the real thing The accountant describes with words and numbers the various items in the financial statements

2 Accountants strive to present financial statements that are relevant to the decisions

made by users of the statements, but sometimes there are trade-offs For example, in deciding whether or not an asset that a company pledges as collateral for a loan is sufficient, a banker may be most interested in the current value of the asset That is, this amount may be the most relevant attribute or characteristic of the asset for the banker’s needs The accountant, however, may be reluctant to present the current value of the asset on the balance sheet because of the difficulty in measuring the value of the asset The amount paid for the asset—that is, its historical cost—may be easy to determine, although not as relevant to the banker’s decision Because of its objective nature, historical cost is the attribute used to measure many of the assets recognized on the balance sheet

3 The realtor will recognize revenue from the sale of the home on July 8 if the cash basis

is used because this is the date cash is received Revenue will be recognized on June

12 if the accrual basis is used because this is the date the sale takes place and thus

is the date on which the revenue is earned

4 This statement is not entirely accurate Because it is based on historical cash flows, a

statement of cash flows is not necessarily the most accurate source of information on the future cash-flow prospects for a company An income statement may in fact pro-vide more important information about future cash flows For example, an income statement includes not only sales on a cash basis this period but also sales on credit that will generate cash flows in future periods Similarly, a statement of cash flows

reports only expenses that required a cash outlay in the current period An accrual-

based income statement provides information on accrued expenses that will result in

a cash outlay in future periods

5 The time period assumption is important in accounting because financial statement

users want information about a company as of a particular point in time and for distinct periods of time For example, a potential stockholder wants to know the financial position at the end of the most recent year and the profit of a business for the most recent year Under an accrual accounting system, revenues are recognized

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when they are earned regardless of when cash is received, and expenses are nized when they are incurred regardless of when cash is paid The accountant does not wait until all of the cash from a sale has been collected to report the sale and does not wait until the cash has been paid to report the expense on the income statement

recog-In this way, the user of the statement receives information on a timely basis

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6 No, the recognition of revenue is not always the result of the acquisition of an asset

Revenues are inflows of assets or reductions of liabilities from providing goods or vices to customers They must be realized and earned to be recognized on the income statement For instance, assume that a publisher sells a magazine subscription and collects cash from the customer in advance At the time cash is collected, the publisher incurs a liability As each month’s magazine is mailed to the customer, a portion of the liability is satisfied and revenue is recognized Thus, in some instances, revenue re-sults from the settlement of a liability

7 A company incurs a cost when it acquires an asset For example, assume that a

re-tailer buys office supplies for $100 on October 21 On this date, it has incurred a cost

of $100 to acquire an asset, namely office supplies The asset will be removed from

the records and an expense recognized, namely office supplies expense, when the

supplies are used up In summary, assets are unexpired costs and expenses are pired costs

8 Depreciation is the process of allocating the cost of a tangible long-term asset to

ex-pense over its useful life For example, the accountant attempts to recognize or match the cost of a machine as an expense over the period of time that the machine is used

to manufacture products

9 Adjustments are made at the end of an accounting period They are internal

transac-tions and therefore do not affect the Cash account Each adjustment involves either

four basic types of adjustments are:

a To recognize the expired portion of a prepaid expense For example, an

adjust-ment is needed at the end of each month to recognize insurance expense for the portion of an insurance policy that has expired during the period

b To recognize the earned portion of a deferred revenue or liability For example, a

publisher has to make an adjustment at the end of each period to recognize the earned portion of a subscription

c To recognize expense at the end of the period before cash is paid For example,

an adjustment is made at the end of the year to recognize income tax expense, even though the taxes will not be paid until early in the following year

d To recognize revenue at the end of the period before cash is received For

exam-ple, a landlord will need to make an adjustment at the end of the month for the rent owed by a tenant but not payable until some time during the following month

10 Balance sheet accounts are called real accounts because they are permanent and

are not closed at the end of a period Conversely, income statement accounts are called nominal or temporary accounts because they are closed at the end of the pe-riod For example, it would not make sense to close the Equipment account at the end

of the period The account should stay on the books as long as the company keeps the asset On the other hand, Depreciation Expense on the equipment is a temporary account that indicates the expense associated with using the asset during the period and is therefore closed along with all other income statement accounts at the end of the period

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11 Closing entries are made at the end of an accounting period They have two important

purposes: (1) to return the balance in all temporary or nominal accounts (revenues, expenses, and dividends) to zero to start the next accounting period and (2) to transfer the net income (or net loss) and the dividends of the period to Retained Earnings

The two possible attributes are historical cost and current value The simplest approach

is to show the property on the balance sheet at its original cost, thus the designation historical cost The use of historical cost is not only simple but also an amount that can

be agreed upon Assume that two accountants are asked to independently measure the cost of a parcel of land After examining the sales contract for the land, they should arrive

at the same amount An alternative to historical cost as the attribute to be measured is current value Current value is the amount of cash or its equivalent that could be received currently from the sale of the asset Current value is not as simple and often not as easy

to get agreement upon Because of its objective nature, historical cost is the attribute used

to measure many of the assets recognized on the balance sheet How-ever, certain other attributes, such as current value, have increased in popularity in recent years The dollar

is the unit of money used in the United States to measure items

a June 14

b April 5

c August 30

Revenues are inflows of assets or reductions of liabilities from providing goods or services

to customers They must be realized and earned to be recognized on the income ment It is not necessary for there to be an inflow of an asset in order to recognize reve-nue For example, revenue can be recognized when a company provides a service for which it had earlier received a deposit The deposit represents a liability, and it is satisfied when the service is provided Revenue is recognized continuously over a period of time for both rent and interest

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The merchandise will be reported on the December 31, 2014, balance sheet as a current asset Revenue from the sale, along with cost of goods sold expense, will be recorded in

2015, the year in which the merchandise is sold

*This is how the company which issued the gift card will record the adjustment when

the card is redeemed

If a work sheet is not prepared, financial statements would only be prepared after ing and posting adjustments

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CHAPTER 6 Cash and Internal Control

1 A cash equivalent is an investment that is readily convertible to a known amount of

cash and has an original maturity to the investor of three months or less It is included with cash on the balance sheet because the risk of a material loss on it is small Unlike other types of investments, such as those in stocks and bonds of other companies, the company holding a cash equivalent knows exactly how much cash will be received when it matures

2 A cash equivalent is convertible to a known amount of cash Therefore, the purchase

of a cash equivalent is not considered a significant investing activity to be reported on the statement of cash flows Cash equivalents are included with cash on the balance sheet, and thus the company is merely trading one cash item for another when it writes

a check and uses the proceeds to invest in a cash equivalent

3 The friend is correct in the observation that all receipts should be deposited intact for

control purposes However, no company should have a policy to maximize the balance

in checking accounts Other than a nominal interest rate paid, cash is a non-earning asset, and a minimal amount should be maintained in checking accounts to pay bills

as they are due Excess cash can be much more productive if it is invested in other assets, such as debt and equity securities, inventories, and plant and equipment

4 When the balance per the bank statement and the balance per the books are

recon-ciled to the correct balance, a service charge is deducted from the balance on the books However, if it is added to the balance per the bank, it is because the company

is reconciling the balance on the bank statement to the balance on the books The bank has deducted the charge from the balance it shows Because the company has not yet deducted this amount, a reconciliation of the bank balance to the book balance requires that the charge be added back

5 The Sarbanes-Oxley Act was passed in the wake of a number of high-profile cases

involving questionable accounting practices Congress decided that action by the eral government was needed to protect the interests of various parties that rely on corporate financial statements in making decisions

6 A board of directors normally is composed of a combination of key officers of the

cor-poration, such as the president, and outsiders The outsiders usually have been or are presently key officers themselves of other corporations or have significant business experience

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7 This misuse of corporate assets could have been prevented by having a procedure in

place for segregation of duties A single employee should not be allowed to order merchandise, receive it, and approve payment for it

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CHAPTER 6 • CASH AND INTERNAL CONTROL 6-3

8 There are a number of limitations on the efficiency of internal control First, a system

of internal control is not cost free For example, the segregation of duties may require

a larger staff than would otherwise be necessary An internal audit staff may be too costly for a small company Second, no system of internal control can prevent collu- sion by two or more employees Third, the lack of support from upper management may weaken an otherwise strong commitment to a system of internal control Finally, the element of human error can never be eliminated in any operation, regardless of how big or small

9 Two basic procedures are essential to good internal control over cash First, all cash

receipts should be deposited intact in a bank on a daily basis That is, no ments should be made from any amounts received prior to their deposit in the bank Second, all cash disbursements should be made by check The use of serially num- bered checks results in a clear record of all payments

10 There may be a benefit in terms of good customer relations to positioning a cash

reg-ister so that customers can read the display However, it is equally important for trol purposes If the customer can read the display, the sales clerk is less likely to ring

con-up a sale for less than the amount received and pocket the difference This control feature is certainly not foolproof in preventing this from happening, but it will act as a deterrent

11 An invoice rather than a purchase order is the basis for recording a purchase and a

corresponding liability (accounts payable) From a legal viewpoint, the purchase order

is merely an offer by the company to purchase and does not constitute by itself a legally binding contract The receipt of an invoice from the supplier is evidence that this outside party has accepted the offer and agreed to sell the merchandise under a particular set of terms and conditions

12 A receiving report is a document used by the receiving department to indicate the

arrival of inventory from a supplier In a computerized system, the same software gram that generates the purchase order also generates a receiving report, showing the various items ordered, the terms of payment, the shipper, and other important information On a blind receiving report, the columns for the quantities of each item are intentionally left blank Rather than being allowed to just check off that the number ordered were all received, the clerk must count the number actually received

13 A purchase invoice is compared with a purchase order to ensure that the goods were

in fact ordered The comparison of a receiving report with an invoice ensures that all goods that a company is being billed for were in fact received

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LO 3 BRIEF EXERCISE 6-3 SARBANES-OXLEY ACT

1 Management is responsible for establishing and maintaining an adequate internal

con-trol structure

2 The independent auditor provides an opinion as to whether management has

main-tained effective internal control over financial reporting

stockholders

4 The audit committee provides direct contact between stockholders and the

independ-ent accounting firm

LO 4 BRIEF EXERCISE 6-4 INTERNAL CONTROL PROCEDURES

Important internal control procedures include:

1 Proper authorizations

2 Segregation of duties

3 Independent verification

4 Safeguarding of assets and records

5 Independent review and appraisal

6 Design and use of business documents

LO 5 BRIEF EXERCISE 6-5 BUSINESS DOCUMENTS

2, 5, 6, 1, 3, 4

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CHAPTER 6 • CASH AND INTERNAL CONTROL 6-5

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Receivables and Investments

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1 The allowance method of accounting for bad debts tries to match one of the costs associated with granting credit, i.e., uncollectible accounts, with the revenue of the period Under the matching principle, an estimate of bad debts is made on the basis

of either the sales of the period or the accounts receivable at the end of the period The allowance method properly matches the revenue for the period against an expense for the same period

2 When bad debts expense is estimated by using the percentage of accounts receivable

approach, the balance already in the allowance account must be considered For example, if the estimate of the accounts receivable that will prove to be uncollectible is

$20,000 and the allowance account has a balance of $3,000 before adjustment, only

$17,000 has to be added to it Under the percentage of net credit sales approach, however, the emphasis is on the increase in Bad Debts Expense The balance in the allowance account before adjustment is ignored

3 An aging schedule is a refinement of the percentage of accounts receivable

approach to estimating bad debts The accountant categorizes the various receivables by the length of time they are outstanding The estimate of the percent uncollectible increases as the age of the accounts goes up

4 A note receivable arises from a written promise by someone to pay a specific

amount of money in the future with interest An account receivable arises from ing a customer an open line of credit and does not normally include interest

5 When a note receivable is discounted with recourse, it means that if the customer

fails to pay the bank the total amount due on the maturity date, the company that sold the note to the bank is liable to the bank for the full amount Therefore, during the time a discounted note is outstanding, the seller of the note is contingently liable Accounting standards do not require the seller to recognize the contingency as a liability, but a note is required to alert the statement reader of the uncertainty

6 The first CD should be classified as a cash equivalent because it has an original

maturity of three months or less The second CD is classified as a short-term investment It is a current asset because it will be converted into cash within the next year, even though its original maturity of more than three months disqualifies it from classification as a cash equivalent

7 Shares of common stock could be classified as either current assets or noncurrent

assets The intent of the company determines the proper classification If Stanzel purchases the Canby Company shares with the intent of selling them in the near term, they should be classified as current assets Otherwise, the shares should be classified as noncurrent assets

8 Any fees or commissions paid to purchase stock in another company should be added to the cost of the investment

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The effect of the adjustment at the end of the year can be identified and analyzed as follows:

Identify ACTIVITY: Operating

and ACCOUNTS: Allowance for Doubtful Accounts Increase

Analyze Bad Debts Expense Increase

STATEMENT[S]: Balance Sheet and Income Statement

STOCKHOLDERS’

NET INCOME Allowance for

Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable

Accounts Receivable Turnover = $240,000/[($40,000 + $20,000)/2]

Accounts Receivable Turnover = $240,000/$30,000 = 8 times

The effect of the adjustment at the end of the year can be identified and analyzed as follows:

and ACCOUNTS: Interest Receivable Increase

Analyze Interest Revenue Increase

STOCKHOLDERS’

NET INCOME Interest

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The effect of the collection can be identified and analyzed as follows:

and ACCOUNTS: Cash Increase Collection Fee Expense Increase

Analyze Sales Revenue Increase (decrease in Accounts

Receivable if sale was already recorded) STATEMENT[S]: Balance Sheet and Income Statement

STOCKHOLDERS’

NET INCOME

enue 10,000

Collection Fee Expense 400*

9,600

*4%  $10,000 = $400

The effect of the sale of the stock on March 5 can be identified and analyzed as follows:

Identify ACTIVITY: Investing

and ACCOUNTS: Cash Increase Investment in Stock Decrease

Analyze Gain on Sale of Stock Increase

STOCKHOLDERS’

NET INCOME Cash 12,300

2,200

FLOWS

deducted from net income under the indirect method of preparing the statement of cash flows Sales increase net income An increase in accounts receivable is an indication that sales exceeded cash collections; therefore, to arrive at cash from operations, a deduction is needed

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REAL WORLD PRACTICE 7.1

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CHAPTER 8

Operating Assets: Property, Plant,

and Equipment, and Intangibles

1 Operating assets include property, plant, and equipment, and intangibles They are

generally presented in two categories on the balance sheet: (1) Property, Plant, and Equipment and (2) Intangible Assets Examples of assets considered operating as-sets are buildings, equipment, land, land improvements, patents, copyrights, and goodwill Operating assets are important to the long-term future of the company be-cause they are the assets used to produce a product or service sold to customers The operating assets allow a company to produce a product efficiently and remain competitive with other firms

2 The acquisition cost of an operating asset includes all the costs normally necessary

to acquire the asset and prepare it for its intended use Acquisition costs include the purchase price, freight costs, installation costs, taxes paid at the time of purchase, and repairs made to prepare the asset for use

3 The acquisition cost of assets purchased as a group should be determined by

allo-cating the purchase price on the basis of the proportion of the fair market value to the total fair market value Market value is best established by an independent ap-praisal of the property If such appraisal is not possible, the accountant must rely on the market value of other similar assets, on the value of the assets in tax records, or

on other available evidence

4 It is important to separately account for the cost of land and building because the

amount allocated to a building represents a depreciable amount, while the amount allocated to land does not Land is not a depreciable asset

5 Generally, interest on borrowed money should be treated as an expense of the

period If a company buys an asset and borrows money to finance the purchase, the interest on the borrowed money is not considered part of the asset’s cost Therefore, interest is treated as a period cost and should appear on the income statement as interest expense in the period incurred There is one exception to this general guide-line If a company constructs an asset over a period of time and borrows money to finance the construction, the interest incurred during the construction period is not treated as interest expense Instead, the interest must be included as part of the ac-quisition cost of the asset

6 The decline in usefulness of an operating asset is related to physical deterioration

factors, such as wear and tear It is also related to obsolescence and technological factors and to the repair and maintenance of the asset A company should use a de-

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preciation method that allocates the original cost of the asset to the periods

benefit-ed and that allows the company to accurately match the expense to the revenue generated by the asset However, the company is not required to use the same method for all depreciable assets Actually, it is not unusual for a company to use two different depreciation methods for the same asset, one for financial reporting purposes and another one for tax purposes

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7 The straight-line method is the most popular method of depreciation for several

rea-sons, including its simplicity and ease of application It is most appropriate for assets that experience a decline in usefulness related to the passage of time It may also be used by companies that wish to report a stable income over time

8 When the straight-line method or units-of-production method is used, the residual

value should be deducted from the acquisition cost to determine the depreciable amount to be allocated over the useful life of the asset When the double-declining-balance method is used, the residual value is not deducted However, the asset should not be depreciated to an amount that is lower than the residual value

9 Companies may use one method of depreciation for financial reporting and another

method for tax purposes because the objectives are different The accountant’s purpose in recording depreciation for financial reporting purposes is to allocate the original cost of the asset to the periods benefited in a manner that matches the de-cline in usefulness of the asset The accountant’s purpose in recording depreciation for tax purposes is to minimize the amount of income tax that must be paid

10 If an estimate must be changed, the change in estimate should be recorded

pro-spectively over the remaining life of the asset Past amounts recorded for tion are not changed or altered The remaining depreciable amount should be recorded over the remaining life of the asset, using the revised estimate or estimates

deprecia-of residual value and asset life

11 A capital expenditure is an amount that must be capitalized or added to the value of

the asset A revenue expenditure is an outlay that should be recorded as an pense in the year incurred An item should be treated as a capital expenditure if it in-creases the life or productivity of the asset Otherwise, the amount should be treated

ex-as a revenue expenditure

12 The gain or loss on the sale of an asset should be calculated as the difference

be-tween the selling price and the book value of the asset as of the date of sale In der to calculate the correct gain or loss on the sale of the asset, depreciation must

or-be recorded up to the date of the sale A gain occurs when the selling price of the asset exceeds its book value A loss occurs when the selling price of the asset is less than its book value The account Gain on Sale of Asset or Loss on Sale of As-set should appear on the income statement in the Other Income/Expense category

13 Patents, copyrights, trademarks, and goodwill are examples of intangible assets

Some companies have a separate category on the balance sheet titled Intangibles for such assets Other companies include intangibles in a category titled Long-Term Assets or in the Other Assets category of the balance sheet

14 Goodwill represents the difference between the acquisition price paid to acquire a

business and the total of the fair market values of the identifiable net assets quired Goodwill can be recorded as an asset only when one company acquires an-other It cannot be recorded on the basis of internally generated factors that some may refer to as goodwill

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ac-15 An argument in favor of expensing R&D is that it allows comparability among firms,

since all firms must record the item as an expense Also, it is argued that R&D should be expensed because it is very difficult to determine whether an asset exists and, if it does exist, what periods are benefited by the asset On the other hand, many argue that R&D is an asset and should be recorded on the balance sheet They believe that if R&D is not recorded, the balance sheet is seriously understated

16 The current view of the FASB is that some intangible assets have a limited life and

should be amortized over their legal life or useful life, whichever is shorter However, some intangible assets are thought to have an “indefinite life” and should not be amortized This treatment of intangibles has been debated extensively, and many disagree with the current view Some would argue that the value of almost all intan-gible assets eventually becomes diminished and therefore amortization should be recognized

17 Amortization should occur over the shorter of the legal life or useful life For

exam-ple, a patent has a legal life of 20 years But if the invention under patent will be useful over only ten years, then the patent should be amortized over the shorter ten-year period

18 If an intangible becomes worthless, the asset should be written off as an expense in

the period when the decline in value occurs If the intangible continues to have value but will provide benefit over a period shorter than was originally estimated, the event should be treated as a change in estimate The portion of the intangible that is unamortized should be amortized over the remaining life of the asset

All of these accounts would be in the Property, Plant, and Equipment category except for Patent, which would be in the Intangibles category

Transportation costs—yes

Installation costs—yes

Repair costs incurred at time of purchase—yes, if it was known at the time of purchase that the item needed repair

Repair costs incurred after the asset has been installed and used—no

Interest on loan to purchase the asset—no

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LO 3 BRIEF EXERCISE 8-3 LUMP-SUM PURCHASE

1 Straight-line rate of 1/10 × 2 = 20%*

2 First-year depreciation: $40,000 × 20%* = $8,000

Second-year depreciation: ($40,000 – $8,000) × 20%* = $6,400

3 The maximum amount that can be treated as depreciation over ten years is $36,000

(*$40,000 – $4,000** residual value = $36,000)

beginning of each year As depreciation is recorded, the book value declines Thus,

a constant rate is applied to a declining amount This constant rate is applied to the full cost or initial book value, not to cost minus residual value as in the other methods However, the machine cannot be depreciated below its residual value of

$4,000.**

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