Learning Questions and Answers for Financial Accounting, Lesson 1.2—Mastery Level

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1

Read the questions first. If you have paid close attention to the material in the guided readings, you should be able to answer some (or maybe many) of these questions. Focus carefully on the ones that you do not yet know.

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After that, read through each answer. Think about the question and how the answer addresses that question. Once you are comfortable with each of these answers, go back through the questions at the top and try to answer them all. Not one-third or one-half but the goal is to be able to answer all of them.

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If necessary, go through the answers again. The goal is not to learn the material in the fastest way possible. There are no prizes for speed learning. The goal is to learn and understand the material completely so that you can make use of the knowledge after you complete this course and move into the next stage of your life.

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(1) – Assume you want to be an entrepreneur and are considering the possibility of creating a shop to produce and sell donuts. Before getting started, you decide to settle on a legal format. What are the three legal formats that are typically available to business organizations?

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(2) – This is not a law course but, in general terms, what is meant by incorporation?

(3) – Is a partnership not a separate legal entity?

(4) – In the U.S. virtually any businesses of any significant size will be a corporation. Why is that legal format so popular?

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(5) – Limited liability sounds appealing. Most people want to know how much they might lose in any situation. Why don’t all owners incorporate their businesses? Why are there millions of partnerships across the country?

(6) – Corporations are required to pay a significantly higher amount of income taxes. Why don’t all businesses become partnership and avoid paying that additional income tax?

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(7) – Assume a person wants to invest in a corporation and is looking at its financial information. The business’s ownership shares sell on a stock exchange for $19 per share. The person only wants to buy a small percentage of the ownership (perhaps 100 shares). How can this person possibly benefit from the acquisition of these ownership shares?

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(8) – Assume a person wants to invest in a corporation and is looking at its financial information. What does the potential investor hope to determine from assessing the financial information?

(9) – What is a dividend?

(10) – Who within a corporation makes the decision to distribute dividends?

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(11) – Who elects the board of directors? What are their responsibilities?

(12) – What are the ownership shares of a corporation called?

(13) – What rights do the owners of common stock have?

(14) – What rights do the owners of preferred stock have?

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(15) – Investors in ownership shares look at financial information and try to predict future dividends and future stock prices. In contrast, what is a person trying to predict who is considering giving a loan or granting credit to an organization?

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(16) – Accountants talk about the communication of financial information. What are the two characteristics typically associated with financial information?

(17) – What are some examples of information that qualifies as financial information?

(18) – Financial information should be delivered to decision makers in a logical framework. What makes up that framework?

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(1) – Assume you want to be an entrepreneur and are considering the possibility of creating a shop to produce and sell donuts. Before getting started, you decide to settle on a legal format. What are the three legal formats that are typically available to business organizations?

A business can become a corporation but only if the owners follow the appropriate legal requirements within a home state. This incorporation process is usually carried out in the state where the business is founded. However, it is possible to incorporate in another state if the law allows. A partnership is simply any business that is not incorporated and has more than one owner. A proprietorship is any business that is not incorporated and has only one owner.

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(2) – This is not a law course but, in general terms, what is meant by incorporation?

When owners meet the mandated requirements, an organization can be deemed by the state government to be a legal entity that is separate from its owners. A business (like Apple or PepsiCo) is a corporation that can take specific actions as if it were a person. Wikipedia explains this as follows: “Corporate personhood is the legal notion that a corporation, separately from its associated human beings (like owners, managers, or employees), has at least some of the legal rights and responsibilities enjoyed by natural persons. In the United States and most countries, corporations, as legal persons, have a right to enter into contracts with other parties and to sue or be sued in court in the same way as natural persons.” A corporation is not human, but it has many of the rights and responsibilities of a human.

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(3) – Is a partnership not a separate legal entity?

No, partnerships have no legal distinction from their partners. Actions of the partnership are assumed to be actions of the partners.

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(4) – In the U.S. virtually any businesses of any significant size will be a corporation. Why is that legal format so popular?

There is a separation of the owners from the corporation that is known as the “veil of incorporation.” This definition means that in most situations the owner is not responsible for any bad actions taken by the corporation. For the same reason, corporate owners can lose their entire investments but no more than that. They have limited liability. In addition, because of the separation, owners can usually sell their ownership shares without seeking permission from the business or the other owners. This last characteristic helps corporations grow in size as additional owners are brought in over time.

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(5) – Limited liability sounds appealing. Most people want to know how much they might lose in any situation. Why don’t all owners incorporate their businesses? Why are there millions of partnerships across the country?

Partnerships can require little or no effort to create. Any understanding between the partners can be used as the basis for a partnership. People appreciate things that are easy and cheap to accomplish. In addition, partnerships provide serious income tax benefits. Let’s assume the standard income tax rate is 30 percent. If a corporation earns income of $100,000, it pays income tax of $30,000. If the remaining $70,000 is then conveyed to the owners in the form of a salary or dividend, those individuals pay their own income tax of $21,000 (30 percent of $70,000) for a total tax of $51,000. If a partnership earns net income of $100,000, the partners are not viewed as separate so they pay the income tax of $30,000 (the income is said to “pass through” to the partners). However, if the business subsequently conveys that income to the partners, they have already paid their income tax and do not need to pay again. In corporations, income is taxed twice ($30,000 and $21,000). In partnerships, income is taxed once ($30,000). This example is simplistic but provides a sense of the enormous tax benefits of a partnership.

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(6) – Corporations are required to pay a significantly higher amount of income taxes. Why don’t all businesses become partnership and avoid paying that additional income tax?

Partners have unlimited liability. If an owner invests $20,000 in a corporation, the owner can lose that $20,000 but no more. However, if an owner invests $20,000 in a partnership, the owner can lose any amount of money depending on the actions of the business and the other partners. Unless individuals can be directly involved in operating the business so they can protect themselves, they do not like the risk of unlimited partnership liability. Furthermore, partners can normally not sell their ownership interest without the approval of other partners which makes the exchange of ownership difficult and limits the potential size of business growth.

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(7) – Assume a person wants to invest in a corporation and is looking at its financial information. The business’s ownership shares sell on a stock exchange for $19 per share. The person only wants to buy a small percentage of the ownership (perhaps 100 shares). How can this person possibly benefit from the acquisition of these ownership shares?

In the future, the business might pay a cash dividend. Or, the price of the company’s stock on the stock exchange could rise. Normally, those are the two ways that an investor makes money from an investment in a corporation’s ownership shares—through cash dividends and appreciation in the price of the company’s capital stock.

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(8) – Assume a person wants to invest in a corporation and is looking at its financial information. What does the potential investor hope to determine from assessing the financial information?

Ultimately, the typical investor can only make a profit from cash dividends and the rise in the price of the company’s stock. Therefore, the investor looks at the financial information in hopes of predicting future cash dividends and the future of the company’s stock price. Nothing is more fundamental to the importance of learning financial accounting than this benefit. Financial accounting is like a crystal ball. If you know how to read it, you can see into the future. If someone asks why you want to learn financial accounting, more than anything else that is the reason. If an investor believes the company is financially healthy and its future prospects are bright, that is strong evidence of future dividends and a rise in the price of the stock.

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(9) – What is a dividend?

A dividend is a transfer (usually of cash) from a corporation to its stockholders as a sharing of its profits. If a corporation earns income of $1 million in the current year, it might decide to pay nothing or a lot to its shareholders in the form of a dividend. Young companies often pay little or no dividends. They retain cash to stimulate increased growth. Mature companies often pay very significant dividends.

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(10) – Who within a corporation makes the decision to distribute dividends?

The board of directors makes that decision. Only the board has the authority to give away the assets of a corporation.

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(11) – Who elects the board of directors? What are their responsibilities?

The board of directors is elected by the stockholders to set corporate policy and oversee management. Because of the separation of owners and the business organization in a corporation, stockholders usually do not participate directly in operating activities. Instead, management is hired to run the company and the board of directors is elected to represent the stockholders and oversee and control the management.

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(12) – What are the ownership shares of a corporation called?

In general, they are called capital stock. Legally, capital stock is divided into two types of stock. All corporations have common stock shares that serve to establish basic ownership. A few corporations (maybe 5 percent) also have preferred stock shares.

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(13) – What rights do the owners of common stock have?

The rights held by the owner of a share of common stock is set by the laws of the state of incorporation. In general, if a dividend is paid by the corporation to the common stockholders, each owner is entitled to a percentage equal to the amount of ownership. Common stockholders are also allowed to vote for the members of the board of directors. Other rights might be available but they tend to be of less importance.

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(14) – What rights do the owners of preferred stock have?

The rights held by the owner of a share of preferred stock is set by the terms stated on the stock certificate. The certificate will specify the exact right (frequently a set cash dividend).

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(15) – Investors in ownership shares look at financial information and try to predict future dividends and future stock prices. In contrast, what is a person trying to predict who is considering giving a loan or granting credit to an organization?

Future dividends and stock prices would seem to be irrelevant to an entity trying to determine whether a loan should be awarded or credit should be granted. Potential creditors are most interested in looking at financial information and predicting whether the organization will have sufficient cash inflows to pay off the loan when due along with any interest charges. If adequate cash is expected to be available when the debt is due, this decision maker has all the information that is needed for this particular decision.

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(16) – Accountants talk about the communication of financial information. What are the two characteristics typically associated with financial information?

For financial accounting purposes, financial information is (1) stated in monetary terms and (2) reasonably objective (it can be verified). The accountant seeks to deliver monetary financial information in understandable terms and within a logical framework.

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(17) – What are some examples of information that qualifies as financial information?

The cost of a company’s inventory is $124,500. A company owes its employees a salary payment of $27,890. An automobile dealer sold a car to a customer for $30,500. All of these are stated in monetary terms and can be verified (so they are objective).

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(18) – Financial information should be delivered to decision makers in a logical framework. What makes up that framework?

As we will explore throughout this course, financial accounting information can be delivered in many forms but the primary method is through the creation and reporting of financial statements. For example, the cost of inventory, the amount owed to employees, and the revenue received from selling a car can all be found at an appropriate spot within a company’s financial statements. Many companies include financial statements within a larger package referred to as an annual report. If you are curious to know more, pick a company that you know (such as McDonald’s) and go on the Internet and search for “most recent financial statements for McDonald’s” or “most recent annual report for McDonald’s.” Start looking to see what information you might find and understand. Over the following weeks and months of this course, we will learn what a great deal of that information signifies to decision makers.