Learning Questions and Answers for Financial Accounting, Lesson 2.1 – Mastery Level

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Learning works better with repetition. It is like exercise. The more times you work on a muscle or on your understanding of a concept, the stronger you become. Everything we do in this course is based on that logic. Learning financial accounting will make you a better investor and/or lender. This knowledge gives you a strong tool that will help you analyze an organization. How was it done in the past and what are its prospects for the future? No one can guarantee that you will always make the right decisions about an organization. Nevertheless, the more you understand about financial accounting, the better your chances are for success.

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(1) – A company wants to construct a new warehouse. It buys lumber, cement, nails, braces, and all types of other needed items. It hires carpenters, bricklayers, electricians, and many other necessary people with a wide range of skills. The company also pays for additional costs such as electricity and insurance. After 10 months of hard work, the warehouse is complete and the company’s records show the cost of the warehouse as $1,274,339.25. What is the chance the actual cost is that exact amount?

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(2) – This is accounting. If a warehouse is said to cost $1,274.339.25, then that is what I expect the cost to be. Aren’t decision makers being misled if the reported numbers are not absolutely correct and accurate?

(3) – A warehouse is said to cost $1,274,339.25 but we know that really is not the exact cost. What can we say about that number? What should the decision maker know about the numbers that are presented in financial accounting?

(4) – What is a misstatement?

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(5) – What are the two types of misstatements?

(6) – What are the two types of fraud?

(7) – Misstatements clearly do happen. However, financial accounting wants to report information that is free of material misstatements. “Material” is an important term here. What is a material misstatement?

(8) – How is financial information described to decision makers to indicate that it contains no material misstatements?

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(9) – One of the chief challenges in preparing financial accounting information is uncertainty. In accounting terms, what is meant by uncertainty?

(10) – How does a company decide what to report when an outcome remains uncertain?

(11) – When a company faces uncertainty, does the reported information ultimately not have to be an estimation? How does financial information make certain that the users understand that what they are reading is not an absolutely assured figure?

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(12) – A language can enable one person to take information from his or her own mind and convey it to the minds of many other people. Language skills (along with opposable thumbs) are often credited with enabling human beings to rise above other animals. For example, if I say, “I drove to campus this morning in my blue car,” I have conveyed several pieces of information into your mind with seeming ease. Without having been present, you have a bit of knowledge about what I did earlier today. How does language allow one human being to communicate with another?

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(13) – Why is accounting frequently referred to as the language of business?

(14) – How does financial accounting manage to function like a language? How does it enable organizations to communicate successfully with investors and lenders?

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This information provides a good start to Chapter Two of Financial Accounting. Once you can answer each of the questions without hesitation, you will be exactly where you want to be in this course.

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Next are the answers. Read each one carefully and make notes of anything that you feel is especially important.

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(1) – A company wants to construct a new warehouse. It buys lumber, cement, nails, braces, and all types of other needed items. It hires carpenters, bricklayers, electricians, and many other necessary people with a wide range of skills. The company also pays for additional costs such as electricity and insurance. After 10 months of hard work, the warehouse is complete and the company’s records show the cost of the warehouse as $1,274,339.25. What is the chance the actual cost is that exact amount?

(1) – In truth, there is probably no chance that this number is the exact cost of the warehouse. There are simply too many variables, too many numbers, and too many events to keep up with during those months. Errors will happen. Information will be written down incorrectly. Numbers will be added wrong. It is not humanly possible to measure every penny, nickel, dime, and dollar down to the exact amount. Financial accounting is often viewed as having an obsession with monetary accuracy. Nothing could be further from the truth.

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(2) – This is accounting. If a warehouse is said to cost $1,274.339.25, then that is what I expect the cost to be. Aren’t decision makers being misled if the reported numbers are not absolutely correct and accurate?

(2) – Keep the fundamental goal of financial accounting in mind. The goal is not about exactness. Financial information helps decision makers judge the financial health and future prospects of a company. Those are imprecise projections. As long as the information is not too far off, decision makers should be able to use them to make wise decisions about the future of the reporting company. It would be extremely costly to add much greater precision. Plus, a lot of numbers in financial information are future estimates where exact precision is simply impossible. Educated decision makers understand that most of the numbers they are seeing are not exact and they should take that reality into consideration when making their decisions about an organization and its future. The same is true whether the decision maker is a potential investor or creditor/lender.

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(3) – A warehouse is said to cost $1,274,339.25 but we know that really is not the exact cost. What can we say about that number? What should the decision maker know about the numbers that are presented in financial accounting?

(3) – The information provided in financial information should never contain any type of material misstatement.

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(4) – What is a misstatement?

(4) – A misstatement is anything in financial information (a number, for example, or an explanation) that is incorrect. If the number says 24 and it really should be 28, that is a misstatement.

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(5) – What are the two types of misstatements?

(5) – (1) A misstatement can be an error. That is any reporting that is wrong by accident. In the cost of a warehouse, there are likely to be hundreds of small errors. No one counts every nail or measures every ounce of glue. (2) A misstatement can also be the result of fraud. Fraud occurs when the financial accounting information is wrong on purpose. No organization should tolerate fraud although small frauds might well exist. If an employee steals a pound of nails from a company, it might be nearly impossible to detect.

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(6) – What are the two types of fraud?

(6) – (1) Fraud occurs when financial records are manipulated to make the company look different than it actually is. An owner or employee might change information to make the company look especially prosperous so that it can obtain a loan or so that the capital stock price is more likely to rise. (2) Fraud also occurs when financial accounting information is changed to hide theft. No one wants to be caught stealing so perpetrators might change financial records to eliminate any evidence of wrongdoing.

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(7) – Misstatements clearly do happen. However, financial accounting wants to report information that is free of material misstatements. “Material” is an important term here. What is a material misstatement?

(7) – A material misstatement is one that is so large (millions of dollars perhaps) or so egregious (a blatantly illegal act, for example) that it would have caused a decision maker to make a different decision about the reporting organization. As an illustration, assume that a company reports owning a warehouse with a cost of nearly $1.3 million. A bank officer is impressed and loans the company money. However, the warehouse really only cost $800,000. The rest of the money was stolen by an employee. If the bank officer had known the actual state of affairs, the loan would not have been granted. By definition, that is a material misstatement because it led the decision maker away from making the proper decision.

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(8) – How is financial information described to decision makers to indicate that it contains no material misstatements?

(8) – Financial information is said to be “presented fairly” according to the rules that are being applied (such as U.S. GAAP). That means that the organization believes the information contains no material misstatements according to those rules. I often tell students that financial information that is presented fairly can be trusted by decision makers and used to help make wise decisions.

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(9) – One of the chief challenges in preparing financial accounting information is uncertainty. In accounting terms, what is meant by uncertainty?

(9) – Many events that happen to an organization take days, weeks, months, or even years to be finalized. A company buys inventory and officials wonder if the merchandise can be sold. A company sells inventory on credit and officials wonder if the cash will be collected. A company is sued because of a series of unfortunate events and officials wonder if the company will be held liable. A company buys a building and officials wonder how long the building will last. In the interim between the initial event and the ultimate resolution, officials are faced with the challenge of reporting that uncertainty in an honest and understandable fashion. Financial information describing uncertain events must be provided to decision makers even though the eventual outcome is not yet known.

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(10) – How does a company decide what to report when an outcome remains uncertain?

(10) – Company officials must gather as much evidential information as possible in hopes of arriving at a reasonable basis for reporting. Frequently, the company will determine what has happened in similar cases in the past and then adjust that information based on current conditions and the uniqueness of the present situation. For example, assume that over the past few years 3 percent of all accounts receivable are never collected. However, in the current year, economic conditions in the country and in the company’s locality are not doing well. More customers are struggling with making payments. Company officials might decide that 4 or 5 percent of the current accounts receivable will prove to be uncollectible. Where applicable, the company could also consult with people who are experts in the field. For example, if a company is being sued, well-known legal experts might be hired to help the company determine what amounts to report.

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(11) – When a company faces uncertainty, does the reported information ultimately not have to be an estimation? How does financial information make certain that the users understand that what they are reading is not an absolutely assured figure?

(11) – Financial information typically comes with a significant amount of verbal explanation. These disclosures help decision makers appreciate the nature of what they are analyzing. Decision makers should never rely solely on numbers. They should also read carefully any accompanying disclosures that provide vital information about those numbers.

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(12) – A language can enable one person to take information from his or her own mind and convey it to the minds of many other people. Language skills (along with opposable thumbs) are often credited with enabling human beings to rise above other animals. For example, if I say, “I drove to campus this morning in my blue car,” I have conveyed several pieces of information into your mind with seeming ease. Without having been present, you have a bit of knowledge about what I did earlier today. How does language allow one human being to communicate with another?

(12) – First, languages create defined vocabulary. Words such as “drove,” “campus,” and “car” are understood by anyone who has a knowledge of the English language. Second, languages have structural rules for grammar, syntax, and punctuation. Words cannot be arranged in a random fashion. “Campus red morning drove my I to this car in” are identical words but result in nonsense because structural rules have not been followed. Successful communication requires a set vocabulary and structural rules.

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(13) – Why is accounting frequently referred to as the language of business?

(13) – Financial accounting allows an organization to communicate financial information to decision makers such as investors and lenders. Financial accounting allows a company to communicate its financial results to literally millions of decision makers.

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(14) – How does financial accounting manage to function like a language? How does it enable organizations to communicate successfully with investors and lenders?

(14) – As we will see dozens of times throughout this course, financial accounting has a well-defined vocabulary. Terms such as “accumulated depreciation,” “LIFO,” “goodwill,” “research and development,” and “earnings per share” all have distinct meanings that are recognized and understood throughout the business world. In addition, this information is presented according to a strict set of structural rules (such as U.S. GAAP). A set terminology and structured rules can enable even the most complex financial information to be communicated successfully to decision makers.

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Now, go back through the questions at the beginning and see how many you can answer. Until you can get them all without hesitation, keep working on the process.

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