Guided Readings for Financial Accounting, Lesson 2.1 – Mastery Level

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“What Should Decision Makers Know in Order to Make Good Decisions about an Organization?” The following guided reading cards were designed to accompany Chapter Two of the updated third edition (Version 3.1) of Financial Accounting authored by Hoyle, Skender, and Kratz (published by FlatWorld). Copyright 2022 by Joe Hoyle

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Watch the opening video for Chapter Two: Introduction to Chapter Two. This video takes less than 11 minutes, but it outlines the entire chapter. By watching the video and then reading the chapter, you begin to gain an understanding of the vital concepts and terms discussed here. Your foundation level of knowledge will increase and help you to enter the world of business as a wiser decision maker.

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Read the first section of Chapter Two (“Creating a Portrait of an Organization that Can Be Used by Decision Makers.”) As you read, consider how this new material builds on the coverage in Chapter One. What is a decision maker actually seeing when presented with the financial information that an organization reports?

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(2Q1) – Ace Company recently constructed a large building to use in its manufacturing operations. The building is reported to have cost the company $32,976,500. Why is that number not exactly accurate? Is financial accounting not supposed to produce correct and accurate information?

(2A1) – Many organizational events (such as constructing a building) have so many separate, complicated transactions to monitor that exact correctness is impossible. In addition, reported events often require estimations. Many estimates prove to be close to correct but very few will achieve exact accuracy. And, decision makers do not need (or even expect) exact accuracy in order to make wise decisions about investing or lending. Why strive for a level of correctness that is neither possible nor needed?

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(2Q2) – Ace Company recently constructed a large building to use in its manufacturing operations. The building is reported to have cost the company $32,976,500. It is often said that decision makers do not need exact accuracy when analyzing financial information. Why not? In reporting construction of this building, why do the figures not need to be correct to the penny?

(2A2) – Decision makers study reported financial information in order to make investing or lending decisions about an organization. They are often attempting to estimate future dividends, stock prices, and cash flows. Financial information can be used for those purposes without achieving precise accuracy. Reported information needs to be close enough to reality to present a usable likeness. Exact accuracy (even if possible) would be more costly to obtain than the potential benefit to decision makers.

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(2Q3) – Ace Company recently constructed a large building to use in its manufacturing operations. The building is reported to have cost the company $32,976,500. Decision makers normally understand that the cost will not be that exact amount. In general, how close should a reported balance be to the actual figure?

(2A3) – Financial accountants assert that they produce a reasonable likeness that can be used by outside decision makers to make wise decisions about an organization’s financial health and future prospects. Accountants sometimes say that they “paint a portrait” of the organization. They produce a useful likeness that enables recognition (and decision-making) although it can never be absolutely perfect.

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(2Q4) – Ace Company recently constructed a large building to use in its manufacturing operations. The building is reported to have cost the company $32,976,500. Specifically, how close to reality does that figure need to be to be judged a reasonable likeness that decision makers can use?

(2A4) – The goal in financial accounting is to produce financial information that contains no material misstatements. Although the $32,976,500 figure does not have to be exactly correct, it must not be materially misstated.

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(2Q5) – Ace Company recently constructed a large building to use in its manufacturing operations. The building is reported to have cost the company $32,976,500. In financial accounting, before information is reported, all material misstatements should be eliminated. What is a misstatement?

(2A5) – A misstatement is simply something that is incorrect according to the rules of U.S. GAAP. A number being reported might be wrong or some part of a verbal explanation could be misleading. Both of these problems are misstatements because the information provided to decision makers is incorrect. A misstatement means that reported information contains some level of inaccuracy.

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The following statement is from the end of chapter material in the textbook. It is true. Explain why it is true. A corporation reports sales of $33,453,750, when the actual figure was $33,453,843. This financial information contains a misstatement. (True or False?)

As indicated, this statement is True. The number that is reported by this corporation is wrong and, therefore, misstated. Because the misstatement is only $93, it is very unlikely to be material. Nevertheless, it is still wrong.

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Work the first Test Yourself question in Section 2.1 of Chapter Two (“For the year ending, January 31, 2018, Walmart reported having made sales…”). You are presented with an actual reported figure from the financial information of a well known company. This question helps make sure you understand the nature of reported information that decision makers analyze. Determine the answer you believe is correct and then carefully read the explanation. This should take only 2-4 minutes.

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(2Q6) – A misstatement is anything reported in financial information that is incorrect. In financial accounting, there are two types of misstatements. What are those two types of misstatements?

(2A6) – In financial accounting, a reported amount or verbal description might be misstated (or incorrect). That misstatement could have resulted from an error—it occurred by accident. A person could have added several numbers together incorrectly by mistake. Or, the misstatement could be the result of fraud—it occurred on purpose. A misstatement might be accidental (error) or might be on purpose (fraud).

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(2Q7) – A misstatement can happen by either an error (accident) or fraud (on purpose). Why would a misstatement be caused by fraud?

(2A7) – Fraud occurs for one of two reasons. First, someone alters a number or some other reported information to make the company look better. A company might need a bank loan or officials could be attempting to increase the market price of the capital stock. Reported information is changed so the company looks more financially healthy. This is known as “cooking the books.” Second, someone changes a number to hide theft. If money is stolen, numbers are often altered to cover up or eliminate evidence of that action.

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(2Q8) – Financial accounting information is useful for decision makers but only if it contains no material misstatements. A misstatement is something that is wrong and can be caused by an error or by fraud. What is meant by the term “material?”

(2A8) – A material misstatement is an error or fraud that is of a size or a type that is so significant that it is likely to affect a decision maker’s decision. A material misstatement is one that can cause an improper decision to be made. If net income is reported as $112,000 but is really $111,000, that misstatement will probably not affect an investor or lender decision and is, thus, not material. If reported net income is $112,000 but is actually only $10,000, that misstatement is probably material. It is likely to affect a decision.

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(2Q9) – Financial accounting information can be used by decision makers for lending or investing decisions if it contains no material misstatements (according to rules of U. S. GAAP). What term is used to describe such financial information?

(2A9) – Information that contains no material misstatements is said to be “presented fairly.” Or, in some cases, it is said to have “representational faithfulness.” Either way, the financial information is viewed as being a reasonable likeness that a decision maker can rely on and study to assess an organization’s financial health and future prospects.

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Work the second Test Yourself question in Section 2.1 of Chapter Two (“For the year ending, January 31, 2018, Walmart reported earning net…”). This question can help you understand the nature of the financial information reported by businesses and other organizations.

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Read the second section of Chapter Two (Section 2.2,“Dealing with Uncertainty”). As you read, think about the kinds of events that an accountant reports about a company. Then, consider where uncertainty might exist in reporting these events. For example, you buy merchandise to sell but can you actually sell it? If so, for how much? Can you collect the sales price from the customer? How can such events be presented fairly when their conclusion is not yet known?

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(2Q10) – Why is future uncertainty such a serious problem for the people who prepare financial accounting information?

(2A10) – Decision makers need information quickly so they can make decisions in a timely manner. No one can wait until the results of every event are fully known. Thus, financial information necessarily contains a great many estimates. How long will a computer continue to work? How much money will be lost in a lawsuit? How many customers will fail to pay their debts? Reporting such uncertainty is a major challenge for financial accounting because it requires an educated guess that might prove to be very wrong.

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(2Q11) – Assume a company has a major uncertainty such as a lawsuit or large amount of receivables that might not be collected. How are those events reported in financial accounting?

(2A11) – Reporting uncertainty is one of the most intriguing challenges found in financial accounting. Accountants do not have a time machine or an accurate crystal ball. They must rely on their own ingenuity to come up with estimates that are presented fairly. Each type of uncertainty creates its own particular difficulties. Accountants gather all the data they can find and use it to establish reasonable reported information.

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(2Q12) – People in business often refer to accounting as the language of business. Why is that reference made?

(2A12) – Languages allow people to convey information. Languages enable the communication of ideas and events between parties because the terminology is set and structural rules exist. Organizations can communicate a plethora of useful information to decision makers because accounting (a) establishes terminology with definite meanings and (b) creates structural rules for the clear communication of financial information.