Guided Readings for Financial Accounting, Lesson 3.1 – Mastery Level

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“How Is Financial Information Delivered to Decision Makers Such as Investors and Creditors?” The following guided readings cards were created to accompany Chapter Three of the updated third edition (Version 3.1) of Financial Accounting authored by Joe Hoyle, C. J. Skender, and Leah Kratz and published by FlatWorld. Copyright 2022 by Joe Hoyle

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Watch the opening video for Chapter Three: Introduction to Chapter Three.

This video introduces you to Chapter Three. The main focus of this chapter is on financial statements, the primary mechanism for reporting financial information to decision makers. Note the structure and contents of each of those financial statements. If you wish, search the Internet for the financial statements of a large company such as PepsiCo and begin to look at the information.

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SUGGESTION: Read the first section of Chapter Three (“Construction of Financial Statements Beginning with the Income Statement”). The basic financial statements (and notes) that companies distribute to decision makers are introduced in this chapter. In the first section, the income statement is highlighted. You will learn about the general presentation of revenues and expenses but also gains, losses, cost of goods sold, income taxes, and the like.

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(3Q1) – An organization conveys financial information to outside decision makers such as potential investors and creditors. In the business world, what is the most frequent form used for this communication?

(3A1) – Financial information is most commonly communicated to outside decision makers in the form of financial statements. U.S. GAAP specifies the structure and content of these financial statements. Most companies of any size make their annual (and sometimes quarterly) financial statements available in both a printed form and on the company website. Essential financial information should be easily available to any interested party.

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(3Q2) – What individual financial statements are typically included in a set of financial statements?

(3A2) – The basic financial statements are (a) an income statement (sometimes known as a statement of earnings or operations), (b) a statement of retained earnings (often replaced by an expanded statement of stockholders’ equity), (c) a balance sheet, and (d) a statement of cash flows. Numerous pages of notes are also included to provide extensive verbal explanations for the reported balances. (Many companies also report a statement of comprehensive income which will be discussed later in this course.)

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(3Q3) – Revenues and expenses were defined in the previous chapter. What are gains and losses and how do they differ from revenues and expenses?

(3A3) – The term revenue reflects the inflow of net assets from the sale of a good or service. The term expense measures the decrease or outflow of net assets in an attempt to generate more revenue. These terms focus on the primary business activity. Any tangential increase or decrease in net assets not directly related to the primary business activity is reported as either a gain or loss. For a restaurant, selling pizza is revenue but selling a stove creates a gain or loss. The company normally sells pizzas to its customers but not stoves.

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(3Q4) – A company operates a donut shop that produces and sells donuts. On its income statement for the current year, the company reports total revenues of $700,000 and total expenses of $600,000. The company also shows a gain of $30,000 and a loss of $10,000. What do the revenue and expense figures reflect?

(3A4) – Revenue and expense figures represent the effect on net assets resulting from the primary business activity which, in this case, is the sale of donuts. The revenue figure shows the increase in net assets from the sale of donuts and related products (such as coffee). The total expense figure is the cost incurred to generate those revenues such as rent expense, salary expense, advertising expense, and utility expenses. The difference in revenues and expenses is referred to as operating income.

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(3Q5) – A company operates a donut shop that produces and sells donuts. This year, the company reports revenues of $700,000 and expenses of $600,000. The company also shows a gain of $30,000 and a loss of $10,000. What do the gain and loss figures reflect?

(3A5) – Gain and loss figures appearing on an income statement reflect activities that have an income effect but did not arise from the primary business activity. For example, the gain might have resulted from the sale of land located next to the shop. There is an increase in net assets, but it is not directly related to the sale of donuts. The loss might have resulted from a fire in the kitchen. Again, an income effect is created but not one tied directly to the sale of donuts.

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SUGGESTION: Table 3.1 of Chapter Three presents one version of a typical income statement. For the various balances that are reported, note their placement within this statement. Where are revenues and expenses shown? Where are gains and losses shown? The statement is constructed to show the results of primary business activities (operating income) as separate from any gains and losses created by other tangential events.

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(3Q6) – Ace Company is preparing an income statement for its most recent year (ending on December 31, Year Six). To keep from confusing readers about the nature of this statement, what heading should appear above the income statement?

(3A6) – Each financial statement is labeled with the name of the organization, the name of the statement, and the appropriate date or period of time. Ace’s statement will start with the heading below. As shown here, an income statement covers a period of time (usually a year or, perhaps, three months).

Ace Company

Income Statement

Year ended December 31, Year Six

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(3Q7) – Net income is a widely reported number in the business world because it reflects the growth in a company’s net assets during the current period from operations and other related events. Few numbers are more closely studied by decision makers. How is net income determined on an organization’s income statement?

(3A7) – On an income statement, expenses are subtracted from revenues to arrive at operating income, the increase in net assets generated by primary business activities. Next, gains and losses (and a few other nonoperating items) are added or subtracted to arrive at income before taxes. Income taxes are subtracted at the bottom. They are an assessment by the government and do not help generate revenue. The residual figure is then reported as net income. The structure can vary a bit but Table 3.1 is a fairly typical format.

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(3Q8) – On its income statement for the current year, the Warrenton Company reports a $278,000 balance which is labeled as “cost of goods sold.” What information is communicated by this account?

(3A8) – Cost of goods sold is an expense account that reflects the cost of merchandise removed from a company by the customers because it has been sold. Assume a company buys a box of donuts for $3 and then sells those donuts for $5. Revenue is reported as $5 and cost of goods sold (an expense) is reported as $3. Both numbers appear on the company’s income statement causing reported net income to increase by $2.

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(3Q9) – On its income statement for the current year, Enwardo Company reports gross profit of $622,000. What does this gross profit figure represent? What information is being conveyed?

(3A9) – Gross profit (also referred to as “gross margin” or “markup”) is the difference between revenue and cost of goods sold. If a company buys a box of donuts for $3 and later sells those donuts for $5, reported gross profit is $2 ($5 revenue less $3 cost of goods sold). Some companies explicitly report gross profit whereas others let the decision maker determine that figure themselves.

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SUGGESTION: Work the second Test Yourself question in Section 3.1 of Chapter Three (“The Bartolini Company…”). This question was written to allow you to make sure you understand what is included on an income statement. Much of this material is probably new to you. Be certain that your understanding is absolutely clear before moving to the next section. Read the question, come up with your answer, and then read the explanation. Reinforcement is always good for learning.

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SUGGESTION: Work the third Test Yourself question in Section 3.1 of Chapter Three (“The Hayes Company is a…”). This question is designed to make certain that you understand the term “gross profit.”

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SUGGESTION: Read the second section of Chapter Three (“Reported Profitability and the Impact of Conservatism”). Accounting has long been associated with conservatism, but most decision makers do not fully understand the implications of that term. In truth, accounting has a slight bias toward reporting conservatively. However, the effect is not nearly as great as some believe.

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(3Q10) – The Addams Company incurs a cost of $6,000. How does a financial accountant determine whether an asset or an expense should be reported as a result of this $6,000 cost?

(3A10) – When a cost is incurred, an asset is recognized if the company expects a future economic benefit. Thus, a cost is reported as an asset if it will help the organization generate revenue in the future. Conversely, a cost is reported as an expense if it helped generate revenue in the past. For recognition purposes, the financial accountant must identify the revenue created as a result of a particular cost. That has long been known as the matching principle.

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(3Q11) – Jefferson Company incurs a $6,000 cost and is not sure whether the benefit will be derived in the future (the cost is reported as an asset) or has already been received in the past (reported as an expense). There is uncertainty. No clear determination can be made about the timing of any revenue generated as a result of this cost. If an answer is not clear, should the cost be reported as an asset or as an expense?

(3A11) – Financial accounting is conservative. It seeks to protect decision makers by discouraging them from being overly optimistic about a reporting company. If the most likely outcome out of several possibilities cannot be determined or if more than one outcome is viewed as equally likely, the option that makes the company look worse is selected. If no judgment can be made, an expense is recognized and not an asset.

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SUGGESTION: Work the first Test Yourself question in Section 3.2 of Chapter Three (“In a set of financial statements,…”). The company has a prepaid insurance account of $19,000. The title indicates that this amount of money has been paid to obtain insurance coverage for the future. The question looks at how this cost is reported. Choose the one answer that is not true and then read the explanation. Always read each answer until your understanding is clear.

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(3Q12) – One of the vehicles operated by the Madison Company suffers a major wreck. When financial statements are being prepared, the company is not yet sure whether its insurance policy will cover this event or not. Depending on that decision, the company might lose $1,000 or it might lose $60,000. Company officials believe it is 60 percent likely that the insurance policy will cover all of the loss except $1,000 but there is a 40 percent chance of a loss of $60,000. What loss is reported on the company’s income statement?

(3A12) – Financial accounting always seeks to produce a reasonable likeness of a company and its operations and cash flows. Here, the most likely outcome is a loss of $1,000. Therefore, that loss is reported. For proper disclosure, information about the $60,000 possible loss is also explained in the notes attached to the statements. Accounting is conservative but achieving a reasonable likeness takes precedent. The most likely outcome is reported.

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(3Q13) – One of the vehicles operated by the Monroe Company suffers a major wreck. When financial statements are being prepared, the company is not yet sure whether its insurance policy will cover this event or not. Depending on that decision, the company might lose $2,000 or it might lose $80,000. Company officials believe it is 50 percent likely the loss will prove to be $2,000 and 50 percent likely that it will be $80,000. What loss is reported on the company’s income statement?

(3A13) – Here, two potential losses are equally likely. In that situation in financial accounting, conservatism is used to protect decision makers. Because neither loss is more likely, the worst case is reported. A loss of $80,000 is recognized. Complete information about both possible losses is disclosed in the notes to the financial statements.

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The following statement is from the end of chapter material in the textbook. The answer is false. Explain why this statement is false. If a company has a possible loss, conservatism requires that this loss must always be reported.

The previous statement is FALSE. Organizations do not report all of their possible losses. In financial accounting, the most likely outcome is recognized which might be little or no loss. Conservatism becomes a factor when outcomes are equally likely. If that occurs, the worst outcome is reported as a way of keeping decision makers from being overly optimistic about the reporting company’s future. Conservatism does exist in financial accounting but it is not obsessive.

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(3Q14) – Jackson Company has had a very profitable year. The board of directors decides to share a portion of these profits with the owners and declares a $1.00 per share cash dividend. How does this dividend distribution to the stockholders affect the net income figure that Jackson Company reports on its income statement?

(3A14) – The issuance of a cash dividend to stockholders has no effect on reported net income. Dividends are not issued in hopes of generating additional revenue. Thus, they do not qualify as an expense. They provide neither a past benefit nor a future benefit. They are merely a sharing of profits with company owners. Dividend distributions are not included on a company’s income statement.

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SUGGESTION: Work the third Test Yourself question in Section 3.2 of Chapter Three (“A company has the following reported balances…”) as well as the One Step Further question. These two problems present a number of reported balances such as revenues, expenses, assets, losses, and dividends. Which of those balances goes on an income statement and is used to determine net income?

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SUGGESTION: Read the third section of Chapter Three (“Increasing the Net Assets of a Company”). The major focus in these pages is on reporting retained earnings. Retained earnings is one of the most misunderstood terms in all of financial accounting. Nevertheless, with a little work, there is no reason why you cannot gain an excellent understanding of retained earnings and the balance it reports.

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(3Q15) – What are the three primary sections of a balance sheet?

(3A15) - A balance sheet reports assets and liabilities. The difference in these two figures is the net assets of the reporting company. The third section of the balance sheet is referred to as the stockholders’ equity section. It informs readers of the source of the company’s net assets. Under normal circumstances, net assets come from the owners (an amount labeled as “contributed capital” or “capital stock”) and operations (labeled as “retained earnings”). Those are the two main subsections typically found in the stockholders’ equity section.

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(3Q16) – A company reports retained earnings on its balance sheet as $105,000. What information is the company communicating with that account balance?

(3A16) – Retained earnings represents (a) all of the net income earned since a company’s inception less (b) all of the dividends distributed to owners during that same period of time. It is the increase in a company’s net assets over its lifetime as a result of operating as a business less the amount of that increase shared with stockholders. (See Table 3.2 and Table 3.3)

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SUGGESTION: When studying the retained earnings balance, look at Table 3.3 and Table 3.4 in your textbook. Table 3.3 presents the net income and dividends distributed over the entire life of a business. It shows the growth in net assets each year from income and the decrease from dividend payments. In Table 3.4, this same information is converted into a statement of retained earnings. The past figures are netted together to provide the opening balance. The current net income and dividends are then included to arrive at the final reported retained earnings total.

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(3Q17) – A company distributes a cash dividend to its owners this year of $90,000. Why is that amount reported as a decrease in the retained earnings balance instead of as an expense in determining the company’s net income on its income statement?

(3A17) – A dividend distribution is not reported on an income statement as an expense because it is not an attempt to generate revenue. Instead, it is a sharing of profits with the owners. The outflow of net assets is reported as a reduction in retained earnings to indicate that this decrease in the size of the company was caused by a distribution of profits to the company owners.

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(3Q18) – A company is started in Year One and earns net income of $100,000 and distributes $30,000 in cash as a dividend to its owners. In Year Two, the company earns another $120,000 and distributes $40,000 as a dividend to its owners. On a December 31, Year Two, balance sheet, within the stockholders’ equity section, what is reported as retained earnings?

(3A18) – Retained earnings is a measure of the portion of net assets that a company holds that were generated by business operations. In the first year, net income was $100,000 and dividends $30,000. Net assets went up $70,000. In the second year, net income was $120,000 and dividends $40,000. Net assets grew another $80,000. The total increase in net assets is $150,000. That is reported as retained earnings at the end of the Year Two. Business activities created that growth in net assets since the company began after deducting the dividends.

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The following statement is from the end of chapter material in the textbook. The answer is false. Explain why this statement is false. Explaining answers is always a good way to learn. A business reports a retained earnings balance of $156,000. This figure represents the monetary amounts contributed to the business by its owners.

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The previous statement is FALSE. This statement claims that reported retained earnings is $156,000 and that the figure represents the amount of money put into the business by the owners. Retained earnings is the increase in net assets over the life of a company generated by the business itself. It is total net income less total dividends. The amount put into a business by its owners is labeled “contributed capital,” “capital stock,” or some similar title.

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(3Q19) – A company has been in business for several years. Net income has been earned each year and a dividend distributed to owners each year. How is this information reported on a statement of retained earnings?

(3A19) – Net income causes a company’s net assets to increase. Dividend distributions cause net assets to decrease. The net growth is labeled as retained earnings. On the statement of retained earnings, the effect of all previous years is shown first as a single net number. Then, the current year net income is reported separately as an increase to that balance (a net loss would decrease it). A current year dividend distribution is shown as a decrease. This format can be seen in Table 3.4 in the textbook.

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(3Q20) – A company earns net income of $80,000 in Year One and distributes a cash dividend to its owners of $30,000. Net income in Year Two is $100,000 and the dividend distribution is $40,000. Net income in Year Three is $140,000 and the dividend distribution is $50,000. How is this information reported on a statement of retained earnings for Year Three?

(3A20) – In Year One, net assets went up $50,000 (net income of $80,000 less dividend distribution of $30,000). In Year Two, net assets went up another $60,000 (net income of $100,000 less dividends of $40,000). The total increase for both previous years is shown on the statement as $110,000 ($50,000 + $60,000). In the current year, that prior net number is increased by $140,000 in net income and reduced by the $50,000 dividend (a net of $90,000) which raises the final retained earnings balance from $110,000 to $200,000.

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(3Q21) – On its balance sheet, a company reports “capital stock” of $42,000 within its stockholders’ equity section. What information is conveyed by that account balance?

(3A21) – Capital stock (also referred to as contributed capital) is a measure of the amount of assets that investors have conveyed to the business since its inception in order to become owners. Hence, investors in this company have given $42,000 (most likely in cash) in exchange for ownership shares. That makes them stockholders of the company. The reported balance shows how that portion of the company’s net assets was derived.

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(3Q22) – A company is created in Year One. Owners invest $13,000 by buying capital stock. The company earns net income of $60,000 in Year One and distributes a $10,000 cash dividend to its owners. In Year Two, owners invest another $9,000. The company earns $70,000 in Year Two and distributes a second dividend of $15,000. What is the company’s total net assets after two years? How does the stockholders’ equity section report this information at the end of Year Two?

(3A22) – Owners put $13,000 into business in Year 1 and $9,000 in Year 2. Capital stock (contributed capital) is reported as $22,000. Business activities in Year 1 created $50,000 growth in net assets ($60,000 net income less $10,000 dividends). In Year 2, the business grew $55,000 ($70,000 net income less $15,000 dividends). Total growth from business activities is $105,000 ($50,000 + $55,000) which is reported at the end of Year 2 as retained earnings. Total stockholders’ equity (and, thus, net assets) is $22,000 + $105,000 or $127,000.

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SUGGESTION: Work the Test Yourself question in Section 3.3 of Chapter Three (“The London Company has just produced …”) as well as the One Step Further question. These problems present a number of reported totals and ask you to make use of the data. Obtaining a knowledge of financial accounting will give you an understanding of the information being reported.

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