Learning Questions and Answers for Financial Accounting, Lesson 3.1 – Mastery Level

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Read each of the following questions. Try to determine as many answers as possible. Mark any questions where you are unsure of the appropriate answer. Then, read the questions again but this time with the answers included. Note the key components of any question that you missed. When you finish, start over with the questions and see if you can answer them all. Repeat the process until you have a strong knowledge of every question and answer. With patience and the willingness to invest your time, you can learn answers to all of these learning questions.

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(1) – Jones Company wants to send out its latest financial information to decision makers. What is the most common way for financial information to be delivered to them? (2) – What is the typical composition of a set of financial statements? (3) – What are the individual statements normally found in a set of financial statements? (4) – Each financial statement is labeled with the name of the organization and the name of the statement. There is also information about the date or dates of the statements. How are financial statements dated?

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(5) – What are the two most important types of information reported on an income statement? (6) – An organization can have dozens, if not hundreds, of different types of expenses. Most such as rent expense are self-explanatory. Most companies report an expense titled, “cost of goods sold,” (or, possibly, “cost of sales”) where the meaning is not so immediately clear. What information does a company convey when reporting cost of goods sold? (7) – Companies will often report a figure on their income statement titled, “Gross Profit.” What is gross profit and why is it important?

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(8) – An income statement reports more than just revenues and expenses. What else will a decision maker find on an income statement? (9) – A company operates a donut shop and made a profit this year. As a result, the company had to pay $36,000 in federal and state income taxes. How are income taxes reported? (10) – The Jones Company has revenues of $600,000 during the current year, expenses of $400,000, gains of $100,000, losses of $70,000, and income taxes of $36,000. What is the resulting total and what is it called?

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(11) – Ace Company spends $18,000 on a specific business activity. Company officials are not sure whether this cost should be reported as an asset or as an expense. How is that decision made in financial accounting? (12) – In the previous question, what happens if Ace Company officials honestly are not certain if the benefit derived from the $18,000 cost will be in the future or in the past? (13) – Why does financial accounting have a tendency toward conservatism? (14) – The Wilson Company has had a profitable year. Near the end of the period, the board of directors meets and votes to distribute a $25,000 cash distribution to all the owners as a sharing of the profits. What is this distribution called? Is this payment reported on the company’s income statement as an expense?

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These questions should give you an excellent overview of the first two sections of Chapter Three. After you have read each question and determined your answer, read my answers (next). Remember that you can MARK any cards that you want in order to return later for additional study. You might also want to make two columns: (A) questions I know and (B) questions I do not yet know. Your goal is to get all of the questions out of column B and into Column A. That is an excellent learning exercise.

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(1) – Jones Company wants to send out its latest financial information to decision makers. What is the most common way for financial information to be delivered to them?

Most organizations gather financial information into a formal structure known as a set of financial statements that are distributed to decision makers and other interested parties every year (and, possibly, more often). Do an Internet search for a company that you find interesting and “financial statements” or “annual report.” In a matter of seconds, you should have access to a vast array of financial information about that organization. Decision makers use that information to make wise decisions.

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(2) – What is the typical composition of a set of financial statements?

Financial statements include several individual statements as well as pages of extensive notes to provide a verbal explanation of the financial information presented in the financial statements.

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(3) – What are the individual statements normally found in a set of financial statements?

An income statement, a statement of retained earnings (or a broader statement of stockholders’ equity), a balance sheet, and a statement of cash flows. As we will discuss later in the course, many companies also report a separate statement of comprehensive income. If you look on the Internet for companies and their financial statements, you will find some slightly different titles but the statements and the included information are basically the same.

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(4) – Each financial statement is labeled with the name of the organization and the name of the statement. There is also information about the date or dates of the statements. How are financial statements dated?

A balance sheet is dated as of one specific point in time. For example, a balance sheet might be for, “December 31, Year X.” All other financial statements are dated for a period of time (such as “January 1, Year X, to December 31, Year X”). These statements describe the financial effect of the events that occurred during that time period.

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(5) – What are the two most important types of information reported on an income statement?

The organization includes all revenues (sales revenue) and all expenses (salary expense, advertising expense, and the like) on its income statement. Any decision maker who wants to analyze an organization will be keenly interested in knowing its revenues and expense and comparing them to previous periods. That information is found on the income statement.

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(6) – An organization can have dozens, if not hundreds, of different types of expenses. Most of them (such as rent expense) have titles that are self-explanatory. Most companies report an expense titled, “cost of goods sold,” (or, possibly, “cost of sales”) where the meaning is not so immediately clear. What information does a company convey when reporting cost of goods sold?

Cost of goods sold is the amount a company paid to acquire the merchandise that it sells. For example, if a company buys a hammer for $24 and sells it to a customer for $40, sales revenue is $40 and cost of goods sold (the related expense) is reported as $24.

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(7) – Companies will often report a figure on their income statement titled, “Gross Profit.” What is gross profit and why is it important?

Gross profit is the difference between revenue for the period and cost of goods sold. If you buy merchandise for $24 and sell it for $40, gross profit is $16. It can also be called gross margin or mark-up. In businesses, it is essential for officials to devise ways to sell items for more than they paid for them. In studying a specific company, decision makers often look for changes in the gross profit over time because that can signal changes in the company’s operations and/or its environment.

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(8) – An income statement reports more than just revenues and expenses. What else will a decision maker find on an income statement?

Gains and losses are also reported on an income statement, usually below revenues and expenses. Gains and losses are events that either increase or decrease an organization’s net assets but are not part of the primary operations. They are sometimes referred to as “nonoperating gains and losses.” Accountants like to separate the results of primary operations from other events that might have occurred. If a company sells hammers but just sold a $10,000 acre of land for $11,000, the $1,000 difference is a gain. It is not a revenue because selling land is not part of primary operations. If a company sells fast food and a delivery truck currently recorded at $25,000 is destroyed in an accident, that is a loss of $25,000 and not an expense of $25,000. The destruction of the truck was related to the business but it was not a typical part of the primary operations.

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(9) – A company operates a donut shop and made a profit this year. As a result, the company had to pay $36,000 in federal and state income taxes. How are income taxes reported?

Income taxes are reported on the company’s income statement. They are often isolated at the very bottom of the statement. They are separated in this manner because they do not qualify as an expense. They do not help the company attain future economic benefits (revenues). They are a government assessment and out of the company’s control. Consequently, they are often reported as just “income taxes” or as a “provision for income taxes.” Although not theoretically accurate, many companies do refer to income taxes as an expense. Financial reporting is not always theoretically pure.

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(10) – The Jones Company has revenues of $600,000 during the current year, expenses of $400,000, gains of $100,000, losses of $70,000, and income taxes of $36,000. What is the resulting total and what is it called?

The final number on an income statement is known as net income. In this case, net income is $194,000 ($600,000 - $400,000 + $100,000 - $70,000 - $36,000). That number is the increase in net assets earned by Jones Company in the current year from operating its business. For decision makers, net income is an extremely important piece of information.

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(11) – Ace Company spends $18,000 on a specific business activity. Company officials are not sure whether this cost should be reported as an asset or as an expense. How is that decision made in financial accounting?

If the benefits of the cost are expected in the future (it helps to generate future revenue), the cost is reported on the balance sheet as an asset. Paying the money to rent a building for next few months is an asset. If the benefits of the cost are in the past (it helped to generate past revenue), the cost is reported on the income statement as an expense. The cost incurred to rent a building last year is an expense. Because of conservatism, if a cost is not clearly an asset, then it is reported as an expense.

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(12) – In the previous question, what happens if Ace Company officials honestly are not certain if the benefit derived from the $18,000 cost will be in the future or in the past?

Accounting is conservative. That means when a reported outcome is uncertain, accountants prefer to report the option that makes the company look worse. In this case, if the company’s accountants did not know whether the cost will provide a future benefit or has already provided a past benefit, they will report the $18,000 as an expense. That makes the company look worse than reporting an $18,000 asset. That is a conservative approach.

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(13) – Why does financial accounting have a tendency toward conservatism?

Financial accounting provides information that decision makers rely on in deciding whether to invest or lend money. If the information is made to look especially good, the decision makers might become overly optimistic and incorrectly invest or lend money which could result in a substantial loss. Conversely, if the information is made to look slightly bad (conservatism), the decision makers might avoid investing or lending money and go on to look for other opportunities. The risk is avoided. Accountants want to avoid being responsibility for the loss of money. If in doubt, they will make conservative decisions.

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(14) – The Wilson Company has had a profitable year. Near the end of the period, the board of directors meets and votes to distribute a $25,000 cash distribution to all the owners as a sharing of the profits. What is this distribution called? Is this payment reported on an income statement as an expense?

This $25,000 distribution is referred to as a dividend. It is not reported on the income statement. It is not an expense because it does not provide any economic benefits for the company. Paying a dividend does not lead to any increase in revenue. It is merely a reward shared with the owners. It is reported on the statement of retained earnings.

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Now, go back through the questions at the beginning and see how many you can get correct. Make good use of these questions and answers. Go through them methodically until you know them all extremely well.

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