Learning Questions and Answers for Financial Accounting, Lesson 3.2 – Mastery Level

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As always, start by reading the following questions. For each question you read, make a list with three columns: (1) Know, (2) Know Somewhat, and (3) Do Not Know. Then, when you get to the answers at the bottom of the list, pay special attention to any questions you have identified in Columns (2) and (3). Never quit until every question is included in Column (1).

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(1) – Alex Company starts its operations as a donut shop on January 1, Year One, and earns net income in this initial year of $100,000. To reward its owners, the company distributed a $22,000 cash dividend to them on November 17. What does the company report at the end of Year One as its retained earnings? (2) – In the previous question, assume Alex Company reports net income of $200,000 in Year Two but also distributed another cash dividend, this time of $50,000. What is the retained earnings balance reported at the end of Year Two?

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(3) – In producing financial statements, a company creates its income statement first and then its statement of retained earnings. Both are dated for the current period of time (normally a year). They both have a heading to identify the company, the financial statement, and the reporting dates. Using the information in the previous question, indicate the structure of the Year Two statement of retained earnings. (4) – Bagley Corporation has net assets (assets less liabilities) of $300,000. The company wants to grow bigger. What are the two normal ways that a company can grow bigger? (5) – Bagley Corporation has net assets of $300,000. The company’s financial statements indicate a retained earnings total of $210,000 and a contributed capital total (or a capital stock total) of $90,000. What information is conveyed by these last two amounts?

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(6) – In the previous question, the owners invested $90,000 in Bagley Corporation by buying its capital stock. Did they buy these ownership shares on a stock exchange such as the New York Stock Exchange? (7) – What is the major purpose of a balance sheet? (8) – Why is it called a balance sheet? Why does it balance? (9) – How are assets and liabilities listed on a balance sheet? (10) – What is meant by the term “current ratio”?

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(11) – What is meant by the term “working capital”? (12) – What are typical current assets? What are typical noncurrent assets? (13) – A company's fourth financial statement is the statement of cash flows. What is a statement of cash flows? (14) – Cash flows are divided into three classifications. One of those is operating activities. Assume that the Candela Company runs a pizza restaurant. For this business, what are examples of cash events that are categorized as operating activities?

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(15) – Cash flows are divided into three classifications. One of those is investing activities. Assume that the Candela Company runs a pizza restaurant. For this business, what are examples of cash events that are categorized as investing activities? (16) – Cash flows are divided into three classifications. One of those is financing activities. Assume that the Candela Company runs a pizza restaurant. For this business, what are examples of cash events that are categorized as financing activities?

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If you have read these questions carefully, you now know which ones you understand and which ones you might not completely understand. Read the answers below. Take good notes. Identify the areas where your knowledge might not be strong and use the textbook or the Guided Readings cards to strengthen your understanding.

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(1) – Alex Company starts its operations as a donut shop on January 1, Year One, and earns net income in this initial year of $100,000. To reward its owners, the company distributed a $22,000 cash dividend to them on November 17. What does the company report at the end of Year One as its retained earnings?

Retained earnings measures the increase in a company’s net assets (from its very beginning) that came about as a result of being a business. Mathematically, it is all net income earned less all dividend distributions since the company first opened. This company started in Year One. Because net income is $100,000 and dividends of $22,000 were distributed, reported retained earnings is $78,000 at the end of Year One. The company’s net assets increased by that amount because of its success in its initial year of business. Net income increased the size of the company by $100,000 but then $22,000 of those net assets were conveyed to the owners. Hence, the growth in net assets has been a net of $78,000. Retained earnings is the accountant’s method for reporting growth from business activities.

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(2) – In the previous question, assume Alex Company reports net income of $200,000 in Year Two but also distributed another cash dividend, this time of $50,000. What is the retained earnings balance reported at the end of Year Two?

The net assets of the company increased by $78,000 in the previous (first) year of operations. The net assets increased by $150,000 ($200,000 less $50,000) in the current (second) year. Overall, the operations of this business have increased net assets by $228,000 ($78,000 plus $150,000) since the company’s inception.

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(3) – In producing financial statements, a company creates its income statement first and then its statement of retained earnings. Both are dated for the current period of time (normally a year). They both have a heading to identify the company, the financial statement, and the reporting dates. Using the information in the previous question, indicate the structure of the Year Two statement of retained earnings.

In Year Two, beginning retained earnings for Alex Company is $78,000 – all of the net income less all of the dividends for all previous years (in this case, that is just Year One). That number is normally found as the ending retained earnings from the previous year. To that figure is added the current net income calculated on the Year Two income statement ($200,000). Then, the current dividend distribution ($50,000) is subtracted to arrive at an ending retained earnings balance of $228,000. That balance is also reported within the stockholders’ equity section of the balance sheet.

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(4) – Bagley Corporation has net assets (assets less liabilities) of $300,000. The company wants to grow bigger. What are the two normal ways that a company can grow bigger?

A company will increase its net assets any year that its net income is greater than its dividend distributions. In other words, it grows through business operations. That is reported through changes in retained earnings. The company will also grow if owners put money into the corporation. That is referred to as contributed capital or capital stock. The owners invest money in the company through the acquisition of ownership (or equity) shares. A company gets larger by its business operations (a larger retained earnings balance is reported over time) and/or by ownership investment (contributed capital gets larger).

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(5) – Bagley Corporation has net assets of $300,000. The company’s financial statements indicate a retained earnings total of $210,000 and a contributed capital total (or a capital stock total) of $90,000. What information is conveyed by these last two amounts?

The retained earnings balance means that all net income since the company began operations less all dividends for the same period totaled $210,000. That figure represents the growth in the size (net assets) of the company from its business activities. The contributed capital (or capital stock) balance tells decision makers that the owners have invested $90,000 in the business which makes it bigger. The $90,000 was contributed in order to acquire ownership shares. Retained earnings and contributed capital are both reported on the balance sheet under the heading of stockholders’ equity. That information provides decision makers with knowledge of how the company managed to attain $300,000 in net assets: $210,000 came from operating the business and $90,000 came from the owners.

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(6) – In the previous question, the owners invested $90,000 in Bagley Corporation by buying its capital stock. Did they buy these ownership shares on a stock exchange such as the New York Stock Exchange?

No. Stock bought on a stock exchange is normally bought and sold between two investors. Investor A buys capital stock directly from the corporation. Then, later, Investor A sells that stock to Investor B possibly on a stock exchange. For the corporation to receive the money, Bagley must sell the stock directly to the owner.

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(7) – What is the major purpose of a balance sheet?

A balance sheet reports a company’s assets and liabilities at one particular point in time, often on the last day of the company’s fiscal year. The balance sheet is not dated for a period of time (as is true for all of the other financial statements) but rather at that one moment in time. Decision makers want to know about a company’s assets and liabilities, and they can find that information on the balance sheet.

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(8) – Why is it called a balance sheet? Why does it balance?

A balance sheet balances because of how it is structured: assets are on one side and liabilities and stockholders’ equity are on the other side. We already know (by definition) that assets minus liabilities equals net assets. We also know net assets (at least in less complex companies) must come from some combination of contributed capital and retained earnings. With replacement, we have a new equation.

Assets – Liabilities = Contributed Capital + Retained Earnings.

If you move the Liabilities across the equal marks, you have the basic structure of a balance sheet as shown in the textbook in Table 3.6.

Assets = Liabilities + Contributed Capital + Retained Earnings

--continued on next card--

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(8) – Why is it called a balance sheet? Why does it balance?--continued

A different way to look at this accounting equation is that assets must come from somewhere. They do not appear by magic. Assets must come from (a) liabilities – companies often borrow money or delay payments of purchases and expenses, (b) the ownership – owners invest money into the business by buying capital stock, or (c) operations – the net asset figure grows because of business activities (net income less any dividends paid). If you want to increase assets, those are the three basic ways. An increase in assets has to come from an increase in liabilities, an increase in contributed capital (capital stock), or an increase in retained earnings (net income less dividend distributions).

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(9) – How are assets and liabilities listed on a balance sheet?

Assets are normally listed as current assets (those that are expected to be consumed or used within one year) and noncurrent assets (all other assets). Liabilities are listed as current liabilities (expected to be satisfied within one year) and noncurrent liabilities (all other liabilities).

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(10) – What is meant by the term “current ratio”?

The current ratio is a company’s current assets divided by its current liabilities. It is a sign of a company’s liquidity—the ability to pay debts as they come due. Within a reasonable range, a higher current ratio is considered to be better for a company.

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(11) – What is meant by the term “working capital”?

Working capital is a company’s current assets less its current liabilities. Again, it is a measure of liquidity. Decision makers often compute and monitor a company’s current ratio and working capital to look for any signs of possible liquidity problems.

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(12) – What are typical current assets? What are typical noncurrent assets?

Current assets often include cash, receivables from customers (called accounts receivable), inventory, and supplies. As we will see later, prepaid expenses and short-term investments are also current assets. Noncurrent assets include buildings, land, equipment, and the like. These assets are expected to be used long beyond one year.

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(13) – A company's fourth financial statement is the statement of cash flows. What is a statement of cash flows?

Decision makers are interested in where an organization gets its cash and what it does with it. The statement of cash flows takes all individual cash flows for the year and divides them into three classifications: operating activities, investing activities, and financing activities. The statement of cash flows is examined in-depth in a later chapter of the textbook.

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(14) – Cash flows are divided into three classifications. One of those is operating activities. Assume that the Candela Company runs a pizza restaurant. For this business, what are examples of cash events that are categorized as operating activities?

Operating activities encompass all cash transactions that occur as part of the day-to-day actions of the business. That would include: cash from selling a pizza, cash from selling soft drinks, cash paid to employees, cash paid for rent, cash paid for cheese, and the like. Those typically happen on a very regular basis as part of normal business operations.

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(15) – Cash flows are divided into three classifications. One of those is investing activities. Assume that the Candela Company runs a pizza restaurant. For this business, what are examples of cash events that are categorized as investing activities?

First, an investing activity is not part of a company’s daily business operations. Second, it involves an asset. As an example, cash received from the sale of land is shown as an investing activity for a pizza restaurant. Cash paid to buy a stove or a refrigerator is an investing activity. In each of these cases, an asset is involved (land, stove, or refrigerator) but the transaction is not a typical part of the daily operations of the pizza business.

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(16) – Cash flows are divided into three classifications. One of those is financing activities. Assume that the Candela Company runs a pizza restaurant. For this business, what are examples of cash events that are categorized as financing activities?

First, a financing activity is not part of a company’s daily business operations. Second, it involves either a liability or a stockholders’ equity account. Cash received from borrowing money on a loan is a financing activity. Cash paid to distribute a dividend is a financing activity as is cash received from issuing capital stock to an owner.

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When you can achieve an understanding of all of these questions and answers, you should be ready to move to our next step. In this program, you are creating a very methodical but incremental path to understanding and, hopefully, success.

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